In any investing environment, there are winners and losers. During crisis environments, the winners are often big winners while the losers are often big losers. Who is poised to come out ahead during the COVID-19 crisis, and who is poised to fall behind?
Where The Money in Distressed Debt Is Flowing Today
In recent years, several prominent real estate funds have emerged that allow investors to pool their money into mutual fund-like securities offered by public real estate companies. Unlike REITs, they typically do not pay ongoing dividends. Instead, investors seek to gain returns through the appreciating value of the underlying assets. COVID-19 is proving to be a unique opportunity for some distressed real estate fund investors, but it could prove to be a pitfall for others.
According to Business Insider, more than $10 billion is about to pour into the real estate sector through distressed debt instruments.
One of the properties responsible for this new opportunity is the Williamsburg Hotel in Brooklyn. Benefit Street Partners is seeking to sell $80 million of distressed debt tied to the hotel. This is not surprising since COVID-19 essentially killed the hospitality industry overnight. That means debt tied to hotels across the country could hit the market in the next few months simply because hoteliers and other industry service providers are seeing a major drop in business due to fewer people traveling. Even with local economies beginning to open up across the nation, the hotel industry is going to struggle to return to its 2019 glory, and it could be a couple of years before it fully recovers. That spells opportunity for investors with cash to buy up the billions of dollars in debt that hotels, as well as food and beverage, restaurant, and tourism companies, have floating around.
Kayne Anderson in Florida raised $1.3 billion in two weeks and ended up turning investors away.
There were 939 commercial real estate funds globally in early April. At that time, they were seeking to acquire almost $300 billion in debt. One estimate in early May concerning the rate of delinquent commercial mortgages was 11 percent. As the economy continues to struggle, this number could go up by the end of the year even if every state opens up its economy completely by the end of this month (which is unlikely). The commercial real estate sector will continue to struggle and we’ll see more distressed debt hit the market as lenders seek to reduce their dry powder inventory.
In essence, firms in industries where the debt-to-equity ratio is high and where COVID-19 has impacted market forces negatively are likely either looking for buyers now for their distressed debt or soon will be.
Who Is Buying Up Distressed Real Estate Debt?
Cash is king. Investors sitting on piles of it have the best opportunity to purchase distressed real estate fund debt in the short term. They not only have the cash to make purchases, but they also have the opportunity to get to that cash quickly and to close deals as struggling lenders seek to recapture liquidity.
Lenders in industries impacted negatively by COVID-19 face a high number of probable defaults. If they can’t sell loans at a discount and regain their financial strength, these lenders will likely fold. Many of these lenders are small or alternative lenders that rose up on the heels of the last financial crisis but which have not navigated through a difficult economy until now. COVID-19 is their stress test.
One industry that is seeing huge fallout from COVID-19 is the retail sector, which was struggling before the current crisis as technology firms like Amazon and Overstock ate into their market share. Neiman Marcus and J Crew are among several retailers that have already filed bankruptcy in 2020. JC Penney is preparing to file and could do so by next week. As brick-and-mortar retailers close store locations, commercial landlords and commercial new construction will suffer (one notable exception is multifamily). If store locations are tied to capital investment, much of that debt will likely find a new home by the end of the year.
It’s likely that large traditional investment firms like Blackstone and Starwood Capital Group are going to swipe up a lot of the debt (and not just in retail). According to Morningstar, they are sitting on billions of dollars in cash and cash equivalents.
Greystone & Co. set up a $400 million fund to buy distressed real estate debt, but, according to company CEO Stephen Rosenberg, the company is wary about buying up debt too soon due to prices going lower rapidly and little market liquidity. In March, Florida-based Directed Capital purchased $10 million in loans for $7.4 million. Some of the investors targeting distressed real estate debt began to look for the opportunities in December, attempting to get ahead of the game.
Preqin reported that private equity firms have been building up distressed debt funds and was holding $77 billion in dry powder in 2019.
There is no doubt that 2020 will be a year of huge capital shifts toward major investment firms, private equity companies, hedge fund managers, and financial institutions that have the cash to buy up distressed debt as smaller players crumble, fumble, and fall to the ground. This will likely trickle down to smaller firms, which will scoop up the deals the larger players take a pass on. Investors looking for a rich opportunity may begin shifting their portfolios to increase liquidity so they can grab the tail end of this opportunity at the end of the cycle.
Where Real Estate Debt is Struggling In 2020
Marriott International carries $12.2 billion in debt and saw a 92 percent decline in Q1 2020 earnings compared to Q1 2019. Struggling to manage liquidity, the hotel chain will continue to struggle as long as shut down orders and social distancing remain in place. The hospitality industry will likely be impacted by COVID-19 for a couple of years.
Related industries such as the airline and cruise industries, as well as entertainment, have been similarly impacted by COVID-19.
The events management industry has also been affected as people are not gathering in large crowds anymore. That includes business conferences, rock concerts, and venues people rent for family reunions, graduations, and weddings. The food beverage, restaurant, and retail sectors are also struggling. These industries tend to be heavily invested in real estate. Companies in these industries with low liquidity and high debt will have to fight to maintain financial health. Their lenders will likely sell at least a portion of the debt in order to manage their own financial health, and that translates into opportunity for debt investors.
Auto sales are down 47 percent in the last month.
What each of these industries has in common is a high dependency on real estate. By the same token, these seven industries with high unemployment due to COVID-19 all rely heavily on commercial real estate development. As companies in these industries restructure their debt load, some of that will likely end up in the hands of investors ready to seize upon the opportunity. You could be one of them.
States are beginning to re-open their economies, albeit some will move slower than others. The weather is warming and optimism is on the rise. While some business sectors—such as retail and tourism—are still suffering from the sudden downturn and the economic lockdown, others saw a surge as a result of the COVID-19 pandemic. Now that we are beginning to re-open the economy, will real estate return to its former state of glory? If it does, real estate professionals around the country may have opportunity zones to thank for it. Here are some ways opportunity zones could pull real estate back up again.
A Brief on Opportunity Zones
Opportunity Zones were created when Congress passed the Tax Cuts and Jobs Act of 2017. In short, these zones were designated as economically distressed zones that provide specific tax benefits to real estate developers in order to revitalize these areas and spur economic development. You can learn more about opportunity zones here.
Fix-and-flip investors have been operating in distressed neighborhoods for years, and fix-and-flip lenders have funded them. The opportunity zones legislation opened the door for alternative lenders to get in on the action. As a result, it opened the door for other real estate developers, including commercial and new construction developers, to operate with more confidence in those areas. Many of these new players were barely getting started, or were in the middle of huge projects, when the coronavirus pandemic hit and the economic lockdown began to implemented. It left their projects in limbo. The question is, will they, or can they, recover?
Opportunity Zone Deadline Extensions
In March, President Trump declared every state, the District of Columbia, and four U.S. territories major disaster areas. According to Polsinelli, these disaster areas will extend important deadlines for qualified opportunity zone investments.
The two deadlines affected are:
- The 31-month deadline for spending cash or other financial assets held by a qualified opportunity zone under the working capital safe harbor plan; the extension is for an additional 24 months.
- Capital received from the sale of a qualified opportunity zone fund; the extension is for 12 months to reinvest the funds in order to count them in the fund’s 90 percent asset test.
The working capital safe harbor extension can be used for qualified opportunity zones in any federally declared disaster area. That means real estate developers and investors in virtually every state could have some relief with this extension. There may be limitations, so Sharestates recommends you get your tax advice from your tax advisor and legal advice from your attorney. Nevertheless, these extensions could provide welcome relief to some opportunity zone investors.
Is Real Estate Development on the Road to Recovery?
While there are some signs of certain sectors of the economy beginning to open back up, there is still a lot of uncertainty surrounding the economy and COVID-19. For instance, researchers still are not sure how the virus will respond to warmer weather or whether it will return in the fall. Furthermore, will opening the economy cause a resurgence in cases even though many states are beginning to flatten the curve? These are some of the unknowns.
Despite the unknowns, state government is beginning to develop plans that allow people to get back to their normal lives. These include continued social distancing measures, mandatory face masks, and enhanced business practices such as reduced shopping hours, limits set on customers per square foot, and limits on how many cash registers can remain open at one time. The idea is to mitigate the effect of the virus and limit its spread while people are allowed to continue their normal routines as much as possible. The question is, will any of this allow the real estate markets to recover and, if so, how quickly?
One sector of real estate that has taken a huge hit is commercial real estate. CBRE predicts a long recovery. That’s possible since office leasing has slowed, the retail sector has slowed, and certain commercial industries such as travel and tourism have come to a halt.
The Motley Fool reports that rents were down initially, particularly right after lockdowns were implemented and in cities where shelter-in-place orders came early on. However, in April, they started going upward again. That’s likely due to the stimulus legislation that was passed as renters began to receive their direct deposits toward the end of the month. Some employers are also beginning to let at least some of their employees start work again, and unemployment insurance has some workers opting to remain at home instead of returning to work. So paying the rent isn’t as big an issue as it was.
If the virus threat continues, however, unemployment and economic stimulus packages will taper off. Some employees could find themselves out of work permanently as businesses shoulder the burden of lower profits due to limited operations. Renters may want to renegotiate rent agreement with their landlords or seek smaller rental units. Ultimately, the rental market will likely recover faster than other areas of real estate, especially if some homeowners end up losing their homes.
In Michigan, commercial developers and construction will be resume operations, with some restrictions, on May 7. Other states are beginning to open up, as well. Still, lost revenue from ceasing operations will be a factor in how quickly the construction sector can recover.
Invesco portfolio managers predict three areas of real estate that will likely recover more quickly than others. These include:
Multifamily certainly has the potential to come out of the COVID-19 crisis more quickly than other real estate sectors. With office space, leasing is more likely to recover more quickly than new construction. The logistics sector also has high potential because even online retailers and digital businesses need warehouses and transportation centers. That need is not going to go away. However, it’s possible that the sector could adapt to a new reality post-pandemic.
How Opportunity Zones Could Play a Part in Recovery
Since opportunity zones provide tax benefits for developers and real estate investors, recovery from the pandemic could lead to more real estate professionals to seek these benefits. It’s likely that new opportunity zone projects will focus on sectors that recover more quickly, and since the focus is on economic development in distressed areas, multifamily investment seems like a likely candidate for new investment.
It also seems likely that new projects could focus on smaller spaces, and new and creative ways to look at new construction and development could also arise to facilitate “the new normal.”
In terms of total recovery, the picture is going to look different for each real estate sector and for each geographic region. Some will recover faster while others struggle. Investors will have to scrutinize every opportunity and be discriminatory in which deals they fund. Due diligence will likely require more nitpicking for a while.
Before COVID-19 made its impact on private lending, there was a new trend developing in correspondent lending. In essence, lenders sitting on too much capital and not enough deal flow were lending to other lenders. It was the fastest-growing space in private lending.
All of a sudden, mortgage refinancing surged while demand for personal lending dropped. Small business lending is soaring. Is there a new normal in lending, or will we go back to the old normal once the current crisis is over?
Business Cycles, Black Swans, and Private Lending
Businesses cycles come and go. There are boom and bust cycles in every sector. We’ve seen various cycles in mortgage lending, real estate, banking, retail, e-commerce, financial services, and more. The savvy investor learns to anticipate the business cycles and develops an investment strategy for each type of cycle. Some investors don’t change their strategies from cycle to cycle but may focus instead on priorities, the value of their investments, or their asset class mix. Private lenders would do well to pay attention to the cycles, as well. That said, there are times when an unexpected black swan event throws a wrench in the business cycle. COVID-19 is such an event.
Heading into 2020, almost every economy around the world was expanding. Many of those economies, the U.S. included, were maturing in that expansion. Since the coronavirus outbreak, however, there have been disruptions on several levels.
For instance, here are a few ways COVID-19 has disrupted the global economy:
- U.S. import and export activity has declined significantly
- Labor market concerns have risen
- Federal Reserve interest rates have been cut sharply
- U.S. Treasury yields have hit historic lows
- Volatility is the order of the day
The list of black swan events that have suddenly made big economic impacts is diverse. War, famine, terrorist attacks, nuclear reactor meltdowns, stock market crashes, and technological failures, just to name a few. The curious nature of black swan events is that they are unpredictable. These are events that no one could foresee but that pack huge financial implications across one or more economies.
What’s interesting about black swan events is that they often create opportunities as they are shutting the door on others. Famed Wall Street trader Jesse Lauriston Livermore turned short positions into $100 million during the stock market crash of 1929, while others were losing their fortunes. While COVID-19 has led to massive unemployment and short-term small business closures, many private lenders are seeing a surge in loan applications. In short, business cycles can be relied upon to an extent, but unexpected events can cause disruptions to those cycles that can benefit those keeping their eyes open for new opportunities.
How to Protect Your Investments in An Age of Volatility
Emotional selling is often the worst thing an investor can do in times of uncertainty. That doesn’t mean investors should hold onto all positions indefinitely. But if you have your investment strategy thought out before a crisis hits, you’ll fare better during the storm.
What can private investors do right now to ensure assets are protected during this turbulent time? Here are a few ideas:
- First, don’t panic.
- Look for where the market is moving right now. Private lending has picked up in some areas. Due to a rise in unemployment and the inability of many renters to pay their rent and homeowners to make their mortgage payments, federal and state governments are issuing relief packages for small businesses. Those businesses that survive through the pandemic crisis may be in the market for a private loan on the other side.
- Try to identify short-term opportunities whenever possible. Until investment markets return to normal and regain some stability, volatility will be the norm. That doesn’t mean “sitting out” is the best strategy.
- Look at previous crises and see if you can find any patterns. Commercial real estate has often done well when residential struggled, and vice-versa.
- Continue to diversify your portfolio. Now might be a good time to look at your asset class mix. Is it heavily weighted toward an asset class that is struggling amid the current crisis, or heavily weighted toward high-risk investments? You might shift some of your assets to an asset class that will serve as a hedge against potential losses in those sectors. But keep in mind that short-term volatility may not affect the long-term position of individual assets within that asset class.
- Realize that, more often than not, real estate typically fares better long-term even if it struggles during short-term crisis moments.
- Don’t be afraid to adopt a wait-and-see attitude. Every investment portfolio is different. You only lose if you sell at the wrong time. Just because an asset’s value has been affected by the current crisis, that doesn’t mean that an asset’s value will remain at its current position after the crisis has passed. There is some talk of re-opening the economy in a couple of weeks. Whether that happens or not, and, if it does, how it happens could mean another shift in market forces that could send a ripple through the economy that counteracts recent market moves.
None of this should be construed as investment advice. You should talk to your financial advisor before making decisions regarding your portfolio, but panic selling is almost always a sure losing strategy, so don’t be overrun with emotion.
How Private Lending is Poised to Change in 2020
It is likely that private lending practices, including underwriting, will change in the short term. No one can be certain how COVID-19 will impact private lending long term. A lot depends on whether or not the economy can get back to normal soon, and how quickly it gets back to normal. That, of course, depends on how soon health and infectious disease professionals can develop a vaccine for the coronavirus and how soon cases of COVID-19 decline over the next few weeks. These are unknowns.
Sharestates is continuing to monitor the private lending industry and the economy overall. Meanwhile, investors should consider that loan underwriting practices are likely to change for the foreseeable future. Lenders are already tightening credit standards. In cases where lenders have been sitting on a lot of capital, those lenders run the risk of too rapidly approving loans and placing that capital at risk. That will require additional control measures to ensure that lending too often and too quickly does not place lenders and investors at risk. That may include a cap on loan originations, loan amounts, and some restrictions on the types of borrowers allowed for such loans.
While uncertainty increases investment risk for lenders and investors, sitting out could be a greater risk. Investors may have to look harder for good deals in this environment, but they do exist.
Housing-related stocks such as Zillow and Redfin fell by more than 10 percent on Wednesday, April 1. It appears these stocks may be responding to mortgage applications falling 24 percent, well beyond expectations, from a year ago due to increased concerns over the spread of the coronavirus. Many economists are predicting that COVID-19 will lead us into a recession. We’re already seeing some fallout in the lending capital markets.
3 Ways COVID-19 Is Impacting the Home Buying Process
In the week ending March 28, 6.6 million Americans filed for unemployment. Half that many filed the week before. Globally, more than 1 million cases of coronavirus have been charted with nearly a quarter of those in the U.S. Several states have issued shelter-in-place orders or lockdowns while others have ordered mandatory quarantines for incoming visitors, and some have issued curfew orders. These restrictions are causing havoc in the real estate market in very real ways.
Here are three ways COVID-19 has impacted the home buying process and will likely continue to impact the home buying process:
- Some states have shut down nonessential businesses, or businesses that are not “life sustaining.” As a result, real estate services such as appraisals and inspections can’t be scheduled in those states. Since homes can’t sell unless those services are performed, the effect is a slowdown in home sales.
- Social distancing is affecting all areas of real estate. Agents are reluctant to schedule open houses while mortgage brokers and title companies are moving services online, facilitating digital transactions rather than in-person meetings.
- One couple in Connecticut found themselves juggling dates and working through a difficult moving process as a result of government-mandated policies.
Other real estate sectors being impacted by the coronavirus crisis include property management, commercial real estate, and new development funding.
3 Real Estate Sectors Hit Hard by COVID-19
COVID-19 is pulling at the fabric of real estate in multiple ways. Here’s how it is impacting three real estate sectors that have enjoyed a long run of prosperity since the 2008 financial crisis.
In the property management sector, millions of unemployed tenants are unable to pay rent. While many have filed for unemployment insurance, it takes a few weeks to receive the first check. Treasury Secretary Steven Mnuchin said in a press conference on April 2 that the first stimulus checks will arrive in people’s bank accounts within two weeks. Still, many people have a rent payment due this week. Some tenants are asking for rent forgiveness during the crisis while some states, including New York, have placed a moratorium on evictions.
Property management firms are caught in the middle, balancing the concerns of both tenants and landlords. Of course, if they’re not collecting rents, they aren’t collecting management fees.
Commercial Real Estate
Retail shop closures are also having an impact in several ways.
- Malls, shopping centers, and other tenant-based complexes may not collect rents from their commercial customers during this time
- Force majeure clauses are allowing commercial developers to break commitments to completeprojects by a certain deadline
- New project developments are seeing delays as many construction crews are out of work due to stay-at-home orders and nonessential business closures
New construction is being impacted in residential, commercial, and industrial sectors. That means there are many developers and project managers out of work, along with their entire employment force including contractors and subcontractors. Of course, that’s having a domino effect on mortgages, rental agreements,
and maintenance sectors.
Even in states where stay-at-home orders and business closures have not been implemented, there has been a slowdown in development.
This, of course, is impacting how and where capital is being deployed in real estate.
How COVID-19 is Impacting the Real Estate Capital Markets
While the real estate market has been impacted at the ground level, the impact may be felt the hardest in the capital markets. Deal flow in private equity and real estate has fallen at an unprecedented global level. The Motley Fool recently reported the 10-year treasury hit an all-time low of 45 basis points after rising to an all-time high of 1.226%. This short-term volatility creates uncertainty, and investors don’t like uncertainty. The fallout is being experienced in the secondary market.
Mortgage bankers often sell loan originations to be packaged into mortgage-backed securities on the secondary market, then hold onto the loans. Recently, brokers have been issuing margin calls. As a result, lenders are seeing their liquid assets evaporate.
This creates a new problem for private lenders. Without working capital, they can’t issue new loans. That, in turn, could create a ripple effect throughout the real estate markets. Developers who can’t get loans can’t build. Rehabbers who can’t fund their projects will buy fewer properties, and they’ll sell fewer properties. Less capital in real estate means fewer real estate deals in all sectors–residential, commercial, and industrial.
Private real estate lenders facing a liquidity challenge amid current and sudden volatility need a capital infusion to continue operating and service the increased demand in loans caused by the rapid unemployment and business closures. That’s why Sharestates has issued a margin call relief program.
The Importance of Capital Liquidity in Real Estate Private Lending
Lenders without capital are like boats without water. The change in environment doesn’t change their nature, but it does affect their ability to function as intended.
While the CARES Act can assist families struggling with paying their mortgages, as well as businesses struggling due to closures, it does little to address the needs of private lenders who have seen their liquid assets drain as a result of margin calls.
The Federal Reserve, in mid-March, lowered its benchmark interest rate to 0%, but that’s done more to hurt the capital markets than help. If private lenders run for too long without liquid capital, it will seriously curtail their ability to issue new loans and maintain operations. The largest operational expense for most businesses, including private lenders, is payroll. Without working capital, private lenders will have to lay off some of their staff. Not only will that hamper their ability to service existing loans, but it will also add to the already skyrocketing unemployment rate. For small lenders, any reduction in employment staff could be drastic.
Additionally, lack of liquid operating assets could cause some lenders to miss mortgage or rent payments on their office space, which would seriously diminish their ability to continue operating.
The most likely scenario would be unnecessary consolidation in the lending market. As smaller lenders struggle to survive through the temporary turbulence, they may find their only option is to merge with a larger lender, sell their loans at a discount, or sell part or all of the business to larger lenders or investor pools for less than the company is actually worth. The best option for most of these lenders is to sell some of their existing loans at a discount so they can continue to underwrite new loans and navigate through the coronavirus crisis intact.
Liquidity is the backbone of private lending. Capital is to loan originations as water is to boats. For more information on Sharestates’ margin call relief program, click the button below.
Since the Great Recession, there have been hundreds of new entrants into the alternative lending space. One of the fastest-growing areas of interest has been debt funds and real estate debt funds in particular. In fact, there were a total of 247 private real estate debt funds that closed between 2008 and January 2015. Those debt funds raised a total of $101.8 billion in institutional investor capital. To get a handle on these private lending real estate debt funds, it’s important to understand the capital stack. What makes up the capital stack, and who has the priority?
The 4 Major Tiers of the Real Estate Capital Stack
Generally speaking, there are two positions in any investment: Debt and equity.
Within these two private investment categories, there are varying degrees of capital investment. The priority of investment return is determined by where the investor sits in the capital stack. In the simplest terms, debt investments have the highest priority while equity investments have the lowest. Unfortunately, few investments are that simple.
There are generally two types of debt. Senior debt is the first lender. This position on the capital stack entitles the investor to the first right of returns. In other words, when it comes to paying off the investment, if a deal is profitable enough to begin paying off investors, the senior lender is the first to be paid back.
What it boils down to is senior debt must be paid off before equity investors see any investment returns. The pay off is, equity investors generally see higher returns due to the higher risk factor.
Junior debt is any secondary loan taken out on a real estate deal. Often called “mezzanine debt,” these loans are riskier than senior loans. They are made with higher interest, and often, stricter terms. Because of the increased risk, the return on the loan is generally higher than the return for senior debt. If a deal goes south and doesn’t earn enough to pay off the first loan, the junior lender absorbs the loss.
After all, debt has been paid off on an investment, equity investors can receive returns. The two most common forms of equity investments are preferred equity and common equity. Preferred equity has the highest priority.
Similar to the difference between senior debt and mezzanine debt, common equity is riskier and therefore is subject to higher returns, but it has the least priority on the capital stack.
To further complicate the structure of the capital stack, preferred equity and mezzanine debt are often referred to as “bridge financing.” That’s because they are often issued in the middle of a project and are often used by developers and deal sponsors to raise capital in the midst of an ongoing project. That is, when further capital is needed to see a project to completion, developers look for bridge financing.
The capital stack looks like this:
The Emergence of Debt Funds Post-Financial Crisis
In recent years, changes to the debt financing landscape have made debt instruments in real estate more rewarding and attractive for investors. The advent of online lending, and the increase of alternative lenders after the passing of the JOBS Act of 2012, has made debt funding more attractive and lucrative for investors while providing some of the same benefits as equity investments. As a result, the alternative lending sector is much more competitive.
New technology has led to new and innovative approaches to lending. Real estate crowdfunding has exploded while securitizations have become more common for startups looking for operating capital. For the investor, these business models represent a steady income with a lower risk threshold.
One emerging investment product is a debt fund. A debt fund is a pooled investment where investors combine their capital to take advantage of new opportunities for returns that were not available to them just a few years ago. Quite often, these funds invest in a diverse range of fixed-income opportunities from commercial real estate to long-term bonds. Generally, the fees are lower than those for traditional equity funds due to lower management costs.
Another unique aspect of a debt fund is the distributed risk factor. Because debt funds invest in a variety of securities with different risk profiles ranging from low risk to very high risk, investors spread their overall risk among the various investments in the fund. Operating like a mutual fund, investors also mitigate risk by sharing it with other investors.
How Real Estate Debt Funds Compete Using the Capital Stack
The key to attracting investors with any debt instrument is to create a product that appeals to their interests. Generally speaking, investors want low risk and high returns. Not all investments, however, can offer both simultaneously. Investments have traditionally worked this way: The higher the risk, the higher for potential returns; lower-risk investments generally offer lower returns.
The increase in real estate debt funds, on the other hand, has turned this traditional model on its head. Debt fund managers can use the capital stack to offer competitive investment opportunities for investors. Here’s how.
- Diversification – Lending is risky. Even senior debt, the highest priority on the capital stack, offers some risk. By diversifying the debt instruments within the real estate fund across multiple opportunities, the risk to the investor is mitigated as opportunities within each fund act as a hedge against each other.
- Focusing on the lowest risk categories – Even though diversification lowers the risk threshold, the rise in real estate lending in the last decade has offered debt fund managers plenty of opportunities to focus on senior debt, the lowest risk category on the capital stack. Fund managers can still diversify within that category and remain competitive. Every investment in the fund still has a higher priority than mezzanine debt and equity investments while offering respectable returns.
- Steady and frequent returns – Rather than tie up investor capital on long-term debt instruments, today’s debt fund managers can focus on short-term investments that provide higher returns even while diversifying portfolios. These opportunities generally yield income monthly until debt instruments are paid off.
- Rotating opportunities – Since debt fund managers focus on short-term debt opportunities, frequent maturation is a built-in component of real estate debt funds. That means fund managers must replace maturing instruments with new investment products on a regular basis. Therefore, investors often see a 100 percent turnover in investment opportunities within the fund every 12 to 24 months. These rotating opportunities serve to lower risk, diversify the fund portfolio, increase returns for investors, and offer a steady income.
Thanks to the rise of real estate debt funds, investors have better opportunities for returns than ever before. Many lenders focus on single investment types such as multifamily or commercial while others diversify their offerings across several types of investments. When performing due diligence, investors should ask how debt fund managers select the investments that are featured in their funds.
In today’s real estate lending landscape, platforms that offer debt funds for investors must offer investors high-return opportunities while mitigating risk. Using the capital stack to build the fund portfolio is the best way to achieve the best possible rewards.
Fix-and-flip investors take great care in buying properties. The BRRRR process involves some math. To ensure a profit on the back end, you have to buy right on the front end. That means calculating purchase price and rehab costs to figure total investment and comparing that to expected sales price at the completion of the project. Investors generally look at loan-to-value (LTV) ratios and after repair values (ARV) to determine whether a project is a good investment or not.
Another strategy called Buy, Rehab, Rent, Refinance, Repeat (BRRRR) is emerging in the real estate investing marketplace. It’s not new, but it does offer some advantages to a straight fix-and-flip strategy. Let’s discuss those.
Buy the Right Property at the Right Price
There are two types of fix-and-flip projects that fit into the BRRRR strategy. One is where the investor goes into the project knowing in advance that he will rehabilitate the property and convert it into a rental property, adding it to his buy-and-hold portfolio. In that case, the investor must calculate expected rents and determine if it will lead to cash flow, or determine if there is potential equity after holding for a few years. If property values go up, he can sell the property later for a nice return.
The other type of fix-and-flip project that might end up in a buy-and-hold portfolio is one that was intended to be sold immediately after repairs, but a change in market conditions has caused the investor to change his strategy to buy and hold mid-stream.
In either case, buying the property at the right price is essential to getting the return on investment expected.
Rehabilitate the Property
Whether you intend to flip the property or convert it to a rental, the rehab part of your project is very important. You don’t want to spend too much money on the rehab or it will eat into your profits. On the other hand, you want to ensure the property is functional after the repairs have been made. If possible, you want to focus on repairs that also add some value to the property, which is very important if you intend the sell the property later.
Rent to the Right Tenant
In a typical fix-and-flip project, immediately after the rehab phase of the project you’ll move into sales mode and try to find a willing buyer as soon as possible. Holding properties cost you money. However, if you are transitioning to a buy-and-hold strategy, then you’ve got to turn the property into a revenue generator as soon as possible. That means you need to find a tenant as soon as possible.
You want to do this before you refinance because most banks don’t want to refinance a property that isn’t occupied. Having an occupant will increase your chances of refinancing.
Refinance to More Favorable Terms
In order to refinance, you need to ensure you have some things in place first. For starters, you’ll need an appraisal.
As soon as you have tenants in place, make sure they know an appraiser will be stopping by to look at the property. You don’t want to surprise them. After you get your appraisal, interview a few banks and compare terms. Find out if the bank offers cashouts. If not, you want to find another one. The cash out is very important in the BRRRR strategy because it reduces your risk. Secondly, find out how long the bank’s seasoning period is. In other words, how long do you have to own the property before you can refinance it?
Seasoning periods are important because if you get stuck in a high-interest loan for long, it will slice into your profits. You want to get your interest down as soon as possible.
Repeat and Profit
When you find a strategy that works, you want to repeat it. Many buy-and-hold investors find that they like the BRRRR strategy and continue to implement it into their portfolios. There are several ways to do this:
- Go all-in – Some fix-and-flip investors convert to the buy-and-hold strategy completely. There are advantages and disadvantages to doing so. If you go all in, you’ll have a large portfolio of properties in your inventory that could be difficult to sell later if the market turns. It could also lower your liquid cash reserves as your capital will be tied up in properties. On the other hand, flipping produces short-term returns and higher capital reserves, which translates into more money for buying properties.
- Half and half – More popular than going all-in is the half-and-half method. Some fix-and-flip investors convert every other property into a buy-and-hold property. In effect, they flip one then hold one. That way, they can keep the short-term returns coming in while building their buy-and-hold portfolio.
- Create your own mix – Maybe you’d prefer to flip 60 percent of your portfolio, or one-third buy-and-hold matches your risk tolerance better. Creating your own strategy can also make you feel like you have more control.
The Benefits of the BRRRR Strategy
In a rising market, it’s usually better to buy and hold. The downside is, it is difficult to time the market. There is no fail-safe way to know the best time to sell. That’s why many BRRRR strategy investors use a 5-year benchmark. They buy, rehab, rent, refinance, and repeat, and in the fifth year, they put the property up for sale.
Using this strategy means you’ll always have properties on the market after the fifth year. If you buy your properties wisely, even in a market hostile to sellers, you could see returns on these transactions.
It’s still important to buy right. Using the same LTV formula you use for fix-and-flip properties will keep you on the right track. If it works for flipping properties, it should also work for your buy-and-hold strategy. The snag will be if you can’t find a renter during the rent phase. If that happens, you can still flip the property and aim for buy-and-hold on the next one.
Since real estate investing often means buying properties at a discount and selling them at full market value, the buy-and-hold strategy gives you an advantage, especially in a market where property values are on the rise. If the rental market is up and home sales are down, it’s also a good time to take advantage of the monthly cash flow that owning rental properties brings. However, you don’t want to get yourself in a bind by holding onto too many properties at once.
Be sure to calculate the costs of refinancing before you make a purchase. Lenders generally finance no more than 75 percent of a property’s value. If you aim for a 70 percent LTV, that gives you some wiggle room. Sixty-five percent is even better.
Banks also charge a refinancing fee. On top of that, you’ve got to pay for the appraisal, title work, and loan processing. It will be worth it if you can cash out your initial investment. That way, you have none of your own money tied up in the project while earning residual income. In the meantime, you can build equity. If you start with 25-30 percent built-in equity, you could be sitting on a gold mine.
Competition in private lending is driving interest rates down on several types of debt products, influencing debt terms. Between 2017 and 2018, private mortgage lending grew 37.8 percent, and that’s just one market segment. This growth is good for borrowers while lenders fight to stand out.
Take short-term bridge products, for example. Five years ago, it wasn’t unheard of to see loan rates at 12 or 13 percent. A couple of years later, they were around the 10 percent mark. In the last couple of years, they’ve fallen into the single digits, and it’s common to see rates in the 6 to 8 percent range. Give it another couple of years, if competition continues to proliferate, and I think it will, we could see interest rates dip below 5 percent.
This is already happening for large bridge loans. When you’re financing a couple of million dollars, the lower cost of capital translates into significant passive income.
In the fix-and-flip sector, lenders, six years ago, were funding 80 percent of the purchase and the same on rehabilitation costs. Loan rates were also in the double digits. But some significant changes in the private lending sector have driven these terms in a direction that is favorable to the borrower. Borrowers can now obtain 85 percent for acquisition and up to 100 percent for rehab costs. Advances at closing are also driving the market as lenders try to make their products more competitive. Again, interest rates are well below the double-digit mark and edging close to 5 percent, even as we’ve seen something of a slowdown in the fix-and-flip market.
Top 3 Drivers of Competitive Prices in Private Lending
It doesn’t matter what the sector is, private lending is growing. The JOBS Act of 2012 not only created new opportunities for lenders and new markets for borrowers, but it has also ensured the growth of these opportunities and markets for years to come. What it boils down to is that borrowers have their pick of the litter among the growing options. Lenders have to remain competitive if they’re going to stick around.
There are three general other market conditions influencing the direction of debt terms. Going into 2020, here are the top three drivers of competitive pricing in private lending:
- An influx of new lenders – The reason competition is heating up, fundamentally, is that new private lenders are entering the market every day. More than half of the $10.3 trillion in U.S. mortgage debt is provided by nonbank lenders. This will likely increase beyond 51 percent by the end of this year. According to ATTOM Data Solutions, the growth of private lending is due to banks not serving all borrowers’ needs.
- The influence of institutional investors – A good portion of these new lenders are institutional investors. Coming to the table with huge cash reserves, institutions that traditionally have not financed startups or introduced loan products are now beginning to do so.
- Broadening of the private lending sector – Private lenders are branching out into new loan categories. While mortgages are the most financed of private lending products, lenders are also financing student loans, home improvement, business startups, equipment, and business asset purchase and leasing, fix-and-flip projects, HELOCs and cash-out products, refinances, and more.
Each of these three drivers points to one main thing driving the terms in private lending: Competition. It’s a borrower’s market.
One More Thing Driving the Competition in Debt Terms
Private lenders are also faced with one more stark reality. There’s no loyalty among borrowers to any lender. The terms are dictating where borrowers go for their financing needs. That means lenders must treat their current customers well.
Whether we’re talking about marketplace lending platforms, institutional direct lending, or refinance products, existing customers expect royal treatment. If a lender has a borrower who has come back for several loans in the last three to five years, that borrower is going to be looking for better debt terms. There are several reasons for this:
- A borrower with a track record can prove they deliver results (and returns); that translates into lower risk
- Their successes, in a lot of cases, means they can personally guarantee their projects
- There’s another lender around the corner working to take that borrower away from you
When borrowers can walk in the door, plop down a half dozen closed and fulfilled contracts that turned a profit for the borrower (and the lender), can demonstrate their expertise in a particular type of real estate project, and show you a quote from your competitor, the only thing a smart lender can do is match or beat the competition’s offer. And that’s precisely what is happening in lending offices all over the country.
5 More Market Trends Developing in Private Lending
Competition in the private lending markets has the byproduct of creativity. What that means for the borrower are more options and better terms. What it means for the market as a whole is lenders doing whatever it takes to secure more business. That’s why these five market trends are beginning to develop now in the private lending markets, which will only make the market more efficient in the long run.
- A move toward long-term products – While fix-and-flips and bridge loans are still popular, there is a move toward long-term financing. Flippers are starting to see the opportunity in buying and holding properties, so they’ll take their rehab loan and convert it into a rental loan to create passive income streams from a percentage of their portfolios. This is being driven by housing prices that are out of reach for some would-be homebuyers. Another part of this is borrowers have some of their duplex and fourplex loans at Fannie Mae and Freddie Mac expiring, so they’re converting those loans into long-term products.
- Lender funds – As the competition heats up, lenders have to get creative. That’s why some are beginning to launch their own funds. The funds are going to happen anyway as more players get into the market. Savvy lenders create their own funds to keep the business in their doors.
- Partnerships – Lenders are beginning to partner with each other on certain types of products. As the private lending market matures, we’ll begin to see consolidations.
- Securitizations – Securitizations are also heating up.
- Floating terms – Borrowers favor ARMs and other floating terms. Cash-out refi is also popular items because they allow borrowers to lower their debt interest. They can then take that cash and reinvest it in other projects.
The current private lending market is a borrower’s market. Competition is high, and it’s driving down debt terms that lenders offer to borrowers. Borrowers can finance more projects, make larger acquisitions, and choose from among a diverse range of creative lending products. Loan underwriting is also tightening as more lenders take it in house.
Lenders want to ensure they get the right borrower. That’s why many private lenders now check FICO scores and verify information that a few years ago they didn’t bother verifying. To mitigate risk, large-project and high-risk lenders are looking at the construction and engineering reviews, judging environmental impact, and taking a closer look at project plans to ensure capital is well-invested. That’s another byproduct of the competitive environment.
One way lenders are controlling money flow is by requiring borrowers to access capital through draws and reimbursements. The property is security. Therefore, ensuring the project is done correctly protects the property and the borrower. Everyone wins in the long run.
Bottom line: Competition is benefitting borrowers at every level of the private lending market.
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The current definition of accredited investor is based on income or net worth, but the Securities and Exchange Commission (SEC) is looking at changing that. In December, the commission proposed changes to the definition that would open the door to new investors able to put capital to work in the private lending markets. Today, I’d like to look at the proposed investor categories and how they could impact private lending.
How Many New Investor Categories The New Accredited Investor Definition Will Create
If Congress accepts the SEC’s proposal, there will be at least six new investor categories created overnight. These include:
- A new category based on professional credentials. Natural persons with Series 7, 65, or 82 licenses would qualify as accredited investors, as would other natural persons with other credentials issued by an accredited educational institution.
- A “knowledgeable employee” of a private investment fund could also be considered an accredited investor.
- Limited liability companies (LLCs), registered investment advisors (RIAs), and rural business investment companies (RBICs) could also be considered accredited investors if they meet certain conditions.
- Any entity that was not formed specifically for securities investing but that owns more than $5 million in investments could also qualify.
- Family offices with at least $5 million in assets under management and their “family clients” could be considered accredited investors.
- Finally, “spousal equivalents” may be allowed to pool their finances in order to qualify as accredited investors.
These are each significant in terms of adding new accredited investors to the pool of available capital for real estate developers and investors in every category of real estate investing currently on the market. It’s also possible that new asset classes based on these new accredited investor categories could be added as market players develop new business practices, marketing initiatives, and business models to serve these categories.
How New Accredited Investor Categories Could Impact Private Lending
In December 2018, there was $10.3 trillion in mortgage debt, 51 percent of which was provided by private lenders, according to Magnify Money. The expansion of accredited investor categories has the potential to add millions, or maybe billions, of new dollars to that mortgage debt pool as new accredited investor category participants scramble to get their piece of the investment pie. While there are platforms that cater to nonaccredited investors, the lion’s share of opportunities still target accredited investors. That makes the significance of the SEC’s proposal tremendous in several respects.
One particular way this proposal is significant is the qualified institutional buyer definition would also change. Rule 144A defines qualified institutional buyer as a company that manages at least $100 million in securities “on a discretionary basis” or is a registered broker-dealer with at least $10 million investment in non-affiliated securities. The proposed rule change would expand that definition to include LLCs and RBICs.
Let’s take a look at each of the proposed accredited investor categories and see how they could potentially impact private lending going forward.
Professional Certifications and Designations
The Series 7 exam is a general securities representative exam. Those who pass the exam may be able to solicit, purchase or sell public and private corporate securities, municipal funds, mutual funds, options, ETFs, real estate investment trusts, mortgage-backed securities, hedge funds, venture capital, and more.
A Series 63 exam is a uniform securities exam not required in every state. In those states where it is required, it must accompany another licensing exam such as the Series 6 or 7 exam.
The Series 82 exam qualifies an individual, if they pass, to sell, buy, or solicit private securities.
At the end of 2018, FINRA reported a total 629,847 registered securities representatives. That means the proposal to change the accredited investor definition by the SEC could potentially add nearly 1 million new investors to the accredited investor market. According to Glassdoor, the average annual base pay for a securities representative is $28,237. The high is $45,000. These investors likely will not individually add a lot of capital to the total investment private lending pool, but they could collectively make a big splash.
Private Investment Fund Employees
Private investment funds typically do not solicit investments from retail investors or the general public. For that reason, they may not be all that active in real estate crowdfunding (RECF), mortgage lending, commercial lending, fix-and-flips, or other private marketplace lending categories, but with an expansion of the accredited investor definition, once private investment fund employees discover they can add their own money to the private lending pool, we could see new business models and private investment fund platforms rise to meet the demand.
LLCs, RIAs, and RBICs
It is difficult to know how many LLCs currently exist. One startup lawyer who answers questions on Quora puts the number at 21.6 million. Even if he overshot his estimate by 100 percent, that’s still more than 10 million LLCs currently in existence.
It’s almost as difficult to calculate the number of RIAs in the U.S. Nevertheless, one organization attempted to do just that. RIABiz reports the number to be 11,473, and says they manage $66 trillion in assets.
SBICs represent a unique class of private investor. Due to the nature of these investments, they have the potential to infuse new capital infusion into specific types of rural businesses and real estate investments. Agricultural businesses, for instance, may rely on land acquisition and development investments. The potential for new capital entering private lending markets with the number of SBICs currently in play is huge.
The specific conditions that that would qualify LLCs, RIAs, and RBICs as accredited investor status are not spelled out by the SECs proposal announcement. However, it’s possible that the number of accredited investors in this category could grow by over 1 million. That could add billions of new capital to the private lending ecosystem in short order.
Entities That Own $5 Million in Investments
This category is likely huge. How huge is anyone’s guess. But it’s entirely likely that the number of “entities” that own more than $5 million in investments is in the millions. The vagueness of this category’s definition makes it impossible to measure the impact to private lending, but it would likely be significant.
There is no way to know for sure how many family offices exist in the U.S. The Family Office Exchange estimates there to be more than 10,000.
Family offices all have their own investment criteria. It’s safe to say that if real estate continues to be an excellent investment as it has been for the past few years, family offices should be major contributors to RECF platforms and other forms of real property-based private lending.
The spousal equivalent category has the potential to make a big impact on private lending. If spouses and spousal equivalents are allowed to pool their finances in order to qualify for accredited investor status, that could potentially add hundreds of thousands of new accredited investors to the private lending investment pool. It could even add millions or billions of dollars of new investment capital.
Accredited Investor Conclusion
It’s impossible to know for sure just how big the impact on private lending could be if new accredited investor categories are created with the SEC’s proposed changes. The potential for new capital to enter the market and establish greater liquidity is enormous. New investment classes could be created to accommodate the new categories. Current investment classes will likely grow stronger. I see the entire private lending market expanding to meet new demand.
The public comment period for the proposed changes is open until mid-February. Get more information here.
Since the financial crisis of 2008-2009, banks and traditional lenders have scaled back their funding of real estate projects. However, private lenders have stepped up to fill the gap.
The private lending landscape is made up of both individual and institutional investors. Data collected by ATTOM Data Solutions indicates that one prominent real estate marketplace lending platform saw a 70 percent increase in home flipping loan dollar volume in 2017 over the year before, and a 50 percent increase in loan originations. Another prominent fix-and-flip lender experienced a 100 percent increase in loan originations. The average gross return on investment (ROI) for flipped properties that year, according to ATTOM, was $68,143.
The data shows that house flipping is growing in popularity. As a result, house flippers are getting deals financed in record numbers. But they’re not going to banks. They’re going to private lenders and marketplace platforms where lenders pool their money to fund real estate investments.
Why Private Lenders Should Fund Your Next Real Estate Project
Private lenders fund more than fix-and-flips. In fact, private lenders may fund virtually any type of real estate investment. That includes mortgages, home improvement projects, HELOCs, commercial and industrial ground-up developments and leases, and more.
They also use a variety of different business models, including marketplace lending, direct lending, and hybrid approaches.
The JOBS Act of 2012 opened the door to private lending for many real estate professionals who have struggled to find funding for their projects. The landmark legislation allowed lenders to use technology in new ways to market their products to potential borrowers. As a result, online lenders, most of them private lenders, have proliferated.
According to the Federal Reserve Bank of New York, online mortgage lenders have improved efficiency and benefited borrowers. They are able to process transactions more quickly than traditional lenders and respond more agilely to demand fluctuations and market conditions. The same is true of online lenders in every vertical.
With more than 200 real estate crowdfunding platforms in the U.S. alone, and billions of dollars funding investments each year ($33.7 billion in 2017), there has never been a better time for real estate developers and investors to find private capital for their deals. You just have to know where to look.
Private lenders do not place as much emphasis on FICO scores as traditional lenders. Rather, they look more closely at deal structure, real estate experience and track record, and project financials. Due to innovation in underwriting and risk assessment practices, private lenders have expanded their influence and helped more real estate pros realize greater profits and fund more deals.
Expectations for the Future Growth of Private Lending in Real Estate
In May 2019, The American Association of Private Lenders (AAPL) surveyed members of its Government Relations Committee to ask them about expectations for private lending in the next five years. The answers were interesting. Industry professionals said they expect
- the number and size of private lenders to grow;
- increased “professionalization”;
- new capital infusion to meet housing demands;
- private lenders to specialize in specific niches;
- private lending to drive platform innovation;
- higher returns with fewer players;
- private lenders to embrace technology;
- private lending to outperform banking;
- significant consolidation among capital providers and originators;
- increased state regulation.
In other words, it appears that private lending insiders expect the market to mature, and since real estate is one of the hottest markets for private lenders, we should expect the real estate lending market overall to mature.
Another thing that could impact the growth of real estate private lending are proposed rule changes for accredited investors. Among these proposed changes, the Securities and Exchange Commission is considering the addition of new investor classes based on occupation and certifications. Other classifications that could gain accredited status include registered investment advisors, rural business investment companies, family offices, and Indian tribes that meet certain investment criteria. If these proposed changes are passed, it would widen the door of demand on private capital, which will lead to market newcomers, new lending products, and a rise in private lending volume. The public comment period for these proposed changes ends mid-February.
How to Find a Private Lender for Your Next Real Estate Project
While market demand for private capital is growing and opportunities for investors are better now than ever, there is intense competition among private lenders, and among investors and developers for private money. That’s a good thing. Still, different real estate projects have different capital needs. Therefore, a search for capital should begin with identifying the type and amount of funding necessary for project completion.
Next, make a list of private lenders who can potentially fill that need. This will require some research.
When evaluating private lenders, look for the types of investments they focus on. If a lender specializes in home improvement projects and your project is a commercial ground-up development, that is not a good match.
You also want to look for a private lender who’s funding criteria match your project capital needs. Does the lender have a minimum or a maximum? Some lenders look for small deals in the range of $50,000 to $100,000. If your project requires millions of dollars in financing, then there’s an obvious non-match. On the other hand, if your project is a smaller project and a lender typically finances larger deals, you can eliminate that lender from your list of potential capital providers.
Another area where you’ll find a lot of diversity is with credit risk terms. Some lenders only fund projects if a developer provides some of their own capital. Others require a strong FICO score or a certain amount of experience. Some lenders use a loose risk assessment analysis while others are quite stringent. You’re looking for potential lenders whose terms match your ability to meet them.
Narrow your list to 3-5 potential lenders before making a final decision. Try to include a mix of lending models — for instance, direct lenders as well as marketplace lenders. You may even include friends and family members.
After you’ve got a solid list of 3-5 potential private lenders, create a presentation with your project details. It should include all project parameters, from acquisition costs to material requirements. Anything pertinent that a potential project funder would want to know should be included. In the case of marketplace lenders, find out what their project deal parameters are and make yours conform.
Finally, you’ll want to perform your due diligence on each potential private lender. What is their reputation among real estate professionals? How many deals of your type have they funded? What is their success rate? Create a list of criteria that are important to you and evaluate each lending candidate according to that criteria. You want to create an apples-to-apples comparison so that you can choose the best lender for your real estate project. When you arrive at your conclusion, you should feel good about the funding source you have chosen and its match with your project.
In the competitive landscape of private lending, it’s important for real estate developers to find a lender who is the perfect match for them and their project. Marketplace lending is an excellent funding model for some projects, but it isn’t for everyone. Perform your due diligence based on your project, its funding requirements, and your personal values.
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Private lending is nothing new. It’s been around a long time. In fact, it can be traced back to Macedonia around 3,000 years ago. In the U.S., the fix-and-flip segment of real estate investing has relied on private money for almost as long as pros have been rehabilitating properties. However, since the financial crisis of 2008-2009, private debt has grown in virtually every real estate investing sector. In the fix-and-flip sector, it has skyrocketed.
As an asset class, private lending emerged in the late 1980s. It started as a unique funding mechanism for mezzanine loans or special situation financing. Today, it’s a common method of funding fix-and-flip property deals with no signs of reduction any time soon.
The Advent of Fix-and-Flip Private Lending
In 2012, President Barack Obama signed the JOBS Act, which made it possible for lenders of all types to directly market their offerings to borrowers. As a result, hundreds of marketplace lending (MPL) platforms sprung up in the years that followed. The first of these was established in 2010 and paved the path for others to follow. Many of these platforms specialized in real estate lending.
There is a lot of overlap between the MPL sector, which encompasses real estate crowdfunding (RECF), and private lending. Private lenders may seek out borrowers through MPL or RECF platforms, but they may also conduct themselves through direct lending models. Either way, the industry has seen tremendous growth since the financial crisis. Lenders leverage the internet to find borrowers and use traditional offline marketing methods, as well. One of the areas where private lenders have found a foothold is in the area of fix-and-flips.
Following the tradition of hard money lending, fix-and-flip financiers issue short-term loans with high interest and fast closings. They also typically have lower credit risk standards than traditional loans, which is why borrowers favor them.
Investors have enjoyed great returns ranging from 8 to 12 percent interest. Lately, however, fix-and-flip real estate investing has come under scrutiny by state regulators and faces a few challenges. It will still continue to be a prominent part of the real estate ecosystem, and private funding of fix-and-flip properties is poised to grow even further as more online platforms offer more deals for investors.
The Current State of Fix-and-Flip Property Lending
In 2017, ATTOM Data Solutions estimated that flippers turned over 193,009 single-family homes and condos during the previous year. It’s possible the entire fix-and-flip industry saw a total of 300,000 properties turned over. Investors saw an average return of 51.9 percent on fix-and-flips that year. The following year was almost as good as investors saw an average return of 49.8 percent. These are the first and second highest averages since the year 2000.
Another event that happened in 2017 to create new opportunities for private lenders and investors in the fix-and-flip sector was the creation of opportunity zones. These zones allow investors to reinvest capital gains into property rehabilitation projects in predesignated neighborhoods or to invest those gains in qualified opportunity zone funds. For private lenders, they represent opportunities to fund projects in these areas targeted for revitalization.
This rise in fix-and-flip property investing has put the sector on state regulation radars. Last year, New York introduced legislation that could increase transfer taxes for investors by as much as 20 percent. If it passes, it could hamper house flipper in New York. Florida has also introduced legislation that could impact fix-and-flippers and other real estate investors.
On the technology front, private real estate lenders are beginning to underwrite loans and assess credit risk using artificial intelligence and machine learning. Deal analysis is also being impacted by new technologies.
While fighting regulation and the challenges of new technology, increased competition from banks is also beginning to impact the fix-and-flip sector. While some banks are referring borrowers to private digital lenders and some are finding unique ways to partner with real estate technology firms, others are developing their own digital lending platforms.
The Future Looks Bright
Since the financial crisis of 2008-2009, traditional lending institutions have tightened their credit standards and shut out millions of would-be home buyers. The situation for flippers is even bleaker. Those without good credit, or wealth to finance their own deals, lose out on lucrative real estate deals. That’s why many of them have turned to private lenders for capital.
In a white paper titled “Private Lending Goes Public” published in April 2018, ATTOM Data Solutions reports that 207,088 single-family homes and condos were flipped in 2017 and that 34.8 percent of them were financed. The dollar volume for financed flips hit a 10-year high of $16.1 billion. Much of this growth is fueled by online lending.
Besides ease of access to needed capital, one other advantage to funding fix-and-flips through private lenders is a path to a quick closing. Borrowers can get their money in 10 days compared to 10 weeks through a bank.
As the volume of fix-and-flip loans has grown, so too has its diversity. What was once relegated to accredited investors has now been opened up to non-accredited investors. And it isn’t just individuals funding the loans. Many fix-and-flips are funded by institutional investors. In some cases, even banks are funding fix-and-flip investors through marketplace lending platforms or other online channels. And the introduction of real estate investment funds gives investors opportunities to invest in fix-and-flip properties by pooling their money to leverage greater returns and lower risk along with other investors. These opportunities will only increase as the market matures.
Securitizations are another area of potential for the fix-and-flip sector. SoFi and Marlette Funding have led the way in asset-based securities (ABS) in the marketplace lending sector. In late 2017, LendingHome funded its second Opportunity Fund with a $300 million credit facility. Last year, Angel Oak Capital Advisors, LLC obtained $90 million with a securitization backed by fix-and-flip loans. There is plenty of potential for such ABS products to grow in size and number within the next five years.
In a sense, ABS aside, all fix-and-flip deals are asset-backed. Where traditional lenders assess credit risk on Fair Isaac (FICO) scores and property values, private lenders care more about deal structure, loan-to-value ratios, and after repair values. Still, there is a tremendous risk to fix-and-flip investing.
How Private Lenders Manage Risk
Fix-and-flip investors are subject to a number of risks associated with property investing. They can pay too much for a property and not leave enough on the back end for profit. New investors typically fail to include fees and holding costs in their equations. Another common mistake investors make is underestimating the cost of repairs or other expenses. Outside of investor control, the market could turn while rehab is taking place, causing the investor to lose on a deal that a few weeks earlier looked like a sure win.
In these cases, a private lender can serve as a check and balance against the fix-and-flip investor’s judgment. By taking a keen interest in the financials of a proposed flip, the lender can spot challenges the investor might overlook. Any red flags can be a cause for rejecting the proposal.
The best private lenders are not just interested in the deal. They’re also interested in the investor. They may look at the credit score, but they also want to know the investor’s overall experience in real estate, his experience in the specific type of real estate deal being proposed, whether or not the investor can back his own project, and the number of successes the investor has.
Private lenders are more than silent financiers. They are partners with a stake in the fix-and-flip investor’s success.