We all know that the COVID pandemic didn’t hit every town with equal force at the same time. So it’s no stretch to conclude that not every town will be impacted in exactly the same way by the economic fallout from the health crisis.
And yet, it’s likely that the communities that are most affected financially aren’t necessarily those that were most devastated by the virus itself. And, while we’re still a long way from recovering from either the disease or the cost of its treatment, there is some predictive analytics that suggests where landlords might have the most trouble collecting rents until both have run their course.
Most at Risk Communities
ATTOM Data Solution released a report ranking U.S. housing markets by their vulnerability to the impact of the COVID pandemic. The paper shows that the Northeast has the largest concentration of at-risk counties, while the West and Midwest have the smallest.
That isn’t surprising. But when you drill into the county-by-county breakdown, it’s not what you’d expect.
Granted, Sharestates is based in and around New York City, so our view might be skewed. Still, the media has appropriately dubbed our town the “epicenter” of the global outbreak, and we venture to say that most people’s enduring image of 2020 to date is some photo of Times Square with nobody in it. But New York County, a.k.a. the Borough of Manhattan isn’t on the list. Bronx County, with the highest proportion of people testing positive in the country and maybe the world? That isn’t either.
Instead, the report reveals that housing markets in 14 of New Jersey’s 21 counties are among the 50 most vulnerable in the country to the economic impact of the novel coronavirus. But the truly bizarre finding is that the second-hardest hit state is Florida, where 10 counties are among the Foreclosed Fifty. In other words, two states account for almost half the potential damage.
And can you think of two states with responses to the pandemic that is more different? In the Garden State, nobody leaves their front yard without personal protection equipment, and, frankly, there’s nowhere to go. In the Sunshine State, hosting spring break seemed at the time to be more important than protecting public health. In the former, decorative masks from Etsy boutiques have become fashion statements. In the latter, a lack of any mask has become a political statement. Granted, New Jersey has been far harder hit, so there is more of a consensus there about the danger just because the danger is more obvious — by an order of magnitude.
ATTOM ranks counties based on an algorithm that factors in the percentage of housing units receiving a foreclosure notice in Q4 2019, the percent of homes underwater in Q4 2019, and the percentage of local wages required to pay for major homeownership expenses. So let’s be clear: This model is predictive. It suggests which communities were most at-risk in the months prior to the pandemic — the ones that were most vulnerable to some disruption or another in early 2020.
Getting Granular On The COVID Impact
“It’s too early to tell how much effect the coronavirus fallout will have on different housing markets around the country. But the impact is likely to be significant from region to region and county to county,” said Todd Teta, ATTOM’s chief product officer. “What we’ve done is spotlight areas that appear to be more or less at risk based on several important factors. From that analysis, it looks like the Northeast is more at risk than other areas. As we head into the spring homebuying season, the next few months will reveal how severe the impact will be.”
The most vulnerable counties in New Jersey include five in the New York City suburban area: Bergen, Essex, Passaic, Middlesex, and Union. Interestingly, Hudson County — which has more confirmed COVID infections than any of them, according to Worldometers — is not on the list. It’s home to posh Hoboken and continuously gentrifying Jersey City, but that can’t be the whole story. Of the bunch, only Passaic has lower per-capita income than Union, and Bergen is one of the wealthiest suburbs in the country. Two of the more down-at-heel New Jersey communities outside the New York metro that made the list are Ocean County, along the Jersey Shore, and Camden County, across the Delaware River from Philadelphia. To its west, Pennsylvania’s Delaware County shares this dubious distinction.
While there are New York counties among the top 50 most at risk of the COVID virus, they’re not in the Five Boroughs. The closest of the four is Rockland County, which is next door to — that is to say a toll bridge away from — Westchester County, the site of New York State’s first hot zone, New Rochelle. Two others, Orange County and Ulster County aren’t too far away, in the Mid-Hudson Valley region. Finally, Rensselaer County is in the Capitol region, near Albany.
Meantime Florida’s COVID cluster is exactly where you’d think — Miami-Dade, Broward, and Palm Beach counties — and yet the economic impact doesn’t seem to be centered along the Gold Coast at all. While Broward does make the list, the risk is concentrated in the northern and central sections of the state, according to ATTOM, particularly Flagler, Lake, Clay, Hernando, and Osceola counties. If you don’t know where they are, you can be forgiven. Hernando is in the Tampa suburbs, and the rest are in the middle of nowhere. Think of Orlando, Jacksonville, and Daytona Beach as an outfield; those counties comprise the swath of shallow left-center where bloop singles land.
Other southern counties that are in ATTOM’s top 50 list are spread across Delaware, North Carolina, South Carolina, Louisiana, and Virginia. The populous suburb of Prince George’s County, Md., is also a risky bet according to the study. Only two ranked counties are in the West: Shasta County, Calif., near Redding, and Navajo County, Ariz., near Phoenix. The five in the Midwest are all in Illinois: McHenry, Kane, Will, and Lake counties, all in the Chicago metro area; and Tazewell County, near Peoria.
And Now Some Good News
But what about those counties at the other end of the spectrum? Is anyone truly immune to the effects of COVID? Apparently yes, sort-of, in an economic armageddon kind of way.
Texas has 10 of the 50 least vulnerable counties in the report. The insulated Texas counties include Dallas, Collin, and Tarrant in metro Dallas-Fort Worth and Ector and Midland in the Midland-Odessa area. Houston’s Harris County is also on the right side of these rankings. And, while that’s welcome news from the point of view of surviving the pandemic financially, they have a cratering oil market to contend with, so maybe they’re not such a safe bet either.
Wisconsin had seven counties on the least-risky list and Colorado with five. Other communities of note include tech industry magnets King County — Seattle — and Santa Clara County, one of the components of Silicon Valley. Again, though, we see some bad news in that good news, as the nearby businesses are exactly those that are never going 100% back to pre-pandemic workplace operations. Many if not most of the employees who were designated to work at home aren’t going back to the office, no matter how many beanbag chairs and foosball tables and Mountain Dew Code Red are on site.
But to leave you with some undiluted good news, a separate ATTOM report shows that much of the foreclosure risk identified in that study remains hypothetical. In reality, there were 156,253 U.S. properties with a foreclosure filing during the first quarter of 2020, and, while that’s up 42 percent from the previous quarter, it’s down 3 percent from the comparable, year-earlier period.
As states begin to open their economies in an effort to recover from the COVID-19 pandemic, new opportunities will arise in real estate as others start to close. From the looks of it right now, commercial real estate is going to have a slow recovery. That will likely include multifamily, though retail and office space is likely to have a slower recovery. But there is one area of real estate that could see a new surge coming out of the crisis: Fix and Flip property investing.
There are two primary reasons, and heads and tails of the same coin if you will, that will likely drive this surge.
- First, as landlords will likely raise rents to make up for lost revenues in the last three months
- New construction will slow down as new home sales fall
6 Economic Indicators Coming Out of the COVID-19 Crisis
There are several economic drivers impacting real estate during the COVID-19 pandemic crisis, and these drivers are likely to continue impacting real estate for the next few months. The most obvious of these drivers is the high unemployment rate, but it’s not the only driver. Let’s look at five of the biggest economic indicators for the COVID-19 recovery.
- There have been 36.5 million unemployment claims since the coronavirus crisis kicked off in March. Most of those happened in April when there was a sharp uptick in claims due to states shutting down non-essential businesses. Even as states begin to open up their economies, even though unemployment claims are tapering off, many workers are opting to stay on unemployment because they can make more than they can on their jobs. That means fewer new home sales as unemployed persons are not likely to qualify for home loans.
- New residential sales in March 2020 fell 15.4 percent from the revised February 2020 estimate of 741,000. With unemployment reaching a staggering rate, I would expect sales in April to have hit the floor. We won’t know for sure until next week, but a decline in new residential sales would mean that rentals and existing residential homes likely were in demand in places where such transactions could take place. With unemployment as high as it is, it’s likely that fewer people are moving. Those who do move are likely moving in with family or downsizing to rental properties.
- New residential construction fell 22.3 percent below the revised February 2020 estimate of 1.5 million. This will impact new residential sales going forward. Coming out of the COVID-19 crisis, fewer people will be in the market for a new home. They will either have to purchase older homes of lesser value, rehabilitated homes, or rent.
- Total U.S. business sales were down 5.2 percent in March 2020 compared to February 2020. Considering the shutdown of nonessential businesses did not take place for most states until late March and early April, it’s a sure bet that April’s figures are even bleaker. Add to that the total U.S. business inventories for March 2020 were down 0.2 percent, the indication is that the manufacturing and trade sector isn’t looking so good. When manufacture and trade falls, it impacts real estate sales.
- Retail and foodservice sales in the U.S. for April 2020 decreased 16.4 percent from March 2020. Since restaurants and foodservice businesses are some of the largest real estate investors, this will have a major impact on commercial real estate for the new few months or years.
- March 2020 sales of merchant wholesalers were down 5.2 percent from February 2020. Again, this will have a major impact on commercial real estate going forward.
These figures are taken from the U.S. Census Bureau.
Current sales impact future investment. If businesses, retailers, and commercial construction enterprises are losing sales today, or have seen a significant drop in sales and inventory recently, they will be reluctant to invest large amounts of capital in real estate projects until they can see an increase in these numbers. That increase will not come until several months after full recovery from COVID-19.
While commercial real estate and residential real estate sales may be suffering, people are still going to need a place to live. For that reason, I suspect renting and fix and flip investing to pick up in the near future.
Why Fix and Flip Investing Will Carry Real Estate for the Rest of 2020
When it comes to shelter, people have three options. They can rent, they can buy new, or they can buy an existing home. With new construction and new home sales in decline as a result of high unemployment and mandatory nonessential business shutdowns, that leaves the inventory for single-family homes to remain in the existing home market.
Landlords haven’t fared too well in the current market either. In some states, like Pennsylvania, landlords are prevented from evicting tenants if they are unable to pay the rent. That means when the COVID-19 crisis is over, it is likely they will raise the rent. This could drive some tenants to the single-family ownership market where renovated homes can attract their attention.
Another consideration is the mortgage market.
According to Bankrate, the 30-year fixed-mortgage rate fell 3 basis points at the beginning of the month. That puts it at 3.52 percent. The 15-year fixed-mortgage rate is down 15 basis points to 3.03 percent.
With unemployment high, fewer people will be in the mortgage market. Those who are will be looking for smaller and more affordable homes, not new construction in the best neighborhoods. Also, new construction and new home sales being in decline mean less inventory, which will drive more home buyers to the rehab market. And it’s likely that mortgage rates will fall some more before they go up again. These are prime conditions for a new surge in fix and flip properties where private investors can take an older home in need of repairs, give it the attention it needs then put it back on the market in time for newly re-employed workers to recover from the financial setback caused by COVID-19.
This is the short-term outlook. Assuming a vaccine is discovered by mid-2021, we should start to be a recovery in the commercial real estate market, including retail and multifamily, and see a rise in new home construction by the end of next year.
To fund this surge in fix and flips, I see marketplace lending continuing to be an option for most investors as the economy recovers. Do your due diligence and go with those platforms with a proven track record.
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.
This time last year, a survey of chief financial officers (CFOs) by the Duke University Fuqua School of Business showed that 67 percent of CFOs believed the U.S. would see a recession by the second half of 2020. That was long before anyone thought about COVID-19 or a coronavirus pandemic. Eighty-four percent of them believed the recession would start by the first quarter of 2021. One month ago, CNN declared the coronavirus recession has begun. When the financial crisis of 2008 hit, I lost half my business because it was tied to real estate. That recession was caused by widespread deregulation and a housing bubble burst. Today’s recession has nothing to do with real estate investing.
That doesn’t mean there won’t be implications for the real estate sector.
What Has Coronavirus Done to The Economy?
More than 17 million Americans filed for unemployment in March. That represents a 13 percent unemployment rate. Several states have ordered “nonessential” business closures, and some industries have completely shutdown.
While the federal government has taken measures to mitigate the impact of these discomforts, many Americans will feel the repercussions for months. The $2 trillion stimulus package passed in late March will help some Americans struggling to pay rent and put food on the table, but it might not be enough for some who could see their jobs completely disappear if their employers can’t recover. The Paycheck Protection Program was designed to encourage employers to continue paying their employees despite business shutdowns, but, again, if economic conditions worsen or continue for a long stretch, it may not be enough.
In real estate, sellers are taking their homes off the market as prices decline. Not only are sellers reluctant to sell, but buyers are also reluctant to buy. On the other hand, there has been a surge of 3-D video home tours online even as new home listings dropped by 27%.
Commercial real estate is seeing its own problems. Retail stores that have been closed or affected by social distancing are struggling to pay their rent. Multi-family residential is experiencing the same tug of war between tenants and landlords, and new construction has been hit as some contractors are out of work.
Nevertheless, we could be turning a corner. President Donald Trump has signaled he’s ready to open the economy on May 1 while several state governors are following suit. Pennsylvania Governor Tom Wolf, who has had the strictest shutdown policy in the country, has targeted May 8 as the day of gradual re-opening.
The question on the table is, what will do this for real estate investing in 2020.
Will 2020 Be a Good Year for Real Estate Investing?
I’m optimistic, and I’m not the only one. One real estate investor is suggesting “Subject To” is the way to go in the current market.
Rather than suggest a single strategy that is best for the current market, I’d like to point out that there is always some kind of deal that is worth considering in any type of investing market. There are always boom and bust cycles, and that includes recessionary environments. Savvy investors learn to make money in all of them.
Real estate cycles typically swing from favoring buyers to favoring sellers, then back again. You also see swings from residential to commercial, and from rental properties to home buying. What’s interesting about the current real estate environment is that it was strong up until the coronavirus pandemic shut the economy down. Since then, it has reached a moment of stasis. We are not dealing with normal market forces.
On the surface, it might seem that the real estate markets are hurting, but I don’t see it that way. I see a strong market waiting for the tide to go out.
3 Potential Scenarios for Real Estate Investing in H2 2020
Looking ahead, I see three possible scenarios for real estate investing in the second half of 2020, but it all really depends on what happens in May.
- Full Recovery – The first scenario is a full recovery. If the country’s economy reopens in May with little turbulence, the real estate economy could bounce back to its pre-pandemic state. In other words, people will start buying and selling homes again, construction will start up again, and we’ll see a full recovery. If this happens, online real estate investing could see a surge as people staying at home during the crisis discover online investing platforms, and pick up their online investing activity when they go back to work.
- Partial Recovery – If the country’s economy reopens and a spike in COVID-19 cases occurs as a result, we could see a new ripple of business closures. However, I think it’s likely that state and federal governments, as well as real estate industry professionals, will be better prepared and install control measures that protect people’s health while continuing to do business. This is already beginning to happen as some states are opening up their economies while requiring face masks to be worn in public. Under this scenario, online real estate investing platforms like Sharestates will benefit as more investors respond by taking their investments online.
- Slow Recovery – Under the slow recovery scenario, COVID-19 cases could spike due to a reopening of the economy and recessionary economic conditions have a bigger impact on the economy as CFOs predicted last year. In this case, online real estate investing may not be as popular as it would be in the above scenario, but will still see a boom.
Much of the progress for the rest of the year will be determined by how the coronavirus responds to summer weather conditions, currently an unknown, and how quickly testing can be done and a vaccine created.
Real estate is intrinsically local. That means the recovery from the current economic climate will likely be local, as well. New York and other major metro areas impacted significantly by a high number of cases of COVID-19 could see a slower recovery than other parts of the country where there has been a negligible impact. Since many real estate crowdfunding platforms offer deals based on physical property projects such as new construction and flipping, this new reality could impact online real estate investing. But it shouldn’t be across the board. Again, in local geographic areas where the impact has been insignificant, there will likely be little blowback. I, for one, am not planning to make any changes to my online real estate investing strategy in the short-term.
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.
House Resolution 748 of the 116th Congress, Second Session. The Coronavirus Aid, Relief, and Economic Security Act of 2020. The CARES Act. The $2.2 trillion, 808-page bipartisan pork-barrel passing as a national security omnibus. By any name, it’s the law of the land now and, unknown to most, there’s more than a little in there about the tax treatment of commercial real estate because of #StopTheSpread.
Of course, there is plenty in the CARES Act that is appropriate and proportionate to the emergency. Extensions of tax filing deadlines, broadening of unemployment benefits and aid to struggling small businesses are all immediate steps that must be taken. And some of those small businesses are real estate-adjacent. And yet CRE abides. Construction continues because, as has frequently been reported in this space and elsewhere, the housing shortage is a pre-existing national emergency.
Here in New York State, the hardest hit by COVID-19 by an order of magnitude, we are functioning under the “New York on PAUSE” stay-at-home executive order. You’re probably under similar restrictions now, or you almost certainly will be by some point next week. The exceptions here are related to “essential” services, which include first responders, pharmacy staff, grocery store employees and the pizza guy. But that lot down the street where the new condos are going up? It’s still teeming with carpenters, roofers, electricians, and pipefitters. Cement mixers, backhoes, and crawlers still swarm. That’s because this work is deemed by the local development authority to fall into the “essential” category.
“Essential construction may continue and includes roads, bridges, transit facilities, utilities, hospitals or health care facilities, affordable housing, and homeless shelters,” according to guidance from Empire State Development.
The kicker, of course, is that pretty much every large-scale multifamily project in downstate New York has some kind of set-aside for affordable housing, so construction really hasn’t slowed much around here.
So the argument could be made that these projects don’t per se need a stimulus to get through the crisis. Nevertheless, they have it. Here are some details.
Down with the sickness
“While the CARES Act provides certain measures that directly impact real estate, the vast majority of its provisions are designed to economically buttress individuals, businesses and hard-hit industries in an effort to enhance their ability to remain solvent and cover operational expenses, including rent and debt service,” according to the blog of law firm Skadden, Arps, Slate, Meagher & Flom. “The provision of monetary relief through the act in the form of emergency cash infusions, financing availability, loan forgiveness/forbearance, tax benefits, and supplemental awards is designed to help owners, landlords, operators, borrowers and tenants survive.”
That said, there are a number of such measures.
The first corrects a supposed drafting error in 2017’s Tax Cuts and Jobs Act. This provision of the CARES Act enables businesses to write off costs associated with building improvements instead of depreciating them. This sounds non-controversial enough, but New York Times readers have been told it’s a $170 billion boondoggle for the well-to-do.
More on that later, but there are other passages that affect CRE. For instance, most borrowers of federally backed mortgages on buildings designed for five or more families can seek up to 90 days of forbearance. These borrowers, though, are forbidden to evict or charge late fees or penalties to tenants during the forbearance period. Also, for 120 days from the date of the act, residential landlords cannot recover rental units or charge fees or penalties resulting from the nonpayment of rent in the event that a landlord’s mortgage is federally insured, guaranteed or otherwise assisted. That means any help from the U.S. Department of Housing and Urban Development, Fannie Mae, Freddie Mac, the rural housing voucher program or the Violence Against Women Act has this string attached.
Beyond that, there is a further earmark of $3.2 billion for a flexible response to the pandemic for tenant-based rental assistance, project-based rental assistance, public housing, and other uses.
The single-family view
Residential real estate also benefits from CARES Act provisions. Foreclosures of most federally backed mortgages on single- to quadruple family homes are prohibited for the 60 days that started March 18. Also, borrowers of federally backed mortgages facing economic difficulties as a result of the coronavirus can seek up to 360 days of forbearance.
Still, there is bound to be some short-term pain in the world of city row houses and picket-fenced suburbs despite the continued strength in CRE. These lower-scale, lower-density projects are considered less essential and, besides, the market for them has pretty much dried up. It’s hard to sell a home if you can’t show it.
And yet, housebuilders and flippers sound downright philosophic about all this.
“I think development will pick up right where it left off,” Philadelphia developer Rahil Raza told WHYY-FM. “I’m not going to say ‘these things happen’ — nothing like this has ever happened — but there are always hiccups in the economy. I think we’ll get back on track.”
He told reporter Jake Blumgart that he expects all this to come out in the wash in about six months.
“I bought these properties for a low amount and so if I have to drop the rent a couple of hundred dollars, I’ll do that,” Raza said. “It’s not gonna break my bank.”
A PR mess?
It’s hard to see how the pandemic might affect real estate markets in general. This is a disruption and, with every family that is diminished by COVID-19, there will be a unique dislocation that can only be modeled in the aggregate but can only be experienced in the particular.
So if you didn’t expect the New York Times to run the headline and kicker: “Bonanza for Rich Real Estate Investors, Tucked Into Stimulus Package: A small change to tax policy could hand $170 billion in tax savings to real estate tycoons,” then you must be unfamiliar with this particular news-gathering organization.
“Senate Republicans inserted an easy-to-overlook provision on page 203 of the 880-page bill that would permit wealthy investors to use losses generated by real estate to minimize their taxes on profits from things like investments in the stock market. The estimated cost of the change over 10 years is $170 billion,” according to Times reporter Jesse Drucker. “[T]he use of [non-cash, depreciation] losses was limited by the 2017 tax-cut package. The losses could be used only to shelter the first $500,000 of a married couple’s nonbusiness income, such as capital gains from investments. Any leftover losses got rolled over to future years.
“The new stimulus bill lifts that restriction for three years — this year, and two retroactive years — a boon for couples with more than $500,000 in annual capital gains or income from sources other than their business.”
Fast Company lumps this in with other “infuriating details and corporate giveaways” in the CARES Act. Writer Marcus Barum lists relaxation of bank reserve requirements, a giveaway to for-profit colleges and an extension of federal funding for the abstinence-only approach to sex education.
He also includes sunscreen becoming an eligible expense for health savings accounts; maybe he never met anyone who ever had skin cancer. But the press has been known to get things wrong occasionally, it might shock you to learn. And provisions in this law that seem like a valentine to the Commercial-Property-Developer-in-Chief could prove to be a magnet for bad publicity.
The constraints on real estate development are related to labor, equipment, and regulation. The current crisis won’t be a big help with any of these, but it also isn’t much of a hindrance. It’s unclear how tax benefits will spur more or faster development, but the money is on the table, so why not pick it up.
In this age of Covid-19 (to address the 10 attogram virus in the room), we’re all being advised to maintain social distance. Until this shakes out, living in high-density cities isn’t as appealing as it was a few weeks ago or — hopefully — as it will again sometime this year. But even before it became a public health issue, many Millennials had already discovered the appeal of moving to a place where they could spread out a bit. While this blog tends to focus on what drives young adults to favor one urban area over another, it’s important to understand why so many have chosen None of the Above, USA.
A reality, not a trend
The appeal of rural life might be underscored by the current, palpable fear of contagion, but is completely independent of it. We’ve seen articles on Millennials moving out to the country since at least 2017, and they almost certainly predate that. And even The PBS NewsHour has reported on this topic.
According to an EY study, young adults are almost as likely to buy a home in the sticks than in the city. The report suggests that, while 31% of Millennials still gravitate toward urban centers when it comes time to buy a home, 26% choose a small town or rural community.
(The report also notes that, between 2016 and 2018, the proportion owning their own homes rose from 26% to 40% while those living with their parents dropped from 30% to 16%. The 43% figure for renters remained constant.)
And the reason is pretty much what you’d expect: money.
“A renter household in an urban area earning the median U.S. household income should expect to pay 36.8 percent of their income on rent each month. In the suburbs, that falls to 31.8 percent; and in rural areas to 23.9 percent,” according to Zillow senior economist Sarah Mikhitarian. “A home buyer looking to purchase the median-valued home in an urban area should expect to pay 26.5 percent of their income on a mortgage payment each month. In the suburbs and rural areas, that falls to 20.2 percent and 13.4 percent, respectively.”
One consistent theme among sources for this post indicates that student loan debt affects the cash flows of Millennials far more than it did those of previous generations.
But what’s the appeal?
According to one report, starting a business is easier in a small town.
“Larger cities have very saturated job markets, especially when it comes to businesses pertaining to the interests of millennials. 30-somethings are finding that in smaller towns, there are more opportunities to open businesses of their own, ”blogger Jonathan West writes in SpareFoot. “Moving to a more rural area affords you the luxury of lax regulation, cheaper real estate, and less job saturation so you can more easily get your business up and running.”
While Millennials consider themselves entrepreneurial, the EY study suggests they might be kidding themselves and actually aren’t starting businesses at the same rate as their elders did. That said, they do tend to work — either willingly or out of necessity — in the gig economy, and remote work is certainly just as viable in these low-cost towns as inexpensive gateway cities.
None of that is to say there are no Millennial business founders. There are plenty and, if you’re looking for heartwarming anecdotes about young adults finding proprietary success in small-town America, Wells Fargo offers plenty as part of the bank’s participation in the nationwide “Rethinking Rural” initiative.
There’s more to the choice of rural vs. urban life of course.
And it shouldn’t be lost that small towns aren’t all the same, any more than cities are. Each has its own personality, and sometimes a person and a community just click. To paraphrase Andre Maurois: In literature as in real estate, we are astonished at what is chosen by others. (The 20th-century French memoirist actually wrote “In literature as in love …” but the logic holds.)
“Growing art communities such as North Adams, Massachusetts or Marfa, Texas are typically sparsely populated areas, but they are currently experiencing a shift in their demographic – as millennials are looking for a slower-paced lifestyle and a close-knit community, and see it in these environments,” designer Rima Abousleiman wrote for Archinect, noting that “neither North Adams or Marfa was inherently predisposed to cater to the arts prior to their current status as a sort of contemporary art haven.”
Patrick Woodie, president of NC Rural Center, suggests that there might be one more clincher to explain the growth of 30somethings in the Tar Heel State’s least densely populated counties, one that improves education, entrepreneurship and even access to health care.
“If there’s not broadband there that’s robust and available, that’s not going to be one of those communities,” he told WRAL-TV, Raleigh’s NBC affiliate.
Where millennials are landing
Of course, the urban-rural divide is more a matter of degree than a dichotomy. There’s plenty of ground in between, figuratively and literally. They’re not so many young singles anymore as they are young marrieds. And, like young marrieds of earlier generations, they’re gravitating to suburbs. According to the EY survey, 41% of Millennials who owned a home in 2018 lived in bedroom communities.
And yet, there are plenty who are setting down roots in cities, just not the overcrowded, noisy ones.
“Madison, Wisconsin, is a new mecca for millennials, according to a recent study from the National Association of Realtors, which ranked the top millennial housing markets based on both their high share of current young residents and of millennials moving in,” writes CNBC real estate correspondent Diana Olick. “Three out of 4 recent transplants to Madison were millennials and they have mostly stayed in the area, giving the city an overall high millennial population.”
Other secondary markets she notes include:
- Oklahoma City
- Grand Rapids, Mich.
- Omaha, Neb.
- Durham, N.C.
- El Paso, Texas
- Salt Lake City, Utah
It’ll be important going forward to keep tabs on this small-is-beautiful trend because there’s some discussion about how desirable cities will be going forward. Again, these discussions predate the current pandemic.
“A 2016 study by University of Southern California professor Dowell Myers contends millennials will be less likely to cluster in cities in the future,” Casey Fabris of the Roanoke (Va.) Times reports. “Three factors — the size of millennial birth cohorts, job opportunities, and housing availability — ‘harmonized’ before 2010, causing millennials to flock to cities, according to Myers. He expects the trends to shift.”
There are many paths to millionaire status, but one of the more common paths is real estate investing. According to The College Investor, 90 percent of millionaires around the world made their millions investing in property. But even within real estate, there are different ways to invest, such as real estate crowdfunding. Some of the more popular, and profitable, means of obtaining wealth for many real estate investors in the U.S. include:
- Fix-and-flip properties
- Rental properties
- Foreclosure and pre-foreclosure investing
- BRRRR investing
- House hacking
- 1031 exchanges
While these are popular methods of real estate investing that have produced much wealth for investors, there is another type of real estate investing that has emerged in the last decade that is also producing wealth for private investors.
The Rise of the Real Estate Crowdfunding Opportunity
Real estate crowdfunding (RECF), which is also known by other names, such as marketplace lending and private real estate lending, combines the concepts of fractional investing and real estate syndication. The ability to collect funds from multiple investors in different geographical locations and pool them into a single real estate project while allowing those investors to diversify their individual real estate portfolios through a single portal has grown into its own industry. As a result, there are now more than 100 real estate crowdfunding platforms, many of them specializing in a particular type of investment.
The practice of syndication was popular in the 1980s before the internet went commercial. The idea behind syndication was that several real estate investors could pool their money into a syndicate, which would choose the properties these investors funded and earn a percentage of the returns for managing the investments.
Fractional investing has been around even longer. The advent of internet-based funding, however, made fractional investing more popular and available to the average investor.
Today, fractional investing opportunities are available as debt-based instruments and equity-based investments allowing private investors from all walks of life an opportunity to buy a piece of a real estate deal and see returns on their investments based on the structure of the deal. Changes in securities laws in the last decade have allowed real estate crowdfunding and private lending platforms a legal means of making public offerings that just a few years ago couldn’t occur. That means real estate investments have opened up to a whole new class of investors.
3 Ways RECF Will Offer Better Future Investing Opportunities
Forbes Councils Member Carlos Jose Rodriguez Sr points out three trends in real estate crowdfunding going into 2020. Each of these trends offers private real estate investors grand opportunities for building wealth this year and beyond. These trends include:
- Bigger and better deals
- Institutional capital
- Mergers and acquisitions
Let’s take a quick look at each of these trends.
Bigger and Better Investment Deals
Real estate crowdfunding has become a competitive industry. As the industry grows, and as more real estate developers adopt crowdfunding as a means of raising capital for their projects, the deals tend to get bigger. That’s good news for investors. Bigger deals mean more potential returns, but another side of that coin is that RECF platforms hone their underwriting and risk assessment practices so that the deals that are funded are actually better investments overall.
Institutional Capital Makes RECF More Efficient
Another trend in real estate crowdfunding is the growing interest of institutional investors. Institutions want to protect their wealth and investments. They are not prone to taking unnecessary risks. When institutions and high-net-worth individuals, who are more sophisticated investors, see an opportunity, they will use that opportunity to maximize the return on every dollar invested.
The fact that institutions are taking an interest in real estate crowdfunding means that the industry has reached a level of maturity, and it makes RECF investing more efficient for all investors involved.
Mergers and Acquisitions
Rodriquez points out that not all RECF platforms will survive. With more than 100 platforms currently existing, and many of them specializing in a particular type of investment, it’s possible that consolidation is just around the corner. There hasn’t been much of it yet, but larger platforms could begin to swallow up smaller platforms. Increased stock market volatility could have a negative impact on the profitability of smaller and struggling platforms, which could end up in the hands of larger competitors. That would simply serve to make the market more efficient. In the long run, investors will benefit from better deals and fewer platforms to choose from.
2 More Benefits to Real Estate Crowdfunding in 2020
As always, investors benefit if they don’t put all of their eggs in one basket. Instead of looking at one vehicle for your investments, you can protect against downturns in one category by keeping your portfolio diversified. In other words, if you’re heavily invested in stocks and bonds, branch out into real estate and commodities. Even within the broader investment categories, you can spread your investments around to protect your entire portfolio. If you are not currently investing in real estate through crowdfunding portals like Sharestates, adding RECF to your investment portfolio will keep your assets spread out among different types of investments and protect your wealth.
Another way real estate crowdfunding benefits investors is by allowing individual investors to put up less money for a shorter period of time. Accredited investors can get into most deals with less than $5,000. Depending on the platform, you can get into a lot of deals for less than $1,000. And you can still spread your investments out among several deals on the same platform.
These deals are also for a shorter period of time. Most RECF platforms provide investment opportunities for 12 months or less. These short-term investments allow investors to ride out volatility waves in other markets while maximizing returns on better investments.
RECF Still Requires Due Diligence
While real estate crowdfunding provides individual investors with several opportunities, you should still perform your due diligence. When you check out a RECF platform, you should look at three things:
- What experience and background do the RECF platform operatives have? The founders of some platforms have a strictly technological background. Ideally, you want to invest in a platform where the leadership has real estate experience.
- What are the underwriting practices? Risk assessment is a very important part of any type of investment. How does the platform evaluate the deals it offers to investors?
- Finally, you want to check the platform’s track record. How many deals fall through? How many get funded? How many deals do they fund every year? The quality and the number of deals offered to investors are a testimony to the quality and character of the RECF platform.
If you’ve already made millions on real estate investments through any of the traditional means of private investing, you should consider real estate crowdfunding for the reasons mentioned above.
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.