Real Estate Crowdfunding: Rehab Loan Risks

Many of the popular real estate crowd funding platforms offer a fix and flip, short term loans as an investment opportunity. Usually these investments have duration of 6-12 months with interest only payments paid to investors. The loan is secured by the underlying property until the borrower repays the loan in full. After earning monthly interest on their investment, investors receive a balloon payment at the end of their principal. With these fix and flip or rehab real estate loans, investors pool their money to buy debt securities that are tied to the performance of a specific loan or pool of loans.

The important item to note is that this type of investment does NOT provide amortized return; you only receive interest payments with your principle returned at the end of the loan term period, hence the interest only payments. While interest rates and investor returns are high (11-12%) there are some real risks associated with such loans that investors should be aware of while chasing yields.

Borrower Risk

 

Purchase price and pressures:     

Lured by the flip and profit infomercials, many get rich quick house flippers have entered the market under the assumption that they can make a quick return on their investments. The major profit in fix and flip is as the name suggests, the home purchase price must leave room for rehab costs and then an up sell to net a profit. The competition in the market however has led to increased bidding at auctions as the housing market recovers. This results in higher than distressed pricing which has reduced profit for house flippers.

Secured P2P Lending Part 2: Ratio Review

Previously, we looked at features of unsecured and secured debt lending, specifically difference between unsecured consumer debt at major platforms such as Lending Club vs real estate based business lending on Reamerge. We went into details regarding real estate capital stack structure and how each position (senior vs mezzanine vs equity) gets paid out if the borrower defaults.

In this post we briefly go, superficially, into the underwriting criteria by Reamerge to evaluate the business cashflow and its underlying real estate as it relates to the margin of safety. In general, businesses that borrow on REAMERGE platform are:

• FICO (Fair Isaac Corporation) Score – of 650+ of the borrower
• Debt to Service Coverage ratio of greater than 3
• Loan-to-Value (LTV) or Loan-to-Business-Value (LTBV) of 65% or less

Real Estate Crowdfunding: An introduction to secured lending

Unsecured vs. Secured Lending:

As we discussed before, P2P lending/crowdlending provides an investor with a low volatility, monthly fixed returns  generating passive income. Reamerge provides its members with a “P2P” or “P2B” lending platform. While LendingClub and Prosper offer investors unsecured loans, Reamerge offers investors opportunity to invest in loans secured by real estate, or other forms of assets (inventory, equipment etc).

What is the advantage here? Unsecured loan is not collateralized and if the borrower files for bankruptcy or fails to meet debt obligation, this presents lender with little or no recourse. The lender will have to file suit against the borrower or turn to collection agency.

Investing in P2P Real Estate Platforms/REAMERGE – a historical overview and comparison with other asset classes

Introduction:

How do you determine if investing in REAMERGE is a “good investment”? In simple terms, it comes down to value. An asset’s value depends mostly on risk and underlying cash flows it produces. With that definition, the best way to assess an asset’s value would be to find a comparable asset with similar risk profile to determine yield/ROI. One can also flip the script and look at it from the other side: compare similarly priced assets and determine the risk associated with the asset. Before delving into a proper comparison of an investment on REAMERGE, let us look deeper into two important topics: diversification and historical returns of popular assets – stocks, bonds and real estate.

Diversification:

At a basic level, diversification helps with risk mitigation, specifically idiosyncratic risk (i.e. Risk that is specific to an asset or a small group of assets). This is more than just investing in different stocks – which hopefully you are investing via ETFs – for example, real estate may be doing well when stocks are not in a bear market.

Institutions such as Harvard have performed very well when it comes to diversification of their portfolios. These institutions go beyond assets such as stocks and bonds.

Now they invest in P2P lending platforms as well. Always ahead of the curve there Harvard…

Modern concept of crowd funding (in equities) and crowd lending (REAMERGE, Lending Club, Prosper etc.) are changing the field of non-traditional investments by democratizing the opportunities. If properly included in the portfolio, investors can achieve higher risk adjusted returns than traditional stocks and bond portfolio while lowering volatility.

Why is that?, because private equity and private lending has traditionally had no correlation with the broader capital market on a local level. What an investor invests in REAMERGE are loans given to cash flowing businesses with real estate. Such private deals are now finally available to retail investors.

Enough talk, let’s jump to facts

Debt (Peer to Business Lending) vs. Equity Investment

Overview:

Peer to Peer lending has been around for a while. This form of microlending was popularized by LendingClub and Prosper with simple enough mechanics: Borrower applies for credit on these platforms -> The platform (LC or Prosper) does their own due diligence if the borrower is viable credit risk -> request gets posted on their proprietary platform. At this juncture, “Peer” investors can pool money and fund the loan. The magic is happening on the efficiency of connecting borrowers with lenders and there by taking out the traditional banks as intermediaries (What happens to savings accounts? Banks used to lend that money to then earn savers interest! except now that just pays less than 1%)

Introduction to Crowdfunding/Crowdlending

Since the financial crisis, banks have tightened their standards and have made it difficult for small businesses to secure the capital they need to expand and grow their businesses. From a banks perspective small business loans simply do not generate the revenue potential that loans to large businesses do.

Banks see lending to small businesses as risky, assessing creditworthiness is difficult due to a lack of information about small businesses, transaction and underwriting costs are simply not profitable enough, among other factors.

So what’s the solution?