Marketplace Lending and Institutional Investors

Until recently it was difficult for smaller investors to participate in direct investments into commercial real estate projects. Even sponsors of smaller non-core real estate projects have historically limited …

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Until recently it was difficult for smaller investors to participate in direct investments into commercial real estate projects. Even sponsors of smaller non-core real estate projects have historically limited their syndication partners to limited numbers of high net worth individuals – partly to avoid having to deal with individualized reports and inquiries from large numbers of investors.

Communications technology and its facilitation of “peer-to-peer” or “marketplace” lenders, however, have now enabled smaller (but still accredited) investors to participate more broadly in specific commercial real estate investments.   The internet has made it possible for accredited investors to gain nationwide access to lending opportunities in commercial real estate that were historically unavailable to them. Technology has also served to automate many of the reporting and communications chores that might otherwise present obstacles in dealing with large numbers of individual investors.

Real estate marketplace sites have experienced significant recent growth, and there appears to be a lot of growth to come, if only because the industry is still nascentThe relatively small share of marketplace peer-to-peer lending companies (such as LendingClub and Prosper) as compared to other non-bank sources (as indicated in the graph below for credit markets generally) indicate the small base from which the entire peer-to-peer lending industry is starting, and the large growth prospects available to it.

Non-Bank Lending

How does this development affect the institutional investors in commercial real estate? At least part of the “buzz” around marketplace lending is its potential to significantly expand the capital pool available to the real estate investment market.   The SEC estimated in 2010 that over 7% of all U.S. households, or approximately 8.7 million households, then qualified as accredited investors. Assuming that the numbers remain roughly similar today (and also assuming that the SEC doesn’t tighten the accreditation requirements, as they are considering), that’s a significant potential market that is likely not fully serviced by existing institutional investors. 

Many of these investors are drawn to higher-yielding opportunities. This often means that marketplace lenders may have initially focused on investments that are not currently well-serviced by traditional institutions. The best of these companies can thus provide institutions with a prime source of deal flow relating to “non-core” real estate projects. Value-add and opportunistic investments often offer better yields and more diversification than core, Class A properties — and institutional competition is already heavy in the latter market. 

Hard money” lending to investors rehabilitating single family homes, for example, can be more profitable than many other private lending opportunities. Most industry followers estimate that hard-money loans account for about 1% of the residential mortgage market.  Assuming annual debt originations in the overall residential lending market of over $1 trillion, this leads to an annual residential “hard money” market size of approx. $10 billion. Deal flow relating to properly underwritten, high-yielding real estate loans is increasingly attractive to many institutions. 

Strategic allocations of some assets to non-core markets is often considered by institutions — but sometimes rejected because of the additional internal resources needed to gain expertise in those new market areas. Marketplace lenders that prove themselves able at performing initial diligence and analytic functions, however, can offer institutions ready access to deals where the bulk of the screening has already been performed, thus potentially opening up a whole new market area for institutional investors. The recent announcement by one major marketplace lender of its partnership with an institutional purchaser of first-lien “hard-money” residential mortgages is indicative of this new trend. 

Many marketplace lenders also sell whole loans to institutional buyers, so that these buyers are themselves listed on the property titles. While these marketplace lenders remain closely tied to the individual investors that drive the “peer-to-peer” portion of their business, these complementary relationships with institutional investors are increasingly driving much of the companies’ growth. Having ready and willing buyers of whole loans available to them means that these marketplace lenders can remain focused on loan origination and careful underwriting. Such synergies with institutions lets the marketplace lenders be less concerned with the “demand” side of the investments, and to concentrate on loan production in areas where they have particular expertise. 

Additional real estate lending deal flow may be increasingly important to institutions if CalPERS’s recent decision to divest itself of hedge fund investment eventually leads other institutions to follow suit and shift some of their assets toward additional real estate holdings. The move into commercial real estate lending has been made more viable because of the general recovery in the sector. Institutions seem to be less focused on more risky speculative investments and more on real estate lending – and the marketplace lenders offer an entrée into a sector of the commercial real estate market that many institutions hadn’t previously focused on.

Internet-based companies have often also shown themselves at being proficient with collecting huge amounts of data and processing that data far more cheaply and quickly than more traditional off-line businesses. Marketplace lenders may, over time, demonstrate an edge in collecting and acting on a variety of customer and financial data across a variety of areas of the commercial real estate investment business. 

At the company that I work for, for example, we are making use of a huge trove of credit data that is available with respect to real estate loans and borrowers across the country. Smart use of this data can help the company to modify its pricing algorithms; if done properly, this could lead to reduced loan losses and better overall returns for investors.

This points to another reason why institutions may be interested in partnering with marketplace lenders — because of their potential to be a disruptive force in the industry. The movement toward P2P investing is already playing out in the consumer and small business credit space, with LendingClub and OnDeck Capital likely to soon complete IPOs at significant valuations. The growth of these companies has been nothing short of phenomenal; Lending Club has doubled its loan origination volume each year since 2007. Banks’ role as the primary source of consumer credit may well, over time, increasingly threatened by P2P platforms.

Can peer-to-peer lenders do the same in the institutional real estate sector? The larger ones, despite their original focus on “non-core” real estate assets, are increasingly offering high-level opportunities to their investors, and thus are already beginning to play in the upper-tier markets now dominated by larger institutions. As this trend continues, institutional investors may well find that partnering with marketplace lenders becomes more of a competitive necessity. Institutional decision-makers should consider how partnering with these peer-to-peer companies may open up the path to new markets and products that are complementary to the institution’s existing areas of concentration.

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