Borrower vs. Asset-Based Lending

Unsecured consumer credit loans – in the online marketplace world, a market generally dominated by Lending Club and Prosper, although SoFi has laid claim to student loans and …

Couple Signing Mortgage Documents

Unsecured consumer credit loans – in the online marketplace world, a market generally dominated by Lending Club and Prosper, although SoFi has laid claim to student loans and Kabbage to small business loans – are usually just that; there’s no collateral behind them in the event of borrower non-performance.

These unsecured loans necessarily involve underwriting (risk analysis) that is based directly on a lender’s assessment of the individual borrower’s likelihood to repay. Credit reports, bank card payment histories help in this assessment, but there’s really not much else to go on.

This is the main reason why credit card interest rates are so high.  LendingClub and others created such a large marketplace precisely because many investors believed that those rates had been a little too high, or credit demands a little too stiff, in the wake of the Great Recession.  Online marketplaces servicing such sectors offered thinner spreads — investors were willing to accept somewhat lower rates, and those returns were still quite good compared to many other asset classes. 

Real Estate Lending is Usually Asset-Based

Lending in the real estate sector, however, is a different animal altogether.  The underwriting turns more on the nature of the underlying property, or “asset.”  By taking a mortgage (or trust deed) on the property, lenders on real estate provide themselves with some level of security – a feature of real value if the borrower turns out to be less than reliable.

Loans secured by real estate are usually secured by a “first mortgage” or a “first trust deed” (the exact instrument depends on the state).  The mortgage (or trust deed) is a legal instrument that essentially pledges the property as security for a promise to repay a loan.  It constitutes legal proof that a loan has been made on the property and is secured by that property.  The “recording” of the mortgage or trust deed with the county recorder’s office serves to puts other lenders on notice that there is now a prior loan on the property.

Because real estate loans are secured by the subject property, they are generally considered to involve significantly less risk compared to unsecured consumer loans.  There’s no assurance against a widespread drop in asset prices, but the relative infrequency of such events, together with the presence of a significant equity “cushion” on most individual loans, generally acts to mitigate such risk.

Risk Controls on Mortgage Loans

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There are several ways that real estate lenders attempt to further control the risk of their loans.

Equity in the transaction. Loans are rarely made for more than the purchase price of a property (although with cheaply-discounted distressed properties, there can be exceptions).  There is nearly always an equity “cushion” – the borrower’s own skin in the game – that provides the lender with a buffer should something happen to the property or if the real estate markets take a dip.  Not only are defaults less likely when this is the case – the borrower now has something to lose — but the change in asset value must be more severe before the lender is adversely affected.

Understanding of Local Market “Comps.”  Since the loan is based as much (or more) on the value of the asset (the property) as on the borrower’s credit, the valuation of that asset is key.  Although every piece of real estate is different, there is almost always some type of value comparison that can be made with similar local properties, so that the lender has a decent understanding of the market value of the security underlying the loan.  Local property appraisals, broker price opinions, and comparative market analyses are all tools available to lenders to make an educated assessment of such value.

Borrower’s Personal Guarantee.  Where a personal (or in some instances, corporate) is obtained, the lender avails itself even more assets against which to make a claim in the event of default.  As with the equity cushion more generally, this guarantee feature also serves to reduce the likelihood of default, since again the borrower has more to lose in such event.

It’s possible for a project to go south — values can drop, a borrower could fall on hard times, it may take longer than expected to complete.  But asset-based loans offer more opportunities for a lender to mitigate their risk.

Benefits of Real Estate Loan Investing

The nature of real estate loans can make them an attractive investment option for many investors.

Security.  Real estate is a “hard” asset that has intrinsic value.  Compare this to “paper” assets, like a stock or bond, which is a variable or fixed claim on future cash flows.  With a real estate loan, lenders know the exact property that forms the security for the loan.

Reduced Volatility.  Real estate tends to be a less volatile asset class than stocks, where price movements can be significant.  As long as prices do not precipitously decline, there is a reasonable likelihood the borrower will repay a loan, because that borrower will have equity in the investment.

Steady Cash Flow.  At the company I work at, interest payments are usually received by investors monthly.  Although no investment is guaranteed, these expected interest payments may provide relatively stable income that can provide a degree of downside protection during periods of stress in the financial markets.

Diversification from Other Asset Classes.  Real estate is a different asset class and behaves in different ways than stocks or bonds.  Crowdfunding further allows investors to participate in real estate opportunities at lower minimum investment amounts – as low as $5,000 — so that investments can be more easily spread across different opportunities, providing added diversification.

Real Estate Investments are a Different Animal

It is important to keep in mind that not all loans are the same.  There are important differences between unsecured consumer lending and the mortgage-backed loans offered by RealtyShares and others in the real estate crowdfunding space.

These loans are based largely on the asset value of the property, which can be estimated by reviewing comparable properties; are secured by that property via a related mortgage or trust deed; involve an equity cushion that serves to reduce default rates; and generally also include a personal guarantee from the borrower to create even more security.  While lenders and investors are bound to analyze imperfectly the various risks involved with making loans, those risks are inherently lessened by these key features of loans relating to real estate.

Lawrence Fassler is the corporate counsel of RealtyShares, a leading online real estate marketplace. Previously he served as the general counsel for another prominent real estate finance company; had run a real estate construction firm; and had worked for over 15 years as an attorney with prominent New York and Silicon Valley law firms (Shearman & Sterling and Cooley). Lawrence also earlier served as the general counsel for a Bay Area medical device company that was ultimately acquired for over $4 billion. Lawrence holds Series 7 and 66 licenses, and has a BS in Mechanical Engineering from UC Berkeley and a joint JD/MBA from Columbia University.

The real estate investment opportunities discussed above still carry significant risk.   The investments currently offered by RealtyShares are private offerings, exempt from registration with the SEC, and the disclosures are less detailed than would be expected from a registered public offering. The investments are also illiquid, with undetermined holding periods and no real preset liquidity terms. These offerings are also currently only available to accredited investors, so the illiquid nature of any investment is heightened – further emphasizing the differences of these securities compared to registered, publicly-traded securities. In addition, statements concerning investment objectives are forward-looking statements and involve only predictions, not guarantees.  Such statements are based upon current expectations, assumptions and beliefs that involve numerous risks and uncertainties, including judgments with respect to future economic, competitive and market conditions, all of which are difficult or impossible to predict accurately. 

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