Lending to qualified real estate investors is a fantastic alternative investment vehicle to produce low-risk, consistent, and attractive investor returns. However, you must prioritize your approach to various risks to be successful. Favorable investment returns are not produced by chance. Sound investments require one to offset risks with comprehensive analysis and produce acceptable returns for the degree of risk exposure. While producing attractive returns to investors is a main goal, mitigating risks and preserving principle should be the first priority. Higher returns are generally desirable, do not pursue higher returns if it comes with a high degree of risk.
In a market filled with various investment opportunities, we have always focused on the niches of the industry we understand best, building success based on the preservation of principal, a high level of control, emphasis on loss prevention, and contingency plans. This way, in both high and low market conditions, ideal or troubled individual scenarios, our priority on risk control has prevented losses and consistently generated attractive returns.
MITIGATING RISK
Structuring loans with sufficient collateral is the most secure approach to avoiding additional lending risk. When a loan is made, the loan is secured by a recorded Deed of Trust. This instrument is officially recorded with the county and gives the lender the right to take the property through foreclosure if the borrower fails to meet the agreed-upon terms in the Promissory Note. This provides a great amount of security to the lender in the event the borrower fails to meet their obligations or is unable to pay the loan back.
What about risks affecting the value of the collateral?
Determine the factors that produce the most adverse impact on the first priority, the preservation of principle. However, even with sufficient collateral from the start, it’s important to critically assess how its value could change over the one-to-two-year term of the loan. Factors such as shifting market demand, budget overruns, project delays, or systemic circumstances such as recessions can all increase investment risk. While one cannot control all these forces, strive to limit exposure through careful evaluation of four categories and their respective subcategories of risks.
"Structuring loans with sufficient collateral is the most secure approach to avoiding additional lending risk."
RISK CATEGORIES
*Highest risk categories affecting real estate debt investments
MARKET
Market selection can play a massive role in the success of your investments. Before considering any investment or loan, first take a macro approach by evaluating factors like the current housing supply, population growth, employment, density, and real estate sales.
Supply & Demand
This is the most important factor to consider when evaluating a market. A seller would want demand to exceed supply, while a buyer wants the opposite. When these two levels meet, the market is in equilibrium, and prices are stable. If supply is low, price will increase with demand, while price will decrease when demand is low, incentivizing the movement of inventory. As a lender, it’s important to assess supply and demand levels to ensure the borrower has a profitable exit strategy that leads to a successful loan payoff.
Population Growth
Demand is a derivative of population growth. Invest in growing markets to maximize occupancy rates, gross income potential, and sales prices. There are three types of real estate markets based on population.
Primary
Gateway or established markets are the largest cities. They include large population centers of 5 million or more people, with established commerce and industry. Usually, primary markets are the economic leader, offering stable demand for real estate, but also some of the most expensive housing. Generally, primary markets are the focus of REITs, private equity funds, and foreign investors. Investments in these areas can generate higher income but offer lower cap rates. Examples include New York City, Boston, San Francisco, Los Angeles, and Seattle.
Secondary
Slightly smaller with populations between 1-5 million people. These markets offer many of the same amenities as primary markets with less population density and lower home prices. Secondary markets are rich in population and job growth, making them the target of investors seeking upside potential. Secondary markets are seeing more growth as people move away from primary markets seeking a better quality of life. Examples include Las Vegas, Indianapolis, and Portland.
Tertiary
Smaller than secondary, typically less than 1 million population, with smaller urban centers and more suburban areas. Tertiary markets are emerging markets with steady job growth, offering investors growth opportunities and business potential. They can be attractive to renters and homeowners due to their affordability and quality of life. Demand will likely increase with population and job growth, leaving the potential for higher yields and favorable cap rates. Examples include Colorado Springs, Des Moines, Kansas City, and Charleston, SC.
All three markets offer different pros and cons. Consider various factors such as the asset type, housing demand, and the degree of leverage offered, against the location of the collateral before providing a loan. A primary market may offer high confidence in selling the asset for the target sales price or leasing up very quickly. In contrast, demand in a tertiary market may still be growing. Sale prices, market times, and lease-up periods may be less favorable and call for a more conservative approach to the degree of leverage offered.
Employment
Industry sectors and available jobs are important considerations when evaluating the stability of the investment market/submarket. Look at the national and state-level unemployment rates, then compare them to the local market. If the local economy has an unemployment rate higher than the national or state level, it can indicate slower growth in that market. Furthermore, knowing the economic composition of the target market is an important consideration to support future growth trends.
Median Home Price
When making lending decisions in a certain market, it’s important to know how the current and future values of the collateral compare to the median home price in that market. If the collateral is positioned to be a much higher-priced property when compared to the median price within that market, the buyer pool might be smaller, with extended sales and marketing time.
In general, within the projects suitable for private lending, pushing to achieve top dollar for homes within a specific market can be an overly optimistic strategy, while seeking to bring the property value to the median or slightly above-median prices is the conservative more practical approach. This is partially why we hear people say “buy the cheapest home in the hottest neighborhood” in order to unlock built-in potential and achieve greater profitability.
In addition, as lenders, it’s critical to evaluate if the borrower is overly optimistic about their sales price expectation, which could translate to unexpected issues in the later stages of the project.
Median Household Income
Comparing median income levels to median home prices can support the evaluation of future growth, demand, affordability, and appreciation of housing. It’s also a measure of the economic well-being of the community. It provides insight into the financial resources available to households, education, and health. The debt to income (DTI, debt/income) ratio is a metric used by banks to qualify prospective homeowners for loans. Ideally, banks want to see a DTI lower than 36% with no more than 28% going toward servicing the mortgage. If the median income is much lower than the median home price, potential buyers might not qualify for their purchase loans based on income qualification, this would produce additional challenges with the exit strategy.
ASSET TYPE
Population density, housing supply, and zoning all play major roles in the demand for certain asset classes. Profitable opportunities can emerge by paying close attention to potential city planning & zoning changes that sometimes occur to accommodate a community’s needs for higher-density residential housing, expanding job market, tourism, and more.
Residential: Single-family homes (SFR), 1-4 units, townhomes, condos.
Commercial (CRE): Multifamily 5+ units, hotels, office, retail, mixed-use, self-storage, mobile home parks.
Land: Brownfield is previously developed land that must be cleaned up before future use. Greenfield is land that has never been developed.
Property Class
Class A: Generally, high-quality newer properties are located in desirable areas which offer the best amenities. Low vacancy rates, higher rent, and low maintenance issues. Stable lower-yield investments.
Class B: Slightly older properties but still well-maintained. Not always professionally managed. Maintenance issues are likely increasing. Lower rental income. Can be great value-add investments since renovations and improvements can upgrade the property class, increase rents, and reduce vacancies.
Class C: Usually, more than 20 years old, and located in less desirable areas. Often require updating and renovations. Vacancy rates may be higher and rents the lowest.
EXPERIENCE
From our experience, there is often a direct correlation between investment failures and a lack of experience, vetting borrower experience reduces the probability of future defaults. Additionally, taking control of the project/asset requires a large investment of time, money, and resources, so lenders must be diligent to avoid being forced into such a position. We believe pre-qualifying general contractors, builders, sub-contractors, and borrowers based on their level of experience is the key to decreasing the likelihood of these events.
Exclusive Sponsorship
Fund Managers must approve or hire only experienced, licensed, insured, and bonded General Contractor(s). The GC must provide a full track record of successfully completed past projects, which must include projects similar in asset class and scale. All construction contracts must be a negotiated GMAX contract (guaranteed maximum price), and contract penalty clauses for production performance delays should be included.
Co-sponsorship
The co-sponsor is often a partnership with the equity fund or developer/builder. They likely understand the market, planning department, the permitting process, and already have preferred vendors, suppliers, and subcontractors. These investments can offer lower returns due to the profit split, but allow the fund to focus on contract negotiations, capital sourcing, and progress.
Borrowers
Experience requirements for borrowers depend on the scope of the project, loan type, asset type, and leverage. The experience requirement should be less strict for small single-family fix & flip projects when compared to a much more complex production level ground-up construction project of ten plus single-family units. As a baseline metric, requiring the borrower to have completed a minimum of five projects will help avoid risks associated with a lack of experience. The borrower must prove they have acquired, successfully completed, and either exited or currently hold and manage the property. The proof is provided by verifying the sales, title, and ownership histories of the provided track record.
"From our experience, there is often a direct correlation between investment failures and a lack of experience, vetting borrower experience reduces the probability of future defaults."
LEVERAGE
Most lending risk is mitigated through leverage constraints that vary based on market conditions and property types. Leverage limiters ensure a suitable amount of equity is reserved in the collateral’s value to hedge against unexpected increases in expenses or decreases in property value. There are three different leverage limiters often used. The maximum loan amount offered is limited to the lesser of the three.
Loan-to-value (LTV)
This ratio is used to limit the total advanced loan funds vs. the appraised as-is value of the collateral. Typically, this ratio will not exceed 80% LTV. This limit can be adjusted down based on market conditions and asset types.
Loan-to-cost (LTC)
This ratio is used to limit the total loan commitment vs. the total costs (acquisition, budget, and interest reserves), typically this ratio will not exceed 85%-90% LTC.
Loan-to-finished value (LTFV or ARV)
This ratio is used to limit the total loan commitment vs. appraised value of the asset after improvements, usually, this limit is <75% LTFV/ARV.
*Common leverage constraint ratios used in private lending based on asset and loan type
Sponsor Investment
Successful real estate investments require a thorough understanding of market conditions, budgets, negotiations, and reliable partnerships. A lending team will forge these skills through years of experience. If you manage a debt fund, consider investing your own money along with investors, this might give you a different perspective on risk and make you a stronger lender in the long run.
Financial Commitment
It’s important that a borrower/sponsor has a financial commitment to their own projects because it’s far less likely that someone will walk away from a problematic project if their own money is at stake. Risks can come from various directions; Qualification and track record alone are good indicators but do not guarantee success; Prolonged time can expose the project to unexpected challenges that can diminish returns; Uncontrollable systemic risks can come into play with extended time; Increasing material costs, labor shortages, and market demand shifts can all contribute to reducing both the top and bottom lines. If a sponsor shares in the risk with their own money invested, it motivates them to keep the project under budget and on track with the intended development schedule. Targeting a minimum of 5-10% equity contribution from the borrower/sponsor will greatly reduce these risks.
Final Thought
Private lending is a much-needed tool for real estate investors, developers, and builders. It provides access to quick and reliable funding solutions built to meet the growing demand for housing and enrich many communities. It provides an alternative, secure, asset-backed platform for our investors to participate in various US markets and leave the heavy lifting to us. Brenance is grateful for the trust our investors place in us to contribute to this cause, while still providing a safe alternative investment platform.
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