The following is a guest post from a lawyer writing about personal finance and investing at The Biglaw Investor.
One of the greatest achievements in the investing world over the past decade has been the dominance of index funds and the retreat of high-fee mutual funds and financial advisors. Investors, as a class, are starting to understand that attempting to beat the public market is a fool’s errand where the only guaranteed return is delivered to the brokers and advisors that take a cut out of each transaction.
At the same time, fast-growing technology has pushed private markets - previously unavailable to most investors - to the public.
Are there opportunities to get returns that aren’t correlated with the broader public stock market? I think there are.
One example of this “private-to-public” shift is the rise of real estate crowdfunding platforms. They open up investment classes previously unavailable to most investors by connecting investors with deals you typically wouldn’t see unless you were actively involved in the business, often outside of the investor’s home area.
For example, if you’ve ever wanted to own an apartment complex in a college town but didn’t leave near a college town and didn’t want the hassle of dealing with college kids, there’s now several options that allow you to get a piece of the equity.
However, I’m most interested in a quiet part of the real estate crowdfunding market known as “hard money lending”. As we’ll see in a second, hard money lending is a bit different than participating in the equity side of a real estate investment. Hard money lending has lower returns, ties up your cash for shorter periods but has the benefit of being backed by a hard asset. You’ll also get repaid before the equity investors see a dime.
What is Hard Money Lending?
Hard money lending is a private loan to an individual or company, secured by a first-priority lien against a hard asset (like real estate), typically for the purpose of fixing and flipping a property.
Let’s walk through a hypothetical example.
Imagine a local real estate fix-and-flip specialist in Texas spotting a house in his neighborhood for sale at a huge discount. The property might be a foreclosure, damaged by a storm or otherwise in a state of disrepair. As someone experienced in the local market, the specialist decides to buy the property, deploy a renovation team and then put the house back onto the market a higher value. To execute this plan, the specialist needs access to a bridge lender that can provide the cash for the purchase and renovations.
When the specialists approaches the bridge lender, it’s important to understand that the bridge lender is familiar with this market as well. This provides a further check on the specialist’s plans to purchase and renovate the property. If the bridge lender is convinced of the plan, they’ll typically provide loans for terms in the 6-18 month range to allow the specialist to execute the fix-and-flip.
Since the specialist intends to sell the property at a higher value, these aren’t your typical mortgages and because things could go wrong, the bridge money lender will typically charge between 7-12% interest on the project and perhaps a small origination fee as well. To smooth the cash flow for the specialist, the bridge lender will also typically only require interest payments during the term of the loan with one balloon payment at the end once the house is sold.
The bridge lender gets a decent return backed by a hard asset for a 6-18 month term. The specialist gets the cash he needs to complete the project with the cash flow flexibility to pay off the loan upon the sale.
How Can Private Investors Participate?
If the bridge lenders are doing all of the lending, how can the average Joe investor participate (or the first-year associate at a law firm)?
The bridge lender is eager to move onto the next deal but can’t since its money is tied up in the current project. Since it makes money on each loan via the loan origination fee, the bridge lender is incentivized to do as many deals as prudently possible without taking on too much risk.
That means the bridge lender is happy to sell the loan to the broader market and move on to the next deal, much in the same way mortgages work where your local bank will ultimately sell the mortgage to the bond market.
Previously these bridge lenders had no such option. Instead, they carried the loan on their books until repayment and passed on other available deals until the cash was available for redeployment.
The maturing hard money lending space is now providing the bridge lender with access to a broader private market where it can sell the loan to a bunch of investors.
Once the loan is sold, effectively the private investors such as you and me are now acting as the lenders in the deal, happily collecting our 6-12% return while the fix and flip specialist and renovation crew continue to execute the plan.
How Risky is Hard Money Lending?
The risk profile of hard money lending is easy to understand once you grasp the concept of LTV or loan-to-value ratio. This is because as a lender of debt, you have a higher position in the capital stack than an owner of equity.
In other words, holders of debt are always paid before holders of equity. Further, holders of debt with a security interest in an asset are paid before unsecured creditors. Therefore, debt holders with a first-priority security interest are at the top of the capital stack.
Here’s an example:
As you can see, the more equity in the capital stack, the more secure the creditor’s position in the capital stack. Because hard money lenders want to see specialists put skin in the game, they rarely lend 100% of the purchase and renovation price to the specialist. Instead, they may only lend 75% of the property’s valuation which requires the specialist to come up with the rest of the money himself.
In the 75/25% example, if the project cratered and the house had to be sold, the hard money lender would have to see a reduction of more than 25% in the property’s valuation before the hard money lender lost his first $1. When the LTV is even lower, the credit is in a better position.
It makes sense that the hard money lender is in the most secure position because the hard money lender is also capped on his upside potential. The most money he’ll receive in the deal is the interest rate on the hard money loan. Meanwhile, the person furnishing the equity portion of the deal has a higher risk/reward profile since he could easily lose everything if the property runs into problems or he could double his money if he’s able to sell the property for 125% of the original purchase price, including the renovation costs.
As you’ve probably noticed, a critical component of hard-money lending is ensuring that the valuation of the property is accurate. An inaccurate valuation makes the loan-to-value calculation worthless. The platform I’ve been using over the past five and a half months provides you with the specialist’s appraisal and also engages a third-party appraisal firm to provide a report on the property, to ensure that the valuation is correct.
Another major risk is that we encounter a situation similar to the predatory mortgage lending that led to the 2008 financial crises. If a bridge lender makes money on each origination and if it’s easy to sell each loan into the market, what’s stopping the bridge lender from doing as many deals as possible without concern as to repayment credit risk since that will be transferred to the investors?
To mitigate this risk we must rely on the platforms themselves and their incentive to only work with bridge lenders that have a proven track record of success. If Platform A works with unscrupulous bridge lenders and starts to have problems with its loans, you’d expect investors to flee to Platform B. Several failed deals could easily be a death knell for Platform A. Therefore, Platform A’s main job is making sure it only allows loans onto the system where it has a high degree of confidence that they’ll be repaid.
Many platforms reportedly turn away bridge lenders and various deals for this very reason. At least right now, they only want to work with the best of the best. However, the concept that underwriting standards will decay over time given the easy ability to resell loans to investors is something that a prudent investor should be considering at all times. I’m comfortable accepting lower returns in exchange for confidence in the valuation report and security of the credit stack.
My Experiences with PeerStreet
Before writing about hard money lending, I wanted to put capital to work on a platform so I could learn about the process. I choose PeerStreet after walking away impressed with the two co-founders, one which is an ex-Google employee responsible for creating Google Analytics and the other which is a former real estate lawyer. PeerStreet appears to be the perfect combination of technology and real estate, with a complex technological backend and a heavily vetted process of finding deals (as of the date of this article, investors on the PeerStreet platform have yet to suffer a loss).
To be clear, there are several ways to get involved in hard money lending. It’s beyond the scope of this article to talk about them all. I’m only focusing on PeerStreet because it’s the platform that I’ve used and the way I’m becoming familiar with the market.
PeerStreet offers two ways to invest. Either I pick the investments available on its platform or I allow the automated investment system to make investments for me based on preset criteria. I’ve done a mixture of both. The great thing about the automatic investment is that after an investment is made I get an email where I can look over the investment and decide whether everything’s okay. If I don’t like it, I have 24 hours to cancel the investment. If everything looks good, I simply do nothing and allow the investment to proceed.
Here’s a look at my PeerStreet portfolio, where I’ve deployed about $10,000.
As you can see, I’m lending money in California, Colorado, Illinois, Florida, New York and Virginia. By only putting $1,000 in each deal, the platform allows you to diversify geographically and across different specialists, thus reducing the risk that you’ll be involved in a particularly painful deal.
You may also notice that on one of my loans no interest has been paid despite originating nearly 45 days ago. Rather than crediting your account with interest when and as it’s paid by the specialists, PeerStreet aggregates the interest payments and pays on the 1st and 15th of the month to provide a more predictable cash flow for the investors. If you’re interested in seeing updates, I’ve posted more detail about my PeerStreet investment here.
Is Hard Money Lending Right For You?
It could be. If you’re looking to tie up your money for a duration between six to 18 months, hard money lending offers attractive returns in the 6-12% range secured by an actual asset and buffered by the equity portion of the capital stack furnished by the specialist.
As for the downsides, to participate on the PeerStreet platform you need to be an accredited investor ($1 million in net worth; $200K in annual income), which means that many investors won’t be allowed to participate. Additionally, the interest you receive from hard money lending will be taxed at ordinary income rates, which can make the real return significantly less for high earners already subject to high marginal tax rates. PeerStreet does offer the option of investing via a self-directed IRA if you’d like to include this asset class as part of your retirement savings, something which I’ve considered but haven’t implemented.
While I’m comfortable deploying $10,000, I suspect that I won’t be increasing this position until I move it into a tax-sheltered retirement account. Given my marginal tax rate of 41%, too much of the returns are eaten up by ordinary income taxes to make this a lucrative investment during this stage of my legal career. However, I would be comfortable increasing the amount of capital devoted to this investment class if I was retired and wanted to generate some additional income.
The final benefit of hard money lending is that it should be uncorrelated to the broader stock market. Sure, we saw a huge housing crises during the 2007-2008 financial meltdown but when you’re investing in hard money lending you’re involved in very specific fix-and-flip deals. While housing prices might decline, so long as you maintain a solid LTV ratio it’s the equity investor that will see his position wiped out. Even in 2007-2008, housing prices didn’t fall to zero. Acting as a secured lender that has the ability to liquidate the house to seek repayment is always the strongest position.