When peer to peer lending platforms like Prosper and Lending Club first appeared, people went crazy for them. It was a new asset to invest in and people were analyzing them to find an edge.
“Investing” in unsecured personal loans sounds risky but with it being so new, no one knew exactly how risky. It wasn't until later that many of these investments would only be available to high net worth accredited investors.
The platforms had their analysts and actuaries try to project default rates and price the loans accordingly… but no one really knows.
The small investment minimums, often $5 or $10, meant that you could spread your investment out across multiple loans and spread out your risk. $100 in one loan to one borrower is more volatile than $5 loans to 20 borrowers.
The problem was that the default rates for those loans were only guesses. Personal loans are notoriously fickle. Think about it – if things are going south, are you going to pay your utility bill, credit card bill, unsecured loan from your bank, or an unsecured loan on a peer lending platform? The answer is pretty clear.
And when those default rate guesses are not accurate, and things go off the rails as we saw in 2007 and 2008 (Great Recession), bad things happen. Instead of 5% defaults you saw 10%+ defaults.
Fortunately, I wasn't allowed to invest in those notes as a resident of Maryland and missed the fun of rising default rates. Nowadays, I can invest in crowdfunded real estate investing and my hope is that by understanding default rates I can avoid those potential losses.
Sadly, when it comes to real estate investing, the risk of default is (literally) a part of the equation. But it's not always the most fun conversation topic. That makes sense; after all, who wants to talk gloom and doom when making money is the real goal?
My Experiences with Crowdfunded Real Estate
To put this article in context, and to help inform you on how I've been thinking about default risk (what I consider the most significant risk of these deals), I wanted to briefly share how I'm involved.
As for this writing, I've committed $15,000 to two deals on RealtyShares (who has since stopped taking new investors and doing any new deals). With RealtyShares, you are investing in individual properties, it's not funds that buy the property. I can't speak to the specifics of each deal, it's against the terms of service plus it's not super relevant, but the first one was a common equity deal with a 5 year hold. The second is still open, though I've committed to the deal.
The first deal has had quarterly cash yields in line with projections, so I've been satisfied with it, and the quarterly updates have been timely and comprehensive. It's a nearly 160,000 sq ft. retail space (a strip mall is what we'd call it growing up in New York) and they provide all the specifics I could think of wanting including full financial statements, balance sheet, and cash flow statements. I feel informed.
What You Need to Know About Default Risk
Without properly adjusted risk profiles, you may end up becoming more familiar with the concept of default than you would like. Take this opportunity to learn more about the ins and outs of default—and how to avoid it.
First, what is default rate? Sometimes called a “cohort default rate,” it is the percentage of loans that lenders write off as losses after several missed payments. After loans have been written off, they are usually transferred to an agency for collection. In some cases, a default interest rate may apply and this is a higher interest rate levied on a borrower who has missed a specific amount of payments.
While individual firms and funds generally do not publicize their default rates, the Federal Reserve reports that in 2017 there was a 0.74 percent delinquency rate for commercial real estate loans booked in U.S. banks. In other words: one out of every 135 CRE loans processed by U.S. banks had at least one missed payment last year.
Why do borrowers default? There are a ton of reasons. It could be as simple as personal financial troubles – as in you're in over your head or over-leveraged. With commercial real estate, most borrowers can be trusted to have the resources to cover cash shortfalls in such events (as evidenced by the 0.74 percent delinquency rate).
That said, you don't want to hold more than your fair share of those 0.74% deals. 🙂
To avoid that, you need to conduct thorough diligence in the real estate sponsor that will control the borrowing entity—and the project's budget—before signing on the dotted line.
How Do I Evaluate Default Risk?
While there is no surefire way to guard your portfolio against investments in loans that will end in default, there are several steps that prudent investors take to protect themselves. The first and most important step is doing thorough due diligence.
As a starting point, here are a few important points to consider:
- Sponsorship. Do I believe in this business plan and the sponsor's ability to execute it skillfully? Has the sponsor previously executed this strategy for this asset type? Or in this market? How many years of experience does the sponsorship group have?
- Physical asset. When was the property built? When was it last renovated? When was the roof, parking lot, elevator or mechanical system last replaced? What is the likelihood that the property will need near-term or long-term capital expenditures?
- Leverage. Leverage can vary from as low as 50% loan to stabilized value (LTV) up to 80% or more. In some cases, it may even make sense to go over 80%. But generally speaking, multifamily projects should be at 80% or less for the senior loan, and other stabilized commercial assets should be at 70% or less. Over-leverage can lead to delinquency, which can lead to default, which can result in foreclosure.
- Debt Terms. Is the sponsor tapping out their wallet on this project? Are the debt terms reflective of the key strengths and weaknesses of the project and the borrower? And is the loan term appropriate? Refinancing risk goes up substantially if the debt matures in a softening market and the property value has dropped.
- Tenants. Are you going to wind up holding the bag if your tenants relocate or neglect to pay rent due to competitive forces or other unforeseen trends?
- Cap rate. How competitive is the current market? Are cap rates (property values relative to operating income) seeing upward pressure, i.e. do property values seems to be dropping? Are interest rates rising? How substantiated is the exit cap rate assumption, i.e. the sales price objective? Does this exit price assumption make sense?
- Market and location. Is the market cycle favorable for your asset? Moreover, is it located in a submarket with positive rental, occupancy, population, demographics, and job growth trends?
- Construction. Does construction, whether new development or value-add improvements for an existing property, have the potential to cause cost overruns or delays? If yes, how is this risk being mitigated?
- Leasing. Has the sponsor allocated sufficiently to marketing, tenant improvement and/or leasing commission reserves to lease up the property?
The list is meant as an introduction, a glossary of what to search for, but not comprehensive. Any of these topics would merit a post of its own!
Risk Profiles by Investment Type
Given what we know about defaults and default rates, what kind of structural risks does your investment carry?
There are three main ways to invest in real estate nowadays:
- Crowdfunding – Where you buy a small piece of a deal like through RealtyShares and others crowdfunding real estate sites.
- Fund Investing – Where you invest in REITs (ETFs or mutual funds) or through smaller REIT-like companies (many of the non-accredited crowdfunding sites are structured this way)
- Direct property ownership – Where you buy property directly or through syndicates
Crowdfunding private shares in real estate projects allows individual investors to put money into a legal entity (LLC) that invests in a real estate project or lends money to that project. Generally speaking, crowdfunding sites offer lower fee loads than most REITs. Also, because these are private investments, the investment performance is relatively less correlated to the S&P 500 and other liquid market indicators. As such, it can be an attractive way to diversify your portfolio, both by geographic market, asset, and investment type.
The fact that there is only one property attached to a given investment means that there is little to fall back on should the project underperform. That said, defaults pose a lower risk profile here as the property secures the loan, thereby acting as insurance. In addition, foreclosure auctions are an option should the sponsor or property owner default.
Publicly Traded Real Estate Investment Trusts (REITs) are professionally managed portfolios of diversified properties; most funds invest in commercial, corporate, or rental assets. Although relatively easy to trade in and out of, publicly traded REITs can involve increased short-term volatility risk because their performance is relatively more correlated to the stock market. If you exit during a recession (as many will be tempted to do), your returns can be damaged.
Fund investing offers a different risk profile from direct investing. Because a fund is a basket of properties and projects, it often hews more closely to cohort default rates and overall market performance. But it offers less control and customization, as investors are unable to select which individual projects they'd like to invest in. That said, these investment types also offer liquidity, meaning you can trade your shares after you've bought in.
Direct property ownership is when you own individual properties outright, yourself. If you're interested in this investment type, you can expect to devote substantial time to your real estate investments and be very hands-on and involved in every detail of those properties. You're in full control and can be as conservative or risky as you like.
That kind of responsibility can be appealing, but it's important to be realistic about the fact that when it comes to owning property outright, the primary risk is you. Have you read the market correctly? Built an achievable business plan? Will you be able to see it through?
The hassles of day-to-day property management are a big reason why many investors prefer to leverage the time and expertise of others. Professional real estate investors at curated marketplaces often devote their entire careers to learning the ins and outs of a given market. Passive real estate investing gives you the chance to benefit from that professional expertise—all while going about your daily life undisturbed.
How to Handle Defaults by Investment Type
What happens when there are defaults at different asset types?
With crowdfunded real estate, you are investing in a note or equity deal with the sponsor. If things do go according to plan, you're relying on the platform to make things right (or as right as possible) and so part of your due diligence has to be in how the company plans to deal with these inevitable situations.
With REITs, the fund will manage the various defaults and look to give you a blended return that satisfies your needs. They may promise 10% (as an example) but that may include deals where they are getting 15% to help counter those deals that may default (or go in arrears on payments, etc). To you, it's an invisible part of the investment and only reflected in the returns of the fund itself.
With direct property ownership, you are the “sponsor” (to use crowdfunded terms) so when you default, that's really on you so it's really not within the scope of this post. 🙂
In the end, whether you're risk-tolerant, risk-averse, or somewhere along the spectrum, diversifying your portfolio has to potential to boost your returns and real estate is a powerful way to do it.
With these new crowdfunding platforms, it's still important to understand that default risk is a serious concern. Don't get seduced by the promises of double-digit returns because not every deal will work out. Know how defaults will be handled because they will happen and you want to know whatever platform you're investing in will have your back and not hide from this rare inevitability.