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After nine years of a rising stock market, we enter 2019 in what appears to be a very volatile time for equity markets. In the space of weeks we’ve seen 1,000-plus point swings in the Dow recently. This begs the question of whether or not 2019 will bring a recession, a bear market or both. I don’t pretend to know the answer, but I am willing to predict that this year will continue to be turbulent for equities.
Unless you have the stomach for day-trading into this volatility or are taking such a long position that current moves in the market don’t affect you, you’re likely trying to develop an asset allocation strategy to preserve capital while still earning a fair risk-adjusted return. Private real estate lending, particularly in the short-term debt space, may offer a unique opportunity in these turbulent times and those ahead.
What is private real estate lending?
In 2017 alone there was nearly $60 billion worth of residential real estate purchased by flippers, who significantly renovate the property, and then either resell to an end buyer or rent it out as a cash-flowing rental home. These redevelopers largely finance the purchase and renovations via short-term bridge loans from private money or hard money lenders. (Full disclosure: This is one function of my company.) And thanks to legislation passed in 2012, if you are an accredited investor, you can invest in these loans as easily as you purchase stocks.
Various benefits come with this mode of investing:
1. They are short-duration loans, typically between six to 12 months. The borrower is incentivized by the short term of the loan and maximizing their return on equity to rehab, sell and repay as quickly as they can. This puts you, as a lender, in a reasonably defensive position.
2. They are secured by a first-lien position against a real asset with considerable equity. A typical loan requires the borrower to put down 15-20% equity into the purchase of the property. The value of the asset is also increasing as it is renovated, meaning the equity cushion typically reaches 30-35%.
3. They offer high yield and current monthly interest. The average annual yield is typically between 8% and 10%. They also pay interest each month, meaning you generate income which can reinvest to compound your returns.
Consider Your Risk
Like any investment, there are risks involved with short-term real estate loans.
1. Housing prices in most markets are back to where they peaked during the run-up to the 2008 crisis. Many investors are rightfully worried that we’re on the precipice of another real estate correction. I personally believe that there are a number of demographic tailwinds that will support a stable and slight appreciation in housing.
For the sake of argument, let’s assume I’m wrong and that we’ll see declining housing prices in 2019. In such an environment, there are benefits to being a lender. The way to earn a return while building in downside protection is by lending capital with sufficient equity capital in front of you.
For these loans, an 80%-85% loan-to-as-is-value ratio (LTV) means that if no improvements are made to the property, the market would need to lose 15% or more before your loan has negative equity (the borrower takes the first-dollar of loss until their equity is eroded). If the home is completely renovated and the loan-to-after-renovated-value ration (ARV) is 65-70%, this means the market would need to lose 30% or more for you to be at risk of losing principal.
For context, the S&P 500 was down 4.38% in 2018. To realize the same loss in these assets, the real estate market would need to lose 20% or more, and the borrower would need to make no interest payments. Relative to the risks of equities, these investments do offer some nice downside protection.
2. Market risk aside, there is also execution risk. You are counting on the borrower’s ability to make improvements to the home to create value. There are a lot of challenges that can arise over the course of a project, such as permitting delays, unreliable contractors, unpredicted expenses, etc. When we choose to fund a loan, we require the borrower to have previous experience with similar scope projects. We believe this significantly reduces the execution risk.
3. Another risk has to do with the illiquidity of these investments. Even if you invest in a loan that has adequate equity protection with an experienced borrower, there is the possibility that the market or other unforeseen challenges cause the return of your principal to take longer than expected. While the term of these loans may be as short as six months, it is worthwhile to consider that your capital may be tied up longer than you expected. To the extent that there is enough equity, the good news is that you will continue to accrue interest and could eventually earn not only your regular interest but additional fees for extending the loan.
Making A 2019 Allocation
If you’re like me and not excited about the turbulent equity markets, setting aside an allocation in short-term real estate loans may make a lot of sense. With various online platforms, you can get started with as little as $5,000 invested. This allows you to “dip your toe” into the asset class and also allows you to diversify into multiple projects in various geographies, creating a portfolio effect. Your downside is protected by a real asset — even in the worst of times, real estate rarely loses 15% of value in a 12-month period. Relative to the alternatives of riding the equity roller coaster or going into cash, the short-term debt loans offer attractive yields backed by an asset you likely understand.