[Editor’s note: This is a guest post from Matt Rodak, CEO of Fund That Flip, an online lender that provides short-term loans to experienced residential real estate redevelopers. Accredited Investors can invest online in loans originated by Fund That Flip. Annual yields range from 9-12% over 6-12 month terms. Fund That Flip was a 2017 Lendit Industry Awards Finalist. You can learn more at www.fundthatflip.com/lender. Matt can be reached at Matt@fundthatflip.com.]
Hard Money Lending: A Quick Intro
Back in 2012, I borrowed money to purchase a house I planned to fix-and-flip. I contributed 20% of the purchase price as a down payment. For the privilege of borrowing the other 80%, I paid a local “hard money lender” a 3.5% origination fee plus interest only payments at a 13% APR.
At the time, I was also an avid reader of LendAcademy and doing a bit of investing on the “peer-to-peer” lending platforms. I was averaging a 10-11% return on the platforms and I remember thinking:
“Why am I paying 16.5%+ for a first-lien loan that’s secured with real estate while receiving an 11% return on an unsecured consumer loan? This makes no sense. This “hard money” market is not operating efficiently.”
I started doing some more research into the market that was originating a majority of these types of fix-and-flip loans, which is called “hard money lending”. There were a few things that became quickly apparent to me.
1. The market was highly-fragmented. There wasn’t a single lender that controlled any significant amount of the national market. More specifically, I couldn’t find a lender that had more than 1% of the overall market. There were a handful of larger lenders that operated in multiple States, but for the most part, this was a market made up of numerous small, local lenders.
2. The use of technology was virtually non-existent. The ability to apply online for a hard money loan didn’t exist. The lender I borrowed from didn’t even have a website. Even the larger lenders I discovered, were mostly operating via email, PDF loan applications and “boots-on-ground” underwriting.
3. Capital formation was very analog. The balance sheets of these hard money lenders were often made up of a few high-net-worth individuals and some additionally sourced “country club” capital. This put them in a perpetual cycle of originating new loans to keep their funds working while also raising additional capital to meet the demands of their borrower base. Too much cash was a drag on returns while not enough would cause them to pass on loans they’d otherwise originate.
4. Hard Money Lenders, generally speaking, had a very negative reputation among the borrower community. This was in part due to the high interest rates. However, upon further digging, the real cause of dissatisfaction among borrowers was the lack of service and transparency. I heard stories of lenders not showing up with funds at closing, leaving the borrower at risk of losing their deposits. Other stories involved undisclosed fees that were charged when borrowers made requests for construction funds. More innocuous offenses included lack of responses to funding requests; long-form loan applications that had to be handwritten; repeated requests for information that had already been provided; and numerous other customer service follies.
2013: The Year It All Began to Change
Midway through my exploration into this space something big happened that started to fundamentally change this market.
In 2013, Congress passed the JOBS Act. More popularly known as “Crowdfunding Legislation”, the JOBS Act created potential for companies to raise capital publicly without all the red tape previously required. While not initially contemplated that the Act would have a profound impact on the real estate market, “Crowdfunding” for real estate quickly became the fastest growing use-case for this new legislation.
The result of this was a host of new entrants into the real estate lending space that were “technology-first” companies. With these new companies came significant amounts of Venture Capital. These venture fueled companies began developing digital distribution channels, sophisticated online loan underwriting and origination platforms and more efficient ways to source capital. This combination allowed them to grow quickly while consolidating some of the fragmented market, achieving scale not previously seen.
The Perfect Storm for Disrupting Hard Money
In addition to the JOBS Act enabling a business model for real estate syndication that was attractive to venture capitalists, a few other market forces aligned in favor of disrupting this market.
First, the real estate market had begun to bounce back considerably, with prices for homes starting to return to pre-recession levels. This reality meant loan portfolio performance was protected by appreciating asset prices. Any underwriting mistakes were forgiven by a rising market, keeping defaults and losses across the industry very low.
Second, yield in almost every asset class had become increasingly difficult to obtain. Equities, trading at all-time highs, made it difficult to allocate at attractive entry points. This combined with historically low interest rates have kept returns on bonds and other income producing assets at all-time lows. This had both retail and institutional investors seeking yield from less traditional asset classes. Everything from Venture Capital to marketplace lenders, and now real estate “crowdfunders”, were receiving new allocations from investors seeking yield.
Put all of these forces together and you had the perfect recipe for attracting institutional capital.
1. Thanks to the JOBS Act, there are numerous well-funded originators that have grown to a large enough scale whereby an institution can allocate a significant amount of capital ($100M+). These technology-first companies are also well organized and professionally managed.
2. A positive track record, partially thanks to a rising real estate market, provided institutions the data they needed to gain a level of comfort to “go long” on allocating capital to these new platforms. Had the JOBS Act been passed in 2006, and these new companies been formed then, the future of Real Estate Crowdfunding might have looked quite a bit different.
3. With opportunities to generate yield virtually non-existent in traditional assets, allocators were open to exploring asset classes that may have been less interesting in other environments.
Where Does That Leave us Today?
Much like the early days of peer-to-peer lending, the new online real estate originators won business by providing a better borrower experience. Online applications with instant feedback on pricing and terms provided better transparency to borrowers. Quick funding decisions that are augmented by large data sets, rather than relying 100% on appraisals, allows these new lenders to provide more certainty around closing. Online dashboards where borrowers can order construction draws and make interest payments make the loan servicing experience easier for the borrower. Regardless of the financial innovation that is to follow, these technology platforms have improved the level of service provided to borrowers.
More compelling though, is the financial innovation that these new online lenders have brought to market. With the growth and consolidation, investment banks such as Jefferies, J.P. Morgan, Nomura Securities and Goldman Sachs have been able to establish relationships with some of the larger originators that are demonstrating an ability to underwrite profitable loans at scale. In 2016, the industry saw one of the first securitizations of bonds sold to hedge funds, private-equity firms and REITs.
In a short amount of time, this industry has gone from being served by local “country club capital” to being traded by some of Wall Street’s largest, most reputable firms. The investment bankers have officially arrived.
That said, the five largest online originators still only write between 5-8% of the total loan volume in the fix-and-flip market. We are still in the very early days of what is likely to be a massive consolidation of a previously fragmented market.
Since 2013 we’ve already seen considerable rate compression in the fix-and-flip market. The same loan I received back in 2012 at 3.5 points and 13% interest can be originated for as low as 1 point and 7.99%. As more liquidity comes to the market via securitization and other institutional asset allocators it should be expected that rates will continue to compress across the country.
As the scale of these platforms continue to grow, pricing and services provided to borrowers will continue to improve as a means to fuel additional growth. For the regional lenders that once controlled this market, it begs the question, how will they remain competitive?
The other lever to pull to win new business is loosening underwriting and due diligence standards. This is a frightening proposition for the industry as a whole. If loan-to-value thresholds increase or diligence standards decrease, it will surely lead to trouble. Any correction in the real estate market could prove fatal to an undercapitalized originator.
It’s my hope, that as an industry, we’ll remain prudent in our underwriting and due diligence standards. Striving for efficient market pricing and a better experience for borrowers is the right course. Cutting corners on due diligence or loosening underwriting is a disservice to both investors and borrowers as it could impact the availability of long-term capital needed for this industry to flourish.
Whatever the outcome, it appears that the online real estate lending market (i.e. Real Estate Crowdfunding) is very close to reaching escape velocity. This was certainly helped by a number of well-timed market forces which have allowed these new companies to reach scale, receive sustainable levels of funding and bring in institutional capital that may be inclined to support this industry through different growth cycles.
Whether institutional capital is “good” for the industry may be debatable. My hope is that it will bring additional levels of accountability, transparency and standardization to this previously underserved real estate market as we strive to improve products and services to our borrowers.