The Market Pushed Us Out of Residential Fix and Flip
Commercial Real Estate
If you are like many investors, you loved our residential loan product. Short-term investments with high yield (9-12%) and monthly distributions, what was not to love? As much as our investors love them, you will no longer find them on RealtyMogul. We stopped originating them. Why? It was not an easy decision to stop offering residential fix and flip, but it bears an explanation, and here is ours now.
Private money lending has traditionally been a local activity. A guy with money makes a loan to a local developer to buy, rehab (aka “fix”) and sell (“flip”, or sell quickly) the property at a profit. The local lender knows the market well and is more than happy to take the property if the borrower fails to pay.
The purely local nature of fix and flip lending changed with online lenders having nationwide reach and access to tremendous amounts of capital, either from retail or institutional investors. At one point, RealtyMogul had in hand nearly $1 billion in capital commitments to purchase fix and flip loans from institutional buyers.
In late 2015, we started to notice a market shift. Fix and flip loan pricing started to drop. First it was 11%, then 10%, then 9%, and in many major markets it dropped to 8%. Throw in the cost of servicing these loans and on an 8% loan, investors’ estimated return is 7%.
Did the risk profile of fix and flip loans suddenly change? We did not think so.
Did the cost of originating and servicing them dramatically drop? While technology started playing a larger role in the space, this drop was too sudden and too sharp.
So, what happened? Market entrants flooded the market, taking the approach that volume is king.
There is something we call the risk/reward calculation in lending. The risk associated with a loan should be commensurate with the reward, or profit made by originating the loan. Take into account the cost of originating and that is how you can determine whether or not to make a particular loan.
At 8%, there should be a relatively lower risk profile to a loan. However, the opposite was true. The dramatic increase in capital in the market meant that riskier loans were demanding lower and lower rates. Borrowers with great experience, credit and lower leverage were able to get rates in the 4-5% range from banks, whereas the 9-12% loans were only available in markets where there were no alternatives and the risk was fairly high.
At the same time, a coming wave of loans started to come due in the commercial mortgage backed securities market. In 2016, Morningstar projected that up to $170 billion in loans were due in 2016-2017. These loans were originated over 10 years ago, right before the market turn, and were done on very aggressive underwriting terms that are no longer available. The net result is that somewhere between 60-70% of these loans due did not have available refinancing options that were sufficient to fully pay them back without more capital, even though many of the loans had solid cash flow. This gap – the space between a loan coming due and the loans available in the market – can be filled with a product called “sub-debt”, which can be structured as either a preferred equity piece or mezzanine loan.
Current market rates for sub-debt are 10-13%, the payments are made monthly, and the loans are secured by occupied commercial real estate with existing cash flow.
Risk-wise, while 10-13% may sound burdensome for a borrower to pay, remember that current interest rates on senior debt are low, so a borrower can take on a 70% loan at 4% and add 10% sub-debt at 12% and have a blended cost of capital lower than 5%, still below historic averages.
If we can offer our investors a 10-13% sub-debt investment supported by cash flow on a commercial property, or a similar-rate fix and flip investment supported by a home being rehabbed, in our judgment it is only prudent to provide the former.
At RealtyMogul, we always reassess the market to determine what is both the right product market fit, as well as a proper risk adjusted return for our investors. Until the market tells us otherwise, residential loans are no longer available at RealtyMogul. We hope you understand and enjoy the opportunity to invest in our sub-debt product.
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