How to lose money fast: A real estate wreck is coming

We’ve all been on I-70 heading to the mountains when traffic slows for hours due to a wreck.  Everyone tries not to look as they pass by, but the vast majority of folks just can’t seem to resist the temptation. 

Unfortunately, there is a wreck waiting to happen. There won’t be bodily injury, but anyone involved is likely to feel it in their wallet.

After the 2007 meltdown, a number of Wall Street folks came up with a brilliant idea to allow individual investors to lend to other investors.  There were also a number of changes by the SEC that enabled small loans to be made that would not fall under traditional security disclosures/regulation.  This created the perfect opening for what is known as peer-to-peer lending.  There are a number of variations that have developed in this sector, but we’re focusing on the real estate arena.

This new lending is a unique financing model: investors pool their money to make a loan on a piece of real estate.  This sounds great in theory: Small investors can invest in a number of transactions in various markets, theoretically diversifying their risk while getting a good return on their investment. So what’s the catch?

First, it is important to discuss the details of how this lending works.  Many peer-to-peer loans are focused on the real estate investor looking to flip properties who needs financing to complete the transaction.  Under a typical peer-to-peer structure, they might lend 80-100 percent financing based on the purchase price or possibly up to 70 or 80 percent based on the after-repair value. Many will also finance the rehab/construction costs within the loan.

So how is this different from a bank?  Banks focus both on the borrower and the as-is value of the property.  Banks typically lend up to 80 percent of the as-is value of the property.  The borrowers have 20 percent real cash in the transaction as opposed to possibly 100 percent financing off the purchase price in the peer-to-peer model.  Along with focusing on the as-is value, banks also ensure the borrower has the cash flow to carry the mortgage for the long-term. Bank lending is considerably less risky due to these factors.

Peer-to-peer lending is considerably riskier since it is dependent on rapid price appreciation and liquidity.  With this type of lending, the intent is for the borrower to “flip” the property and not to hold the loan long-term.

As a result, the vast majority of the borrowers do not have the cash flow to carry the loan long-term, so the model works only when prices are appreciating quickly and there is ample liquidity in the market.  Without these two factors, the model implodes, as borrowers are stuck with vacant properties (remember the intent is to fix and sell quickly so they are typically not rented) without the cash flow to carry them (since the properties are vacant the borrower has to carry utilities, taxes, mortgage, etc..).  If the borrower fails to pay, the lenders ultimately are responsible for the negative carrying cost of the property.

The peer-to-peer model is also dependent on future value (basically the value of the property in the future after the property has been rehabbed).  Future value is determined by an appraiser hired by the lender.  The appraiser must first look at as-is value (what it would sell for today), factor in improvements, and ultimately determine what the property could possibly sell for in the future.  This is very difficult to get correct. 

In my opinion, many appraisers have a tough time getting today’s value correct, let alone factoring in improvements that have yet to be completed to determine a future value. If you saw my prior article: What do dominos and appraisers have in common, you’ll understand why I am skeptical of the accuracy.  Furthermore, the future value is predicated on a market continuing to appreciate.  Hopefully, we haven’t already forgotten about the last real estate wreck where prices actually decreased. 

So what will cause the next accident?  Unfortunately, it will not take much, since there are three factors that inevitably will change (the rate of appreciation, market liquidity and future value).  With three dependent variables it only takes one to cause a hiccup in the road and ultimately lead to a cascading wreck.  We’ve all seen on I-70 where one vehicle starts to slide and takes out 20 others within minutes.  The same thing will inevitably happen soon in peer-to-peer lending.  Fortunately, there is still time to avoid this upcoming wreck.