Real Estate Yields: Secured Real Estate Debt Investing

by Rob Phillips, CPA

P2P (Peer-To-Peer) lending has been around a long time and is essentially, microlending. The modern P2P lending model, however, was popularized in early 2006 with the rise of Lending Club and Prosper. The mechanics of the model are actually quite simple to understand. First, somebody who needs to borrow money applies for credit with a company like Prosper or Lending Club. The company then performs their own due diligence (background check, credit check, etc.) to determine if the applicant is a viable credit seeker.

Once the borrower is approved, they are assigned to a specific credit risk category (similar to FICO score rankings) and this category is used to determine the interest rate the borrower will pay on the loan funds. Next, the borrower’s loan request is advertised on the company’s online platform so individual investors or groups of investors can fund the loan.

The importance of this model cannot be understated: it is providing a platform to more efficiently connect people who want to lend money with those who are seeking to borrow money thereby disintermediating banking.

How Does The P2P Lending Model Relate To Real Estate Investors?

RealtyShares provides its own form of P2P lending to our members. Whereby Lending Club and Prosper are offering personal unsecured loans to their members, RealtyShares is offering investors an opportunity to invest in loans secured by specific real estate properties.

With an unsecured loan, the debt obligation is not collateralized by a lien on the borrower’s assets in order to protect the lender in case of the borrower filing bankruptcy or failing to meet the debt obligations. This presents a risk to lenders since the lender will have little or no recourse if the borrower fails to timely pay interest and/or principal when due. Rather, the lender will have to resort to filing suit against the borrower personally or turning to a collection agency.

On the other hand, a secured loan is backed by an asset, or is said to be collateralized. In the case of Real Estate Secured Debt, the loan is collateralized by the underlying real estate. In some cases, there are further assurances of repayment such as a personal guaranty from the borrower.

There are many syndicators who offer investors the ability to loan their money to borrowers through a secured loan collateralized by a specific real estate property (or pool of properties). This is more commonly referred to as Trust Deed Investing since the instrument that is recorded against the property and serves as the “security” for repayment of the loan is called a “Trust Deed”.

The collateral characteristic offered by Real Estate Secured Debt is critical in providing investor’s a margin of safety. This safety cushion is the difference between the loan amount and the value of the property, and can easily be identified with the Loan-to-Value (LTV) Ratio.

If the borrower does not meet their debt obligations, the lender has the ability to foreclose on the property in order to recoup their investment, plus any interest accrual owed to them.

Margin Of Safety

A first trust deed indicates that it is the first lien on the collateralized property, meaning it is the most senior position which will be paid out first in case the borrower fails to meet the debt obligations, resulting in default and a foreclosed sale of the property. Any position that is not senior is commonly referred to as the junior position, or mezzanine debt.

In other words, a mezzanine loan is any loan that is not the first trust deed. Mezzanine positions inherently carry more risk than the senior position, given that they have a lower priority to be paid out in case of default. Accordingly, given their position, mezzanine debt investors require a higher return, typically 2-3% higher than senior positions, to compensate for the higher risk.

Although the senior lien has priority over other liens, it is important to note that that in some cases the senior may be subordinated to certain unexpected liens such as a tax-lien or a mechanic’s lien.

What’s Next?

In the next post of this series, we will discuss the benefits and risks of secured real estate debt versus other types of debt investing. We will also go into more detail on the debt investments and light on the underwriting criteria that goes into vetting some of these debt investments in order to ensure an adequate margin of safety for investors.

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