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Golden Rule

March 2022 Insight

Our guest writer this month is Dennis Lanni. Dennis is our partner in the Debt Liquidity Fund, and one of the sharpest debt pros we have ever come across. He began his career in 1998 as a Stock Options Market Maker on the Pacific Stock Exchange for TD Bank in San Francisco, California. Since 2001 Dennis has been active in distressed residential property, which has involved in the revitalization and disposition of over 1,000 distressed residential properties and in the workouts of non-performing residential loans.  He currently resides in Folsom, CA with his wife and two children.

Remember the Golden Rule! Whoever has the gold, makes the rules!  From The Wizard of Id – Daily Newspaper Comic Strip created by Brant Parker and Johnny Hart in 1964.

To imagine a world without the ability to finance and borrow against real estate seems implausible. The affect that financing has on real estate values by creating demand and providing transferability cannot be overstated. For example, values are impacted on properties that can’t be traditionally financed, or have an increase in mortgage interest rates, which in turn has an influence on the demand and transferability of the Real Estate. Both Demand and transferability are two of the four essential elements (nicknamed “DUST”) that contribute to real estate values; D (Demand), U (Utility), S (Scarcity) and T (Transferability) as described below:

Demand: The desire to buy and an ability to pay.

Utility: The item satisfies a human need or desire, such as Shelter, Income, or Recreation.

Scarcity: Limited in supply, as supply diminishes, value increases.

Transferability: Able to transfer from one owner to another.

Financing in real estate is the equivalent of water to a fish; it is crucial, and is instrumental to the healthy functioning of the real estate ecosystem.  The goal of this article is to touch upon the following topics: 1.) Benefits of investing in real estate loans, 2.) Loan product types & real estate loan investments, 3.) Risk vs Reward.

  1. Benefits of Investing in Real Estate Loans: The benefits of loans backed by real estate fall into two categories: Passive Income and Capital Appreciation.
    • Passive Income is the most common reason why investors invest in loans. Money is lent out, and in exchange the borrower agrees to pay a certain payment amount for a defined number of months. At the maturity of the loan term the property is sold or refinanced, and the unpaid principal is paid back to the lender (investor). Loans are secured by real estate (properties), which helps mitigates loss of capital because the real estate can be foreclosed on for repayment if necessary.
    • Capital Appreciation occurs when purchasing a loan, or more commonly loan pools, at a discount to the unpaid principal balance. Most people are not aware that loans on the secondary market can sell for below the unpaid principal balance.  Depending on the circumstances of the loan or loan pool, the selling price can range from selling above the unpaid principal balance for Fannie Mae insured loans, or up to a 50% discount for non-performing junior loans.

Unlike traditional lenders who underwrite loans using what is called the five Cs of credit (Capacity, Capital, Conditions, Character, and Collateral), non-traditional lenders underwrite loans focusing almost exclusively on the property value (Collateral). For a non-traditional lender, the lower the loan to value the better.  Since non-traditional lenders have flexible lending guidelines, they often lend to underserved markets that traditional banks cannot or will not touch due to strict guidelines or political pressure, such as lending without a personal guarantee or investing in non-performing loans.

  1. Loan Product Types and Real Estate Loan Investments: Property types are categorized as either Residential or Commercial, and further delineated into subcategories (i.e., single family home, duplex, apartments, office, warehouse, etc.). Borrower types are categorized into Owner-Occupied and Non-Owner-Occupied Owner-Occupied Borrowers that own residential properties significantly outnumber Non-Owner-Occupied Borrowers. Most alternative loan funds choose to avoid Owner Occupied loans because of the myriad of consumer protection and compliance regulations.

Types of Real Estate Loan Investments: the two most common loan investments are single loan investment(s) and Loan fund investments:

Single Loan investments/Trust Deed investments can be made directly as a “one off”, where the investor is the beneficiary/lender on the recorded loan. Direct loan investments have pros and cons; some pros are a) the lender/investor is in control, b) there are reduced 3rd party costs, c) generally no other partners are involved.  Some cons are a) direct management so you need to make decisions, b) Legal compliance (you better know what you’re doing or know someone who does), c) Concentrated risk of a single loan.

A Loan Fund investment is where the investor invests in a company that owns the loans.  Loan Fund investments also have pros and cons; some pros are a) multiple loans to offset threats like nonpayment, bankruptcy, delinquent property taxes, condemnation, code violation, etc.., b) Fulltime, dedicated loan management team dealing with day-to-day activities, c) sourcing and vetting multiple loan opportunities daily. Some cons of a Loan Fund investment are a) higher costs, b) less control over day-to-day activities, c) Possibility of the mismanagement of the Loan Fund’s assets.

  1. Risk vs Reward: Are you on Offense or Defense? I tend to underwrite loans with a “glass is half empty” mindset. I do this because as a lender I do not have direct control over the real estate.  My job is to consider negative outcomes and how they could affect our loan investments, because for the most part, positive outcomes are what the borrower has already agreed to (i.e., the terms of the loan). The true goal is to identify asymmetrical risk reward scenarios; for example, a senior loan with an interest rate above 10% at 50% LTV, when prevailing mortgage rates are at 5% at 80% LTV.

Below is a list from low to high risk ranging from a-i (a= low risk and i= high risk).  Typically, with less risk there is less reward (i.e., lower interest rates).

a) Federally insured loans.

b) Non-Qualified Mortgages, which are usually fully documented loans that don’t quite meet the Federally insured guidelines (i.e., loan balance exceeds the Fannie Mae loan limits).

c) Non-conforming Senior Performing loan(s) below 70% LTV

d) Performing Junior loan(s) at a CLTV (Cumulative Loan to Value) below 70%

e) Construction loans

f) Non-conforming Senior Performing loan(s) above 70% LTV

g) Performing Junior loan(s) at a CLTV above 70% CLTV

h) Non-Performing Loan(s)

i) Non-Performing Junior loan(s)

Investing in real estate loans has endless possibilities to not only earn great returns on capital, but also gives borrowers an opportunity to improve their financial stability by assisting real estate owners in growing their rental portfolios, helping families keep their homes by restructuring non-performing loans, providing rescue loans so the borrowers can avoid a foreclosure, and the list goes on and on.

This is just scratching the surface of investing in real estate loans and how vital that role is to the real estate market. As a final take away, I want to leave you with the version of the Golden Rule that I prefer; “Do unto others as you would have them do unto you.” I always remind myself that our borrower’s success translates to ours.

Dennis Lanni