Private Lending hiccups

Japan and several of European countries around the globe got sucked into the negative yield vortex – interests rates dipped into negative territory. Depositors over there are paying financial institutions to safe-keep their money. Faced with inflated prices across asset categories, good deals in commercial real estate are harder and longer to come by these days. While waiting for the right investment, investors can consider gaining indirect exposure to real estate through private lending.

Private Lending secured by properties is none other than a form of asset-based lending where individuals like you and I (the lenders) play banks (or glorified pawn shops). Investors can either invest into debt funds in which collaterals are spread across a pool of assets to achieve degree of diversification or lend against one specific asset. Here I’ll share an hiccup experience on one of my private lendings.

 

The Backdrop

The property backing my loan is a condo unit in a fractured class B/C condo in the Carolinas. The borrower, an active RE investor (let’s call him “REB”) has a portfolio of properties and various development projects in the area. He picked up a number of condo units for cheap from a fire sale. The unit required little cosmetic upgrades so not a major lift. I first heard of REB from some podcasts.I later connected with him on Bigger Pockets. Several months later, as I was deploying capital, I decided to carve out a small portion to start a lending relationship with REB. As part of my due diligence, I spent time tour several of his projects and met with his attorneys, and some other partners who worked with him on his development gigs. At any rate, I decided to proceed with writing a first lien loan for 6-month period in exchange for monthly interest-only payment at annualized rate of low double digits, I thought this loan could buy me time while I shop other investment opportunities. In the meantime, I could earn some carry. Back track a bit: I had been talking to several real estate investors taking private loans but they all required fairly high minimum to start with at least a year term, some even longer, and the return is lower than what REB offered me. Given REB had been in the real estate space for some time I thought it’s a slam dung. I would just collect my checks for 6 months and reassess later.

First three months progress as expected; I got paid. Right around Thanksgiving, check stopped. Upon inquiring, REB told me that his father’s health deteriorated and needed REB and his siblings took turn looking after. REB had to travel from one side of the State where he lived, to another side of the State where his parents resided. He didn’t have time to ACH me the payment but would catch up soon enough. Who can fault him for taking care of family member, especially ailing parents? Okay, fair enough I thought. Christmas and New Year came and went. Nothing. It’s the Holidays, I told myself. Relax! As we move further past new year, my performing loan turned non-performing, then eventually to default and stayed there for several months.

The Hiccups

When it rained, it poured. As it turned out a series of unfortunate events befell REB. The first wave was the around-the-clock caregiving to his parents. As a result of rushing to places, REB got into a car accident and was hospitalized himself for a brief period. Later on, he caught his wife cheating on him and they proceeded to file for divorce. Some time later, his dad passed. I don’t mean to trivialize these things but you can’t just make them up!  Communication with REB was spotty and irregular; whatever calls to discuss next steps were repeatedly re-scheduled or missed. I got more and more frustrated as time went on.

 

Mixed Feelings

Of course I sympathized with REB’s difficult circumstances. But my feelings were mixed with anger. I was angry for being held hostage by someone else ’s life events that were not of my making. REB was not to blame as he didn’t will them either.   We were all just trying to cope. There were times I really wanted to find out when I could see some cashflow and to step up on our communication. The better part of me knew that given the circumstances I needed to give REB room to breath and mourn. The situation was tricky as it called for patience, empathy and sensitivity but also the need to nudge things along. So nuanced and draining!

As an aside, what made it worse was that I was counting on the originally scheduled repayment in March to meet a liability coming due in June. I thought building a 3-month window between the two events would give me more than enough time to re-direct the payoff to cover an upcoming payment. Boy was I wrong in this particular case. Since I had a non-paying receivable, no payoff was forthcoming. I certainly did not have enough time to find a buyer and close the sale so REB can pay me back. I had to scramble to  come up with the money to put out my asset-liability mismatch fire. Siren!!! (Stay tuned on how I dealt with that in another blog. Suffice to say I did not patron a pawn shop :-]

I considered seizing the collateral. Technically I could because the Deed was in my name already. But I dragged my feet for several reasons. One being that the property is a condo and thus not financing friendly by banks given the investor concentration in the HOA. With limited agency/bank financing, my only exit would be to sell to another investor as opposed to a homeowner – not a prospect I like. It’s not the kind of property a typical homebuyer goes for anyway. Another reason was that while the property produces generous cash-on-cash return on paper (unit was tenanted by then), anything major breaks would erode “bigly” into my PnL. The alternative is wait and do nothing; but while my unpaid principal balance plus the accrued was still less than the market value, my loan had been negatively amortizing. If noting happens, eventually I would be underwater. Time was not on my side. Chop! Chop!

Righting the course

Just as I accepted the unavoidable to take over the property, my “luck” turned the corner. A prospective buyer that REB found earlier approached me directly. That buyer wasn’t too responsive to me previously but his financing failed through so he looked to me, lender to Seller (REB), to extend him (the buyer) a loan. We ended up hashing out new loan terms ourselves shortly thereafter. He wanted to buy & hold. Ideally I wanted to exit completely as this experience left me a rather bad taste in my mouth.  But the thought of sourcing buyer myself, vetting them and “wasting” more time exhausted me even more.  Clipping coupon for another year was not a bad alternative.  There weren’t (and still aren’t) too many good opportunities for me to re-deploy into anyway.  I could pair off my other debt position if the right investment comes along so this “lazy” solution was not that hard a pill for me to swallow.

In the end, I managed to recoup all the accruals and extended a new but smaller loan (hence repatriating some of principal back and de-risk) to the new buyer.  Did I leave money on the table by not flipping it for a profit? Who knows. While what transpired is not an outcome I envisioned going in, I am glad the fiasco was over.  Fingers crossed that my new loan wouldn’t be as “tumultuous” and dramatic as the last one.

My takeaways from the experience

#1 – I can study the market, underwrite properties, vet the borrower but I don’t know how to underwrite an extension risk resulting from life events that impact borrower’s ability to fulfill his or her end of the bargain.  Life events are things such as illness, death, divorce, etc. I am not the only one stumped by this either. Another private lending I am part of – one that was originated by a group of seasoned active investors with whom I invest passively – is delayed by, guess what, “borrower needing to take his mom in & out of hospital”, among other things, or so it was communicated to me. Sounds familiar?!?! Even though in that case the borrower has a team, progress is moving at snail pace, if at all.  The contractor had been putting “finishing touches” since April and property has yet been listed (we are in Aug). Sigh! What to do about it going forward? As far as I could tell, not much; you can either roll with it (take over the project and monetize the asset yourself to make a profit or at least be made whole, modify loan terms, etc.) or wait it out.

#2 – Real estate is illiquid and everything takes longer than you expect. Duh! You are probably thinking “tell me something I don’t know.” Knowing it is one thing; experiencing it is another. It takes time to line up financing, perform due diligence, get permits/certificates, to schedule closing, the list of things that can be derailed and cause delay goes on and on. It’s important to build in contingencies. It’s the nature of the beast. Know it and accept it.

#3 – Transparency & open communications when things go sideway is key.   When investors are left in the dark, they assume the worst.   Providing regular updates when things are not going as planned are key not only to keep investors informed but when done right, it could help manage expectation and build trust. Email suffices and doesn’t have to be lengthy. Just state the facts, explain causes (if known), and share actions plan to take/next steps plus an ETA, caveat with dependencies as appropriate.   It’s not much to ask and not that hard.

Bottom line

Live and learn. Don’t let a hiccup stop or scare you from investing. Not every investment would be a home run and that’s okay.  Learn from it so you could improve next time and be a better and smarter investor today than yesterday.  The one thing you must avoid is NOT GETTING STARTED . Also, don’t do it alone.  One of the best things you can do is to learn from the experience of others so you could avoid the pitfalls and/or mistakes.  I want to encourage you to take your next step, or perhaps even your first step, as an investor with the goal of increasing your cashflow.  Contact us to help you get over the doubts and uncertainties that are keeping you stuck.