What are the biggest risks of peer-to-peer real estate lending?
Using a peer-to-peer lending platform to finance a real estate deal can allow a borrower to quickly access capital for investments. However, these loans have several drawbacks, including that they have short payback periods. Because of that, if a real estate flipper or developer runs into a lengthy project delay, such as problems obtaining permits, bad weather, or contractor issues, they could default on their loan, which could cause them to lose their entire investment in the project.
One of the greatest risks for investors who lend money to a company or individual, on the other hand, is that the borrower could default on the loan. When this happens, an investor can lose money.
The default rate on loans made by P2P lenders tends to be higher because they focus on providing funds to borrowers with higher risk profiles, such as those with lower credit scores. However, there is a notable difference between unsecured social lending made by a P2P platform like LendingClub (NYSE: LC), for example, which doesn't use collateral to secure loans, and those backed by real estate.
The only thing backing loans for things like debt consolidation and home improvement projects is a borrower's ability to repay. As such, if those borrowers can't make their payments, the loan servicer might need to write off the remaining loan balance. If that happens, the investors can lose a substantial portion of their initial investment in a loan since there is no collateral securing the debt.
I can attest from personal experience that some P2P loans made through Lending Club can lose close to 100%. Because of that, investors often earn less on a portfolio of loans purchased through a P2P platform than the implied interest rate, which has been my experience with Lending Club.
Real estate-backed P2P loans, however, are less risky than unsecured ones because the borrower must put the property up as collateral. As such, if the borrower defaults, creditors can sell the property to pay off the loan. Creditors with first-lien positions get paid first and could make their entire investment back if the property sells for a higher value than the loan amount.
Meanwhile, losses tend to be a much lower percentage of the initial investment than with other P2P loans.
In my experience investing with Groundfloor, one recently defaulted loan still delivered a net recovery of 89% of my initial invested capital. Because of high recoveries like that, my actual returns have come in higher than the expected return.
Another notable risk for both borrowers and investors with peer-to-peer lending is the possibility that the P2P platform could go bankrupt. If that were to happen, an investor could stand to lose their entire investment in a worst-case scenario, while borrowers would lose a funding source. There is an elevated risk that this could happen given that the social lending sector is relatively new -- the first one launched in 2005 -- and most platforms aren't yet profitable. If a significant economic downturn occurs, causing default rates to skyrocket, financially weaker platforms could potentially go out of business.
Given this risk, investors should limit the capital they allocate to P2P loans as well as on P2P platforms. Personally, I've limited my platform risk by keeping my total investment per crowdfunding platform to less than 1% of my invested capital.
Peer-to-peer real estate lending: A potential option for real estate investors who need or have capital
The social lending market emerged to fill a gap between the traditional banking sector and demand for loans from individuals and businesses that needed money but couldn't get it from those financial institutions. It aims to match borrowers at higher risk of default with investors willing to accept that risk in exchange for the potential of earning higher returns.
The P2P real estate lending market, meanwhile, brought that same model to the property sector. As such, it enables borrowers to quickly access capital for their projects. Investors with money to lend, meanwhile, can potentially earn attractive returns with a bit less risk than with other P2P loans since physical properties act as collateral backing these loans.
While the sector is still emerging, it's beginning to play a vital role in providing both access to capital and more opportunities for real estate investors.