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Borrower vs. Banker - Which Side Is Better?

As we deal with COVID-19, one of the key questions for investors is what happens to the real estate market in the coming months. The impact to the stock market was swift and clear, but the implications to the real estate market is more difficult to assess.

The amount of risk depends on which side of the equation you are on. Are you a "borrower" or a "banker"? The risks are quite different.

The Borrower Side of the Equation

When most investors think about investing in real estate, they usually assume they need to be on the borrower side of the deal. They seek to purchase a rental property in good condition that they plan to hold for numerous years. Alternatively, some investors focus on older properties with a fix and flip model. In both cases, the investor is on the borrower side of the equation.  As long as the home is rented, the renter pays on time, home prices keep rising and there are no major maintenance issues, it is smooth sailing for the long term. For fix and flips, the borrower needs to finish the project on time and on budget and then quickly disposition the property. But what happens when the market slows down, the renters or buyers disappear and market values decline? Things become much less clear on the performance of your investment.

The Banker Side of the Equation

With real estate note investing, investors have an opportunity to be on the "banker" side of a deal. Lets take an example: a project costs $350,000 including the purchase and renovation of a home and the borrower is seeking a $280,000 loan from a note sponsor.

You decide to invest $5,000 in the $280,000 note. In return, you will receive a pro-rata share of the interest income from the note. When the borrower sells the property, you receive your principal back. Unlike a traditional 15 or 30 years mortgage, the principal is returned when the investment is complete, not gradually every month. The sponsor of the note carries the first lien on the home to ensure that the note is paid back in full with interest.

But what happens when the market slows down? Your risks include the borrower not being able to make the interest payments on time and/or the borrower is not able to sell the home. In a worst case scenario, the sponsor forecloses on the home and sells it at the current market value to get as much principal back as possible.

Borrower vs. Banker - The Numbers

Lets compare the numbers with a simple scenario.

A $350,000 residential debt deal includes $70,000 cash down from the borrower combined with a $288,000 investment from the sponsor using a 12 month debt note at 10% interest. The closing costs and fees are absorbed in the loan. We ran two scenarios. The first scenario assumes the property has no appreciation before the market downturn ($350,000 market value). The second scenario assumes that the property has a 10% gain ($385,000 market value) before the market downturn.

Now lets consider 10%, 20% and 30% property value reductions in the downturn.  

Scenario #1
Market Value of Property: $350,000
Borrower's Investment:  $70,000
Banker's Investment:  $288,000

Scenario #2
Market Value of Property: $385,000
Borrower's Investment:  $70,000
Banker's Investment:  $288,000

As you can tell by this very simple example, in a market downturn, it's clear that being on the "banker" side of the equation is lower risk. If the property is either sold or foreclosed at the current market value, the loss that the borrower takes is significantly higher than the banker's loss. As the "banker", you get the upside of having received interest income regardless of the value of property. In addition, if the market value goes down and the investment must be liquidated, the loss comes from the borrower's equity value first. Only after the borrower has lost all their equity does the lenders' principal investment get impacted.

Investing as a "Banker"

Investing in real estate debt notes provide investors the opportunity to participate in the "banker" side of the equation. While the above example makes it seem very simple to be banker, its not the case. Like any investment, its critical for an investor to do their research on every project. What location is the investment in? Some states have foreclosure rules that benefit the borrower, while other states have rules that benefit the banker. What is the sponsor's track record? What is the borrower history? Finally, how does the downside risk compare to the interest rate on the note? A diversified portfolio of real estate investments, both in residential debt and commercial debt deals is a great way to diversify your portfolio but it is important to do your research.

In summary, being the "banker" can be an attractive proposition when the future of the real estate market is unclear but only if you do your research, select only deals with a solid foundation and diversify across multiple holdings.

Good luck investing!

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