Home resales declined after the 2008 financial crisis, but they're now on the rise again thanks to low interest rates and rising home prices. And with renewed interest comes investors looking for higher returns.
But this real estate strategy of buying homes, renovating them and quickly reselling them requires fast financing, for which developers are willing to pay high interest rates. The loans are secured by the property and have short terms, usually less than a year, and the funds that fund the loans offer guaranteed returns of about 8% for those who can raise a minimum investment, usually $100,000.
The home-flip financing industry has been booming for decades and has been on the rise recently. Flips accounted for 5.7% of all home sales last year, the highest level since 2006, according to Atom Data Solutions, a national real estate database. The trend, made popular by TV shows like HGTV's “Flip or Flop” and Bravo's “Flipping Out,” has caught the attention of Wall Street. Last week, Goldman Sachs acquired Genesis Capital, a major lender to home flippers.
But these loans — also known as fix-and-flip or hard-money loans — carry risks, including that developers will be unable to repay the loans or that property prices will fall, making it difficult to sell or even rent the properties.
Chris Gootek, a former Morgan Stanley stock analyst who has been an independent investor in Grand Rapids, Michigan, for the past decade, said he lost money in a loan fund in 2008 but remains bullish on the sector.
“I was getting good rates of 12 to 13 percent for a few years, but then I had a really bad experience in 2008,” Mr. Gootek said. “I lost a lot of money. It was poor underwriting.”
Newer funds from lenders such as Genesis Capital of Los Angeles and Anchor Loans of Calabasas, Calif., say they are becoming more transparent and conservative in their underwriting. Mr. Gootek puts about 20% of his liquid assets in a fund managed by Seattle investment bank Broadmark Capital, which manages $350 million across 200 short-term loans.
“The fund has not been tested since 2009 and I am very aware of that,” Gootek said. “There is some risk of real estate values resetting, but I am comfortable with a meaningful investment process.”
To skeptics, the quick recovery of real estate speculation may evoke the go-go thinking that led to the mortgage crisis just a decade ago. But investors say hard-money loans are more stable than bank mortgages because they are secured by real estate that has a lower loan-to-value ratio, a risk assessment used by lenders.
The industry average loan-to-value ratio is about 55 percent, compared with 75 percent to 80 percent for a typical mortgage. This provides ample protection against a decline in the property's value. It also ensures that developers won't walk away from the property because they've put a lot of their own money into the project.
“At the time the loan matures, say 11 months from now, we want the borrower to be successful,” said Stephen Pollack, CEO and president of Anchor Loans.
If a developer runs into a problem, “we'll help them find a solution,” he says. “We might ask them to bring in tenants and take out rental loans. But if the risk of the loan changes and the leverage amount becomes higher, we want to do something to put us in a safer position.”
In other words, developers have to put more money into it, but Pollack said most of them agree to this because they want to continue their relationships with their anchors.
The term of the loan is also shorter than a mortgage, so the risk is less.
“We're seeing an asset bubble in the stock market, and bond prices are rising,” said Shannon L. Sakocia, managing director at Boston Private Wealth. “Is this creating an opportunity for another bubble in the real estate market? The reality is that the short duration of the loans makes them easier to monitor. It's completely different from securitization.”
To make their portfolios more stable, some lenders are diversifying across multiple states to avoid being confined to one market or branching out into different property types, such as retail or land.
“The benefit to high-net-worth investors is instant diversification,” says Joseph L. Schocken, president of Broadmark Capital, “and it's very unusual to have such a diversified portfolio generate the roughly 11% yield we've generated. The remarkable thing is the stability.”
His firm has two funds running and is launching a third, all focused on fast-growing cities like Atlanta, Denver and Seattle, and he said his goal is to make the loan book as transparent as possible.
The average loan size ranges from a few hundred thousand dollars to $15 million, depending on the lender. At Rubicon Mortgage Fund, loans average $800,000 to $1 million. Rubicon is focused on the San Francisco Bay area but has diversified into retail, warehouses and land, said Douglas C. Watson, a principal at the firm.
Hard-money lenders boast about their speed — they can usually make loans in under a week, compared with the months it can take traditional banks — and for the small builders and home flippers who rely on these loans for business, the speed at which these lenders can make money outweighs the high interest rates they charge.
Jeff Walker, president of Square One Homes of Renton, Wash., which is building apartment complexes in Seattle, said he has used hard-money lenders for more than a decade. He borrows frequently from Broadmark and tries to laugh off the interest rates, which are typically around 12 percent for a one-year loan, plus a 4 percent fee. “These are exorbitant rates. What are you going to do?”
The company's timeliness is key for him, as he needs to move quickly in Seattle's booming real estate market.
“If I say I'll get it done within 48 hours, they'll help me,” he says. “I'm not a cash buyer, but I can compete with the cash buyers.”
But even Walker, who says he typically makes a 35 to 40 percent profit on his projects, is cautious, saying too much of a good thing can become too much.
“Seattle is a booming market,” he says. “It'll all end at some point, but why not do it while you can?”
Investors don't seem to fear the risk of collapse.
Richard Mulcahy, president of Northwest Bank's Washington branch, said he began investing his own personal funds in hard money loans after seeing builders do well on the loans.
“Most builders are able to get to the national bank stage, but many are willing to pay the credit costs because they know they will get financing,” he said.
Mulcahy said he has invested about 50% of his assets in the Broadmark fund. “Every industry expert, including one of my sons, says it's too expensive,” he said. “That speaks to my absolute comfort level and the way they've set up the fund,” he said. The fund has no debt and invests only in first lien securities.
Goldman Sachs' acquisition of Genesis Capital may signal an evolution in the industry.
Genesis Co-Chief Executive Officer Rayman Masouda said the company has expanded rapidly since receiving at least $250 million in investment from Oaktree Capital Management in 2014, buying up shares from earlier individual investors and expanding nationwide.
Matoda said the company is currently focusing on small and medium-sized real estate businesses rather than individual borrowers.
“When real estate booms, many people mistakenly think of it as a 'once in a cycle' opportunity,” she says. “It's driven by metropolitan areas. We're improving America's super-aging housing stock.”
But the business is still driven by wealthy investors who can meet the minimum investment of more than $100,000.
“In these markets, the risks are reasonable,” Gootek said. “If Seattle real estate is crashing, the stock market has already crashed.”