Understanding Collateral in Real Estate Crowdfunding

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There’s a lot of talk going on in the P2P lending sphere about secured vs. unsecured loans. There’s also a degree of confusion: are unsecured loans really so scary? Are secured loans totally safe? What does it exactly mean that a loan is “secured” in the first place?

Let’s start from the beginning. An unsecured P2P loan is backed only by the borrower’s creditworthiness, i.e. their (presumed or actual) ability to pay back. If a borrower defaults on an unsecured loan, the lenders have no way to get their money back. 

A secured loan is supported by collateral. Collateral is an asset (usually tangible, e.g. property) that the borrower offers to the lender as a form of protection. In such a case, should the borrower default, the lender has the right to seize the asset, thus receiving compensation for the unreturned money. Most of all though, putting a worthy asset on stake provides the borrower with an incentive (a “stick”) to keep up with their financial obligation – otherwise, they potentially have a lot to lose (imagine putting your home as collateral).

Real Estate as Collateral

Property is probably the most obvious and common collateral in both P2P lending and traditional credit markets. Going a step further, property ownership is the most obvious and common real estate collateral type. This means that in the case of default, the lender(s) can seize the property (or its relevant share corresponding to the value of their loans), sell it and recoup the invested capital. The property in place can be land or buildings, from homes through office buildings, factories and warehouses to shopping centres and the like. Such collateral is usually a very safe option for the lender – properties tend to come with a high value and low depreciation, pretty much guaranteeing the payback. 

But there are also other options for securing the debt with real estate. Here are a couple of examples:

  • Assignment of rents entitles the lender to the income generated by leases or rents of the associated property in case the owner defaults on their loan. For example, if the property is a residential building and the owner receives monthly rents from tenants, the lender can “take over” that income, creating a regular cash flow.
  • First security interest on all assets on the premises allows the lender to claim the assets on the premises of the property (e.g. materials and equipment on a construction site, manufacturing machinery in a factory building). The lender can then sell the assets to recoup the capital.

Another way to look at real estate collateral is the priority in the repayment of debt. We outlined the range of risk-return options, or positions in the capital stack, from senior debt to common equity, in the article on investment types in real estate crowdfunding. In the context of real estate collateral, senior debt (the safest, low-return option) can be regarded as the first lien position. Essentially, should the borrower default and the collateral is liquidated, investors in the first lien position have the priority (i.e. receive any money from the property sale first) over investors who are further in the capital stack (bridge debt, preferred and common equity owners).

Other Forms of Collateral for Crowdfunding Real Estate

There are many ways of securing a debt. If you take out a car loan, the car usually becomes the collateral. If you use a credit card, it is likely to be secured with your savings deposits at your bank. Some collateral options, other than real estate, you might encounter in P2P lending world include:

  • Inventory, for example, the goods your company trades;
  • Invoices issued to your customers that are still pending and can be used (often by small businesses) as collateral;
  • Personal guarantee, including personal net worth and any personal assets that can be leveraged against the debt (although it doesn’t provide “hard” collateral, it adds a level of accountability and confidence that borrowers are capable of servicing the loan).

There is one additional and initially counterintuitive type of collateral that is particularly relevant for, or even “a unique feature of”,  P2P lending markets. It is called social collateral. The idea of social collateral is based on the premise that the borrower puts their reputation and social ties on the line and has a deep personal interest in sustaining those. This notion is often applied to closed networks, where members know each other personally (e.g. borrowing from family and friends), or depend on each other in meeting obligations (e.g. group lending in microfinance).

How does it work with P2P lending? Imagine you have taken several debts already and repaid all in or ahead of time – you are likely to get a boost on your profile in the form of good credit history and high star rating received from satisfied lenders. As a result, next time you need cash, you can get a bigger loan with a lower interest rate – people will be happy to lend money to someone as reliable as yourself. On the other hand, a single default can effectively exclude a borrower from getting another P2P loan. This “peer pressure” provides a significant incentive for returning borrowers to meet obligations and sustain a positive creditworthiness score.

The importance of social collateral in P2P lending is well-visible in, for example, LandlordInvest’s credit rating methodology, developed around the three Cs: Capacity, Character and Collateral. Character, which includes the borrower’s profile and creditworthiness, is the most important element (60% of the total score). Only then comes Capacity (an assessment of a borrower’s ability to afford a loan, including income and expenses – 25%) and “hard” Collateral (the value of the underlying asset – only 15% of the total score).

Secured or unsecured loans?

Unsecured loans dominated the P2P lending markets early on. Then, the sector began leaning towards secured debt given the inherited risks and low performance of many unsecured loans (this was evidenced, for example, in the shift of the major P2P lending investment trust towards collateral-backed investments – we wrote about it in the article on P2P lending funds). However, some new studies speculate that the inherent features of P2P lending (soft information and social collateral) can, in theory and over the longer term, lead to a sort of equilibrium, where low-risk borrowers (those with a good history and high ratings) could force high-risk ones off the market.

All in all, having a tangible, high-value asset as collateral is definitely a good thing for the lender in terms of security (although bear in mind that the returns on secured loans are much lower). To me, however, the “magic” of crowdfunding and P2P lending lies elsewhere – in the online networks of people who can share information, sustain social connections (despite having no personal ties), and eventually, trust one another. This is still a work in progress, but let’s hope we get there someday.