Oct 27, 2023
Let’s discuss the difference between what we call the “active” investor vs. the “passive” type. These adjectives are just names, or descriptions, that we have given them. But it is the profile, the characteristics, the DNA of the respective investor types that is important for the discretionary investment (or “blind pool”) fund manager to really understand as it can have very serious implications for the level of success that is achieved or not in raising capital (and the speed with which that success or lack thereof is realized) in their fund. So is it better to invest in a one-deal-at-a-time or in a blind pool? One is not necessarily or automatically better than the other. They simply have different characteristics, economic structures, security interests, and fundamental risks (although certainly there are some of the same in both). There are pros and cons of each approach,, but we are going to start with individual deals. We will speak of “whole loans” when referring to individual deals. This could just as easily be direct ownership of real property or some other real estate based asset and, for the purposes of this discussion, would also include fractional ownership of these individual deals, even though that format has other additional nuances and risks that we will not discuss in this article. For clarity to the reader, we will write from the perspective of the investor and communicate our beliefs about the difference between investing in a single real estate based asset (whether that be real property or debt secured by real property) and investing in a discretionary fund comprised of such assets.
In our opinion, the biggest advantage of a whole loan (again from an investor’s perspective) is that one knows precisely which asset protects their capital. They are not relying solely on the originator (the private lender/broker who procured the deal in the first place). There is a specific piece of property securing the loan that an investor can assess, evaluate, and underwrite, although we would argue that often they rely heavily on the originator’s opinion of value. There should be a perfected security interest, typically in the form of a recorded deed of trust, in the collateral that secures the note (the promise to repay the loan on whatever terms have been negotiated) naming them as the beneficiary. In the event of default by the borrower or problems with the originator, this affords the investor significant protection of their capital. The investor also has some ability to negotiate the terms of the deal, including the interest rate received, any split of points or fees, the term of the loan (maturity date), and others. The investor may allow the originator to service the loan on their behalf, or the originator may give the investor a choice of whether or not to engage them for this purpose, and the originator may or may not keep an interest rate spread. Being able to pick and choose specifically which deals to go into and “knowing” specifically what asset secures their capital account is what makes the whole loan model so appealing to many investors.
So what are the downsides of the whole loan model? To us, the biggest is the lack of diversity afforded to the investor by owning the entire deal (this is mitigated somewhat in the case of a fractional interest in ownership of a trust deed, but that model has other risks and downsides of its own). The investor is taking all of the exposure to any risks associated with that particular deal and does not achieve any diversification of risk when investing in one deal. For some “active” whole loan investors, it may make sense to mitigate some of the risk by investing in multiple individual whole loans. We have seen over and over again situations where individual investors love the whole loan model… as long as the borrower is paying. But if a borrower defaults, the payment stream on that loan typically ceases entirely and now there is zero cash flow. In addition, the investor is generally responsible for advancing any costs necessary to exercise default remedies (namely to hire counsel and proceed with foreclosure) which can be very significant and ongoing. Cash flow can go from being very strong to actually negative in this situation. The time it takes to foreclose can vary dramatically by state and borrower response and behaviors, such as bankruptcy filings, damaging the property, etc. The ultimate recovery on that asset can also vary wildly depending on multiple factors. The point is that the whole loan investor assumes all of this concentration risk. To us, the second largest risk (which is usually far less potentially impactful than the first) is yield drag due to repayment of capital if there is an inability to redeploy funds in a timely manner. Since the investor owns the asset in the whole loan model, they receive all the cash back upon payoff of that loan, which is often short term in nature. If one is getting 12%, for example, and it takes 90 days to find another suitable whole loan investment to replace it, the cash typically sits idle for that period and the true return to the investor is only 9%. This non-deployment period is often not considered by the whole loan investor and usually results in a significantly reduced annualized return. In a pooled investment vehicle, if one loan pays off the cash and the cash comes back to the fund and, depending on the fund structure, is redeployed by the fund, the investor may continue to receive dividends or interest without interruption.
Each situation is different and we are generalizing here. However, these are fundamental issues with whole loan investing that we have seen play out over and over again, both the pros and the cons, for investors in this marketplace. Further, there are all manner of subtleties in behavior by both originators (mortgage brokers, private lenders and dealmakers) and investors that develop over time as relationships evolve, which may impact performance and returns. We came to deeply understand these behaviors after many years in the trenches of the space. These tendencies manifest themselves in what to us are predictable outcomes, again both to the good and the not so good, depending on the level of depth of understanding of what dynamics are at play. For these and other reasons, the whole loan model tends to attract what we have labeled as the “active” investor who has a desire to get involved in the process of individual deals. They are often people who have some background and experience in real estate and have the requisite skills and abilities to make well-informed and well-educated decisions. They want “control” and they seek involvement and influence. They believe deeply that this affords them more safety and better outcomes. And they very often will not consider any blind pool investment because they feel they lose this control and influence.
For certain investors, as well as for certain originators, brokers, private lenders and other real estate based dealmakers, the whole loan or single deal model may be preferred. We find, however, that quite often investors as well as the originators of these assets are not clear on the characteristics of the different models and the various risks associated with each of them or what is even available. Many times people are predisposed to do something a certain way because that is the way they have done it or that is what is familiar to them.
Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions.