Aug
28

How Defaults Work

One of the risks of any debt investment is the chance that the loan goes into ‘Default’, where the borrower is no longer able to pay interest on the loan or repay what they’ve taken out (the principal).  When this happens, lenders have different options for recovering their investment, depending on the nature of the loan.  

Generally speaking, there are two main types of debt: unsecured and secured.  Unsecured debt refers to a loan that is only backed by the borrower’s ability to repay (creditworthiness). Examples of unsecured debt include credit cards, student loans and personal loans.

With unsecured loans, in the event the borrower is unable to pay interest on the loan or repay the principal (loan amount) when it’s due, the lender doesn’t have a tangible asset they can seize and sell in order to recover their investment.  As such, the lender has a very limited set of options to recover their investment, such as sending the borrower to a collections agency.

Secured debt refers to loans that are backed by some tangible asset (called collateral), such as a house, a car, an airplane or even construction equipment.  In the event that the borrower defaults on their loan, the lender is able to seize the underlying asset in order to recover their investment.

AlphaFlow invests in secured debt; loans that are backed by the property that the developer is going to be rebuilding and selling. More specifically, these loans are called ‘First Lien’, meaning that the lender has the first claim on the asset in the event the borrower is unable to repay.  Functionally, this means that the lender has the ability and right to take possession of the property and take necessary steps to reclaim its investment plus any additional proceeds from the sale of the asset, minus legal costs.

Here is a simple scenario: Lender A makes a loan to Borrower B in the amount of $70,000 on a house worth $100,000. Borrower B makes no interest payments. Lender A takes necessary action: at first, they attempt to recover owed payments and get Borrower B to become ‘current’ on the loan. If this is unsuccessful, Lender A has the legal right to foreclose on the property (seizes it from the borrower). Depending on the State and legal jurisdiction, the foreclosure process can take 3 months or 3 years. Once a foreclosure is complete, Lender A, who now owns the property, sells it for $100,000.  Lender A now has their initial $70,000 back, as well as $30,000 in proceeds from the sale, less any fees related to the foreclosure and sale processes.

Depending on the terms of the loan, lenders may include late interest fee payments, as well as default interest penalties. Foreclosures are not a common occurrence, since borrowers have a vested interest in the property they have borrowed against. Using the example above, Borrower B has put $30,000 of his own money into the property, and Lender A has lent him $70,000.

There are common reasons for borrowers to make late payments such as higher construction costs than budgeted and delays in getting permits and therefore getting started. Borrowers may end up being charged late interest fees, which are shared by the lender with AlphaFlow investors.

In the case of a foreclosure (and if default interest has been written into the loan agreement) investors will receive this default interest, in addition to any outstanding regular interest that was owed by the borrower. In other words, AlphaFlow investors will first be made whole on their principal and interest, then if available, default interest and penalties. After these interest payments have been made, the lender will retain any remaining equity from the foreclosure sale. AlphaFlow investors do not participate in the equity proceeds from the foreclosure sale.

In the case of fractional loan purchases, the lender owns the underlying loan and controls the default and foreclosure process.  AlphaFlow would stay in constant contact with the lender to monitor progress and determine the date of resolution and loan and interest payback.

As such, one of the risks to be evaluated when purchasing any form of fractional real estate debt is the operational processes put in place by the lender to bring delinquent or defaulted loans current and, in the worst case scenario, to handle foreclosure.  AlphaFlow’s lender diligence takes this operational aspect into heavy consideration.

Before working with a lender, our investment team does a full review of the lender’s ‘asset management’ procedures.  This starts with looking at the originator’s draw administration processes to ensure funds are being disbursed in a reasonable manner to the borrower.  The review also includes looking at procedures for when a loan doesn’t pay interest, and timelines for starting the foreclosure process. As well, any agreements with third party servicing firms to handle different parts of the process would be included in the review.