Shortly after the new year, we sent our clients our Quarterly AlphaFlow Investor Letter, sharing our thoughts on our industry and how we view the investment landscape today. You can find that letter below:
Please click HERE to download a PDF of this January 2018 Quarterly Investor Letter.
Sailing into the Brume
“To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them — ideally, all three.” – Howard Marks
With a new year upon on, I wanted to share some of my thoughts on our industry today, where I think things are headed in 2018, and what AlphaFlow is doing to get ahead of these market shifts.
TLDR: We are still seeing a great deal of outstanding risk-adjusted return in the market, but the noise has increased and so both diversification and independent underwriting are more important than ever.
In the second half of 2017, we commonly heard about the larger role institutional investors are playing in real estate bridge lending but there has been less discussion of what it means for retail investors. Institutional investors bring two unique attributes: (1) the need to put enormous amounts of capital to work, and (2) an ability to accept lower gross yields in exchange for volume, as they can often boost returns via leverage. Lenders and marketplaces are naturally incentivized to focus on volume, so we’re seeing changes in behavior:
- Rates are dropping industry-wide but to a greater degree with online platforms than we see with traditional offline lenders. In some cases, borrowers are capturing these savings as lenders use rate to win more business while maintaining spread (i.e. they still earn a 1-2% spread for servicing, even if they lower the rate). Elsewhere, lenders are increasing their spreads as they push the boundaries of what rate investors are willing to accept (we’re seeing many notes where borrowers are paying 11-12% and investors are being offered the note at 7-8%). In both cases, investors are experiencing diminishing returns.
- Loan amounts are being increased. Historically, lenders have taken the LOWER of purchase price or appraisal / BPO in setting a loan-to-value. We’ve seen this switched to taking the higher of these two metrics in order to maintain a particular LTV benchmark while actually lending more capital.
- LTV thresholds are being blown out. Lenders who have seen low defaults in particular borrower cohorts are making big bets that these DQ rates will continue, even with higher leverage, so they’re lending close to 100% of purchase price in some cases.
To loosely borrow from the derivatives world, we’re starting to experience our own version of basis risk, in which yields are not moving in line with the risk behind loans. The larger worry for all investors though is if we are straying into basis uncertainty, in which we’re not even sure if the data and processes we use to underwrite loans are any longer tied to loan prices (yields) at all (e.g. we’re seeing loans we rate as highly risky being offered at 7% and others we think are fairly low risk at 11%).
In a consolidated market like stocks, basis uncertainty can mean it’s time to step away. In a fragmented market like ours though, it creates an opportunity for generating alpha (particularly as housing markets correct), as the market may be rife with mispriced debt (particularly with offline lenders).
Looking ahead in 2018, three things jump out to me:
- Shift to secondary and tertiary markets. The doubling of the standard deduction should help boost homeownership demand in the Midwest and South, where few mortgages (or property tax bills) are large enough to warrant itemized deductions. For those on the coasts though, where a much higher percentage of mortgages fall into this expensive category, we’re going to see cooling home prices. We moved past the “lowhanging fruit” in many primary markets like LA and Chicago 18 months ago, which today means flips there usually involve more construction and lower margins for error. Add in the new tax bill, and investors need to look more to smaller markets like Pittsburg, Cleveland, and Kansas City for attractive loans.
- “When do I get my money back?” From questions about rising rates to a potential correction in the stock market, the market is filled in uncertainty that’s only being exacerbated by today’s geopolitical environment. The result: investors are looking to decrease the duration on their portfolios in order to give them the opportunity to appropriately rebalance their investments as circumstances shift. To address this need for clients, in Q1 we’ll likely develop a shorter-duration product with a guaranteed maturity.
- So much noise! From new behemoth institutional investors transforming the space to lenders contorting their standards to meet their needs, 2018 is going to produce a lot of noise in the market. We’re already rejecting over 90% of loans we review today, and while we think that number will decrease as we expand our relationships with traditional offline lenders, the investment environment is only getting cloudier.
We’re addressing these shifts in a number of ways, but I’ll highlight three initiatives here:
- Doubling Down on Analytics: In Q2 2017, we launched our internally built analytics platform, AlphaFlow Advanced Analytics, powered by an amazing partner in TheNumber. We recently expanded our work here and will be pushing out v2 in January to boost our ability to produce our own valuations (and thus LTVs) and better track markets as a whole.
- Improved Portfolio Management: We’re now building better portfolio management tools, which combine monthly reporting and property monitoring via our analytics platform to enable us to spot dangerous situations like market shifts before loans hit maturity.
- Clustering: Over the next year, we’re going to shift most of our investing to 12-15 target markets. Clustering not only allows us to drill in at the neighborhood-level to produce good returns, but also helps us mitigate downside. If you’re in this industry long enough, you need to be comfortable that at some point you’re going to own houses. Investors with the ability to manage assets (i.e. finish projects and fill homes with renters) will not only protect their downside, but also produce huge returns by positioning themselves to buy non-performing loans from lenders/investors who lack such capabilities.
There is more noise than ever in the market, but I believe the cycle has a long way to go in a number of cities around the country. Diversification is necessary but not sufficient in this fragmented market filled with bespoke underwriting practices and a lack of standardized metrics. Ultimately, we still see attractive risk-adjusted returns, but they require more work than ever to earn.
Thank you for entrusting us with such an important part of your life. Happy New Year!
I’ve heard from a number of you that you’d like us to write about the market more often, so we’ll plan to do so at least quarterly moving forward. We don’t claim to have a monopoly on market intelligence though. I’d love to hear what you’re seeing and what you think about the market in general, specific lenders, what you’d like us to do, or anything else you’re thinking about as you build and adjust your portfolio.
Please click HERE to download a PDF of this January 2018 Quarterly Investor Letter.
About the author:
Ray Sturm is a leading entrepreneur in financial technology, and is currently the CEO of AlphaFlow. Prior to launching AlphaFlow, he founded RealtyShares, one of the P2P industry’s top platforms for real estate investing. His early career in finance included investment banking at Bear Stearns, restructuring at Lazard Frères and private equity at CCMP Capital.
Ray has a BBA-Finance from the University of Notre Dame and a JD/MBA from the University of Chicago.
Legal Information and Disclosures
This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. AlphaFlow has no duty or obligation to update the information contained herein. Further, AlphaFlow makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. AlphaFlow Advisor, LLC (“AlphaFlow”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumption on which such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of AlphaFlow.