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  • Kelli Garrett

Navigating Investment Risks: How We Manage Risk in Our Real Estate Debt Fund



When we get on a call with a potential investor for our debt fund, one of the first questions we are asked is, “What are the risks associated with your fund, and how do you mitigate them?” This is a very important question because, as we all know, risk is all around us. We are constantly exposed to risk when we roll out of bed in the morning, walk across the street, or get behind the wheel of a car. Like these simple activities, all investments carry some risk, and our fund is no exception. 


This is why it is imperative that companies you are investing with have comprehensive risk management strategies to help mitigate the risks associated with their business. Below is our fund’s list of potential risks and how we manage them.


High Loan-to-Value (LTV) Ratio


The real estate market, like the economy, is cyclical and, therefore, naturally experiences periods of expansion and contraction. And within those times of contraction, real estate values can potentially go down. I worked in the lending business and was personally invested in real estate during the 2008 financial crisis. I saw firsthand that values can and will change when supply outpaces demand, paired with fear in the market. But one of the primary reasons why the financial crisis of 2008 was so severe is that many banks were lending at very high LTV ratios, which meant that some of the borrower’s mortgages were at or near the appraised value of the property. 


This is why our current business model at Rehab Wallet is set up to lend at a maximum of 70% of the property’s after-repair value (ARV). The lower ratio of 70% is less risky for the lender and the investor because it allows for natural market adjustments without the fund being affected.  


Inappropriate Usage of Borrower Funds


Because the vast majority of the properties within our portfolio require some degree of renovation, we are often asked, “How do you ensure the renovation funds you loan to the borrower are used to rehab the property and not for some other unrelated purpose?” We solve this issue by requiring our borrowers to complete renovation work before receiving their allocated renovation funds. 


Although we finance the costs associated with renovating a property, we will not disperse those rehab funds to the borrower at the time of closing. Instead, we hold back the renovation amount until the borrower requests a “draw” of their rehab funds. For the borrower’s draw to be approved, they must perform the necessary renovations and provide proof of completion via pictures or videos. Once our team has approved the completed work, then and only then will the draw be processed, and the borrower will receive funds for the rehab portion of the loan.  


Unfamiliarity With the Location


When the question arises, “What is important when looking to buy real estate?” we have all heard the familiar response: “Location, Location, Location.” And even though over 55% of our existing loans are in the Charleston, SC Tri-County area (which is where I flipped houses for almost two decades), there is still no way for one person to know everything about every city, town or neighborhood. For this reason, we utilize third-party software tools to produce data and valuations for the properties we are considering financing. 


In addition to this, we also require a broker price opinion (BPO) on every property within our portfolio of loans. A BPO is a real estate professional’s estimate of a property’s value based on the sold prices of comparable homes in comparable neighborhoods. 


Foreclosures


No matter how exceptional a lender is at risk management, there will be occasional borrowers who cannot fulfill their loan obligations. Sometimes, unexpected life events happen that throw a wrench into the best-laid plans and give the lender no other option than to foreclose on a property. Since the company’s inception, we have had two foreclosures out of 1363 total loans. We are very proud of this low number; however, as we continue to grow, our number of foreclosures will inevitably increase. 


So, although we cannot completely avoid foreclosures, there are things that we can do to keep this number as low as possible. One way we do this is by maintaining a high repeat borrower rate. We love having repeat business because we already know the borrowers, and they have a track record of making payments and finishing their rehabs on time. 


We are happy to say that our return borrower rate is 85%. Also, in Q1 of 2022, we hired a full-time director of compliance to monitor and analyze borrower timelines and quickly recognize potential red flags that could indicate a borrower is in trouble. Hiring this person has allowed us to be proactive regarding potential default issues instead of reactive after the fact. 


Another strategy we use to keep foreclosures at a minimum utilizes a combination of the two individuals just discussed: our repeat borrowers and our compliance director. For example, let’s say that our compliance director, through her monitoring systems, discovers that one of our new borrowers may be in trouble and in need of help. She may recommend that the troubled borrower either sell to or partner with one of our repeat borrowers to avoid defaulting on the loan. This proactive, hands-on mentality has allowed our foreclosure rate to remain low.  


Lending Regulations


There are many federal regulations that pertain to lenders, most notably the Dodd-Frank Act, enacted in 2010. However, our company does not fall under the Dodd-Frank regulations because we only lend to business entities (LLCs), not individuals. But, because we lend in several states, state-specific lending regulations and closing documents may be required. Therefore, we always consult with an attorney when lending in a state for the first time to ensure we are compliant with the guidelines for that specific property/location.


Slow Demand


Fortunately, we have yet to experience a time of slow demand within our business. We have always had more demand for our funds and services than capital available to lend. I believe “relationship capital” is the most important currency to grow a business. This is why building strong relationships with potential and current customers is one of our company’s core values. 


Some ways we build those relationships are: 1. Attending and sponsoring monthly real estate meet-up groups where investors and flippers frequent; 2. Speaking on podcasts, webinars and at in-person real estate investor conferences to promote our brand; 3. Social media posts targeted directly to real estate investors, such as our “Flipper Tip of the Week” series; 4. Delivering exemplary customer service to keep our existing customer base happy and coming back to us repeatedly. These are only a few examples of what we have done in the past and will continue to do to keep the demand for our services high. However, if that were ever to change and demand slows, we would simply ramp up the outreach efforts that we already have in place.  


Borrower Delays in Selling or Refinancing the Property after Rehab


As you know, our lending product at Rehab Wallet is mainly used by one of two types of investors: A flipper buying a home to renovate and then immediately re-sell the property or an investor buying a home to renovate and then refinance the property with a longer-term lender to keep it as a rental. But sometimes, there can be delays in selling or refinancing, which causes these loans to remain on our books longer than expected. This is another one of those times where we use “relationship capital” to assist borrowers if they are ever in this situation. Nurturing those strong relationships allows our team to keep an open dialog with our borrowers to brainstorm different solutions, alternative exit strategies, etc. 


I hope this list helps you understand the investment risks and what we are doing to manage them. Our entire team works hard every day to ensure that when we get behind the wheel of the car we call Rehab Wallet, we fasten our seat belts, drive the speed limit, and constantly keep our eyes on the road. I believe this will keep us on the path to success for our investors and company!


Article written by Kelli Garrett of Rehab Wallet

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