Managing risk in residential real estate market
“A rising tide floats all boats….. only when the tide goes out do you discover who’s been swimming naked.”
Warren Buffett’s addition to John F. Kennedy’s popular ‘rising tide’ quote highlights that levels of risk may not always be apparent. In times of economic upturn, lots of property finance firms might have success. However, when the economy turns, many might become vulnerable and exposed. Within the ever-changing environment of real estate, economic downturns serve as critical assessments that distinguish those with effective portfolio risk management and operational efficiency from the rest.
In real estate debt, low mortgage rates and rising property prices give a significant tailwind and safety net to managers. However, in a downturn, the effectiveness of certain asset managers becomes especially apparent through their strategic use of in-house origination and workout teams.
In-house origination enables asset managers to see large volumes of deal flow. Coupled with a diverse product offering, managers can dial up exposures to certain products, tailoring portfolios in line with market conditions. Leveraging this capability allows asset managers to customise and refine their pipelines to carefully construct an attractive portfolio. They can select the best loans for origination in order to maximise potential risk-adjusted returns for investors. This vertically integrated framework distinguishes traditional asset managers, who typically fundraise first and source loans later, from an asset manager within a lender. An integrated structure can allow managers to plug capital directly into their origination pipeline, helping to reduce the likelihood of investors being potentially exposed to cash drag.
Origination is only half the equation. Once a deal is identified, an asset manager needs to assess and underwrite any risk. Conducting origination in-house can help to ensure that risks are identified early and appropriate measures are taken to protect investors’ capital by dedicated credit risk specialists. Understanding a borrower’s financial background helps underwriters determine if the risk is appropriate and proportionate to the terms of the loan, thus safeguarding investor capital.
The value of independent in-house capabilities is more apparent in difficult macro-environments. The existence of separate, dedicated teams for each function helps to ensure that a focus on, for example, workout situations, doesn’t dilute the focus of other teams such as origination and underwriting. A well-coordinated in-house origination and underwriting team can also enable lenders to provide efficient turnarounds from application to completion, supporting deal flow.
Economic downturns also emphasise the importance of effective in-house workout strategies, from recoveries to enforcements. Dedicated expert credit risk and recoveries teams allow individuals with experience across a range of economic cycles to respond effectively when markets turn. They recognise that the fundamental underwriting considerations underpinning lending remain constant – i.e. securing debt against value.
Specialist internal workout processes help lenders to proactively mitigate risk. The entire lifecycle of a loan is under review, especially as it approaches maturity. This includes vigilant monitoring of defaults and interest arrears as part of a high level of oversight throughout the process. Insights into why borrowers are, or may be, struggling, can provide a strategic advantage from the perspective of the financial stability of investor capital and may bolster financial resilience.
Ethical, responsible lending is at the forefront of LendInvest’s regulated lending proposition. From time to time a borrower may get into financial difficulty and need support. A lender should not shy away from enforcement proceedings when appropriate, however, this should be a last resort after appropriate support has been exhausted. The most effective way to navigate workout situations is through clear, helpful communication with borrowers.
A collaborative approach, with “boots on the ground”, helps to resolve issues and implement solutions before considering formal measures. This strategy frequently proves advantageous for the lender, borrower, and investor alike. It seeks to appropriately safeguard capital as well as protect borrowers and preserve relationships, ultimately positioning all parties for future mutually beneficial collaborations.
LendInvest, as well as its fund management capability, has separate specialist in-house teams overlooking every aspect of a loan life cycle. These include origination and underwriting as well as work-out and special servicing expertise. With 15 years of experience in specialist lending, we have originated over £6 billion of loans since inception and currently manage a loan book of £2.6 billion.
Some lenders do not adequately address problems in their portfolio, characterised by insufficient provisioning and a lack of robust risk management frameworks. This often manifests as perpetually extending loans until defaults are booked all at once. Conversely, experienced asset managers proactively manage their portfolios, provision loans, and report back to investors. This provides a transparent methodology to facilitate investor insight and potentially produce smoother returns across the course of an investment. In downturns, when the risk of default rises, effective portfolio risk management becomes especially apparent and important to investors.
Managers that invest in robust in-house origination, risk management and work-out capabilities should potentially provide a better client experience, see more deal flow and ultimately have the capability to construct a higher quality portfolio for investors. When loans underperform, such firms are also better placed to proactively manage positions in order to protect investors’ capital. Those who embrace the power of in-house operations may not just survive downturns but may pave the way towards sustained success for their investors.
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