With some creativity, flexibility, and patience, the challenges of 2021 can become opportunities for your fund in 2022.

Most major metro markets have seen steady price and income growth in 2021, particularly in the residential sector. Fortune Magazine recently reported:

“Instead of creating a housing bust, the pandemic helped spur one of the most competitive—and tight—housing markets in recorded U.S. history. Between August 2020 and August 2021, home prices soared a record 19.9%—dwarfing the previous biggest 12-month price jump (14.1%), which came in the period leading up to the 2008 meltdown.”

The saying goes that “a rising tide floats all boats.” That certainly was the case in 2021 for many borrowers.

Challenges Ahead

Looking forward to 2022, your borrowers will be faced with some, if not most, of the following challenges:

Building material cost increases. According to a recent National Association of Home Builders study, the cost of building materials has risen 13% year-to-date in 2021.

Increased labor costs. The competition for skilled labor is intense in every industry. Nationwide, 92% of contractors say they have had “moderate to high levels of difficulty” finding skilled workers, according to the U.S. Chamber of Commerce’s quarterly construction report released Sept. 22.

Entitlement, permitting, and inspection delays. These are due to municipal hybrid work schedules.

The strong possibility of rising interest rates, although the timing is uncertain. The Federal Reserve is currently divided over when to raise rates, but the operative word is “when,” not “if.

Shrinking margins. This is due to a combination of the foregoing factors, particularly in the fix-and-flip space throughout most major metro markets. An August 2021 report from the ATTOM national real estate database reports: Home Flipping Rate Falls in First Quarter to Lowest Level Since 2000; Prices on Flipped Homes Drop, Leading to Smallest Profit Margin in 10 Years.

iBuyers scaling back, or ceasing operations, and dumping product back on to the market. Zillow will stop buying and renovating homes and cut 25% of its workforce, according to multiple national media sources.

These borrower challenges will result in some, if not most, of the following challenges for your private lending fund in 2022:

• Rehab/construction holdback balances insufficient to complete the work proposed.
• Extension requests due to a combination of the foregoing challenges.
• Problems and delays for borrower exit strategy because there should be a reduction in the qualified buyer pool in the case of rising interest rates. The average rate on the popular 30-year fixed loan will rise to 4% in 2022, according to the Mortgage Bankers Association’s recent forecast.
• Static or decreasing valuations on your underlying security.

The Silver Lining

The investors in your fund are reading the same things you are and will be asking you questions. As the fund sponsor, your challenge—and your opportunity—will lie in how creative, flexible, and patient you will be. Your investors will be looking for transparency and creativity as you continue to provide consistent returns on their investments.

Let’s focus on the silver lining to borrower challenges first:

Rehab/construction holdback balances insufficient to complete the work proposed. Fortunately, most of you will have flexibility to restructure your loans in this scenario, at least in the near-term. The significant rise in real estate values over the past 12 months, particularly in the residential space, should leave you with sufficient equity to advance the additional funds necessary to complete the project and execute the exit strategy you originally envisioned during the initial loan underwriting phase. This should also result in additional earnings to the fund in the form of points and modification fees as you restructure.

Timing is everything, so the sooner you meet with your borrower, identify cost increase issues, and restructure the loan, the sooner you will get to your exit strategy. No one’s interests are served by unwanted delays in the rehab/construction process.

Extension requests due to development or rehab/construction delays. It’s not a matter of if, but when, some of your borrowers will approach you for loan term extensions due to pandemic-related delays. Again, a proactive approach is necessary. Meet with your borrower early and often. Assuming there is enough equity in the transaction, the loan extension should result in additional earnings in the form of both points and modification fees and additional interest earnings.

The challenge arises if there is not sufficient equity to extend the loan. In this situation, first pursue cross-collateralization with other borrower assets or contribution of additional borrower equity. Foreclosure should be your last course of action for cooperative borrowers.

Exit strategy impacted by rising interest rates. Like the situation addressed above, rising interest rates may result in payoff delays and extension requests. Your strategy and options should be similar to the narrative above.

Static or decreasing valuations on your underlying security. This should not be a challenge in most metro markets in 2022. As we get later in the year and into 2023, stagnant valuations could become an issue. You’ll need to closely monitor valuations in 2022 to ensure continued compliance with your loan documents and loan-to-value representations to your investors.

Effectively determining valuation is a challenge in any market. The well-documented shortage in appraisers will make timely valuations a challenge. Consider alternative methods such as hybrid appraisals, desktop appraisals, drive-by appraisals, broker opinions of value, Zillow, Redfin, and LoopNet searches—as well as your local market knowledge.

Turning to opportunities with investors:

Your investor reporting will become more critical in 2022. Transparency is key with investor communication. As we all know, bad news does not get better with time. You need to understand each of your markets and product types well. At the earliest indication of challenges, be proactive with your borrowers and open and transparent in communications with your investors.

As mentioned, with a bit of creativity, flexibility, and patience, challenges can become opportunities. As challenges arise with a particular product type, perhaps consider a shift in lending focus. The decline in fix-and-flip opportunities is well documented, but there are still plenty of opportunities in the private lending space. Here are some “value-add” lending options for you to consider:

Build up or out. In many major metro markets, the average sales price per square foot still exceeds the cost per square foot to build. Building up or building out can create additional value, assuming your borrower isn’t overbuilding for the market. Driving your neighborhood and doing background market research will give you a good indication of this strategy’s potential.

ADUs. The national affordable housing crisis is well documented. Many older urban areas are designed with alley-loaded garage access. These areas are excellent opportunities for building rental ADUs over the garage, providing much needed affordable housing. The property owner gains additional income, increasing their ability to afford the property.

Zoning law changes. Similar to the previous point, many cities are reevaluating their zoning laws in an effort to incentivize more affordable housing. For example, borrowers/developers in several California cities can now build ADU and junior ADU units “by right” in neighborhoods previously zoned for single family.

Income-producing multi-family and commercial property. In some ways, this is a larger fix-and-flip, with your exit strategy being conventional debt financing for your borrower. Many longtime owners have properties in need of rehab, repair, and market repositioning to take advantage of increasing rental rates in their market. A 3- to 5-year loan can provide the dollars necessary to bring the property condition up to market and stabilize it at the new market rents. Once stabilized, you may be able to bring in conventional debt financing to replace your loan.

In terms of options for your investors, consider creating separate funds targeted to specific product types or lending and investment parameters. Here’s a three-fund strategy to consider:

• Fund One. This is a lower risk, non-leveraged fund targeting the traditional fix-and-flip, acquisition bridge, and value add, rehab/construction loans with 6- to 24-month terms. This fund would provide investor returns in the 6% to 7% range.
• Fund Two. This is a slightly higher risk, leveraged fund targeting income-producing multi-family and commercial properties with 3- to 5-year terms. This fund would provide investor returns in the 7% to 8% range, assuming you can fix the cost of your fund leverage in the 4% to 5% range. This fund also provides a bit of an inflation hedge as the income increases on the underlying security.
• Fund Three. A higher risk, non-leveraged workout fund targeting distressed properties and defaulted loans, this fund requires patient investors, which is likely the case for most of your current investors. This fund is in essence the “bad bank” positioned to take on the difficult task of loan workouts or foreclosures by purchasing problem loans from your existing funds or from others. This fund would provide double-digit investor returns.

Again, 2022 will likely be another year filled with challenges and opportunities. Creativity, flexibility, and patience will yield the strategies you’ll need to meet the challenges head on—and turn them into opportunities.