A gap in the market gives online lenders an opportunity if they define their position in the larger market.

It is becoming increasingly apparent that there is a sizable shift occurring within the online real estate lending world. Original models are not working, and the lines differentiating online and non-online lenders are further blurring. Recent industry observers are imploring the still-fledgling industry to change strategies or perish. Change, become profitable or fade away. Sounds a little Draconian, but reality is not always kind.

Here are three strategic challenges the current online real estate lending platforms should address to define their position in the larger market going forward.

1. Institutional vs. private investors
2. Expanding the investment product (longer duration loans)
3. Risk sharing and investor advocacy

Institutional vs. Private Investors

So where do you go, and what do you do? The answer depends on whether you choose to stay with private investor money or you elect to move to the institutional investor strategy.

Institutional investors dictate what they want and how they want it. There is no right or wrong answer, but it is not a coincidence that many platforms are moving toward the institutional investment community to fund debt, especially mid-sized commercial real estate loans. It is much more efficient to have deep pockets for funding larger loans; however, swings in the market can affect their appetites greatly. Institutional investors are generally programmatic and want volume for their program, so your platform needs to be an efficient and prolific originator to fill a commitment.

The more challenging group is private investors. Private investment is a very sizable market, and there is a great opportunity should you choose to pursue or maintain this course. There are also challenges the current online platforms face and changes that need to be addressed when following this strategy.

Not all accredited investors are experienced real estate investors. Many of these investors are not openly shopping the internet trying to find good real estate debt investments. Maybe one day, but not right now. It is also a misnomer to believe that “if you build it, they will come.” Another is be happy and stay with you and never lose money because you are “transparent.” You must earn and respect their investment dollars and never assume that just by putting deal documents online ensures that an individual investor fully comprehends the underlying risk(s) involved or insulates you from investor blowback if a deal goes bad. Proprietary credit scoring also may not provide enough clarity to the investor to understand the risk, or how you have identified and interpreted it. Transparency alone does not ensure comprehension. Private investors need trust, and that can be achieved through understanding and aligning with the platform’s credit philosophy and culture, a history of demonstrable integrity and a highly experienced investment management team. You have to pass the smell tests—and keep passing them.

This is not necessarily an either/or issue. There is no industry rule or protocol that would preclude a strategy to include both private and institutional investors. You must be prepared to manage the distinctive expectations of both. Institutional investors may provide a deeper funding source, but they also may be narrower in investment scope. It would, therefore, be a wise decision to create investment vehicles for private investors to broaden funding capabilities and volume.

Expanding the Investment Product (longer duration loans)

Recent history has shown us that private investors are attracted to short-term debt investments. The residential fix-and-flip segment provides very short loan terms, or what can be called micro terms, of one year or less. That is why it is popular with the current online and non-online private money platforms.

This is a viable market but, ultimately, a limited market because:

1. There are no barriers to entry.
2. The sheer number of existing and new platforms offering that money is large.
3. The fierce competition will denigrate credit and leverage standards and drive down yields.

There is nothing wrong with this type of investment, but there is a gap in the current market between very short micro term loans (residential fix-and-flip) that are dominating the current private investment offerings and the longer duration term loans of 3-5 years, or mini term loans attracting institutional investors (mainly middle market commercial real estate bridge loans). Accumulating enough private investors to fund a middle market $5-10 million loan amount could be daunting and inefficient. However, offering shares into a diverse pool of longer term small balance commercial and investment real estate loans would be efficient and an attractive offering to private investors.

The gap can be filled by creating and promoting longer duration mortgage investment offerings for the private investor community. Educating investors, wealth managers, advisors, IRA professionals, etc. can expose and enlighten the private investor community to the benefits of portfolio diversity through longer investment durations. This will open even greater investment opportunities within the wider segment of the market. If this process starts now, it can be a strong hedge against any downturn in the availability of the micro term loan market or a viable alternative portfolio diversification strategy.

Risk Sharing and Investor Advocacy

Risk sharing is a fundamental and time-tested practice within the money lending business. It comes in different forms, from co-investing to risk retention to buy-back provisions and much more in between.

Dodd-Frank has brought this back to the forefront by basically mandating credit accountability between sellers and buyers of securitization bonds. Even fintech leaders are recognizing the future of lending and investing by advocating ”skin in the game” as a risk mitigant.

With the recent serious missteps within the online-lending industry, including allegations of fraud to gross negligence, a risk sharing program can build and reinforce trust and strengthen lender/investor accountability. It may not be enough to be a platform for other people’s money. If a platform had its own money invested alongside its investor, it would establish a real investment partnership and truly align all interests—and build a deeper trust quotient with investors.

A risk sharing strategy can be accomplished through financial engineering methods that create different investment structures for different investment/risk tolerances. It sends a strong professional message of “I believe in my product, and so can you.” It can also take the guesswork out of having to choose the right real estate investment platform. A firm that structures a large part of its business around the risk sharing concept will have a competitive advantage over firms that are in reality only middleman platforms, giving that firm a true market differentiator.

The universe of online and offline, traditional and nontraditional mortgage lenders, brokers, conduits and debt aggregators is vast. Competition is fierce and will get fiercer as more people enter the pool and as the economy cyclically slows or contracts. All successful mortgage firms utilize technology as an integral tool, and most credit fundamentals have been
around for a long time.

As we witness the new mortgage fintech firms and the traditional mortgage bankers becoming closer in strategy and appearance, who will survive?  What will set you apart not only from your immediate peers but from the larger, competitive market? It is time that online lenders mature and realize the need to find their space at the larger table and that just being a middleman, or a deal matchmaker, may not be enough to meet the competitive challenges that lie ahead.