Hard Money Lending—PeerStreet Update

I made my first investment in a hard-money loan on the PeerStreet platform about a year ago, so I’m starting to gather enough data to see how it’s performing as an investment. I thought the platform had a lot of promise in tapping a specific market without much additional risk, so didn’t hesitate to open up an account once I saw the deals available on the platform (you can read the original review). Plus, living in NYC, I wanted a little exposure to the real estate market since I’m permanently renting.

If you’re not familiar with hard money lenders, these are short-term loans made to real-estate investors interested in (usually) fixing-and-flipping a property. The investors are typically looking for short-term loans (6–24 months) and often need the money quickly as soon as they’ve identified a project. Banks are not interested in these short-term and quick-turnaround loans, which means that real estate investors pay slightly higher interest rates to access the lending market.

Before PeerStreet and similar fintech companies created this space, the real estate investors typically turned to wealthy investors or small original loan companies. In both cases, these investors would lend the entirety of the purchase price money, thus taking on the risk of substantial capital loss should something happen with the property.

In the new market, the lender (that’s you) takes part in a loan syndication and provides the capital to the real estate investor. Assuming all goes well, the lender can expect to make somewhere between 6%–12% on the invested money. PeerStreet uses technology to bring thousands of hard-money loans to retail investors, usually taking a 1% fee along the way (in other words, the borrower may be paying a 9% interest rate, of which 1% goes to PeerStreet, and 8% goes to the investors).

I invested $10,000 on the platform across ten separate loans in May 2017. Today, my account is worth $10,480.35 for an annualized return of 6.75%. That’s a pretty good return for an investment that is backed by the equity in the real estate (more on that later). Of course, the $480.35 is ordinary income subject to my marginal tax rate, which means that my after-tax return is more like $283.40 (or a 4% annualized return). Still, it’s substantially more than the 1% I could get in a high-yield savings account.

The downside is that the money isn’t nearly as liquid. The ten loans that make up my portfolio have various maturity dates stretching from May 2018 to January 2019. If I needed this money in a hurry, I wouldn’t be able to access it. Initially, I made the investment using $10,000 I had in a savings account for a car fund. I was tired of seeing the cash eroded by inflation, plus I thought this experiment would be fun! Given the illiquidity, it probably wasn’t the best place to park short-term savings, but I have no intention of buying a car before January 2019 anyway.

The other risk is default. I’ve had a couple of my loans change status from “Current” to “Late 30”. That makes you a little nervous, as it’s possible to lose the entire amount of your principal, which would certainly wipe out any gains. In each case, the loans eventually returned to “Current” status. What’s impressive is that this entire process is taking place without my involvement. Other than initially funding the loans, I rarely think about the money invested on PeerStreet. It’s encouraging to think that people are buying, rehabbing and selling houses behind the scenes with no involvement from me while I’m earning a decent return.

What happens if peerstreet goes bankrupt?

In my original post, someone pointed out something that I understood about the PeerStreet platform but which alarmed the reader. Here’s the condensed comment below:

“Before anyone invests a dime in these platforms, you need to understand exactly what you’re buying. These loans are UNSECURED. Even though Peerstreet’s Note to the borrower is asset-backed, the loans that PeerStreet sells to investors on its platform ARE NOT asset-backed.

So the loan underlying the Note is secured. But the Note itself isn’t secured. You, as an investor, have no security in the property.

So if you’re lending through this platform, understand that you’re simply making a regular commercial loan to PeerStreet. You’re not buying a secured Note.”

The commenter is about 90% correct in this analysis. It’s practically impossible (and probably not economical) for PeerStreet to set up an LLC for each property and allow you to own a piece of the LLC that in turn holds a secured note against the property. It just wouldn’t work at scale. So, what solution did these platforms develop? Or, more specifically, what did their law firm develop?

Peer Street Funding LLC is a special purpose vehicle separate from Peer Street, the corporate entity with the website. When you invest in a loan, you purchase a note from Peer Street Funding LLC, which in turn uses that money to acquire the hard-money loan from the loan originator (i.e., the original entity that funded the underlying investment). The relationship is explained in the Private Placement Memorandum.

The note you own is unsecured. The investment Peer Street Funding LLC holds is secured by the property. Your note is tied to the underlying investment. If the underlying investment fails, you don’t get to seek money from Peer Street Funding LLC on account of the other investments it owns. Specifically, the mortgage dependent promissory note (the one sold to you) says “Should Company not receive any payments relating to the Corresponding Mortgage Loan, Company will not owe anything to Holder.”

Essentially, what they’ve set up is a back-to-back loan where your money is used to fund the purchase of a loan, which itself is back by the real estate. Since Peer Street Funding LLC is a special purpose vehicle, its bankruptcy should be remote and separate from PeerStreet the fintech company. Additionally, because the notes are tied to the underlying investments, if the investments fail to perform your investment should be isolated from those bad investments.

One can imagine a scenario where the housing market crashes and the fix-and-flippers go bankrupt. Let’s say 15% of all investments owned by Peer Street Funding LLC fail and are somehow worth zero (highly unlikely, since the investments are secured by the actual property).

Is it possible that the holders of the notes that relate to the 15% of failed loans decide to sue Peer Street Funding LLC for losses? Yes, I suppose it is. Is it possible that Peer Street Funding LLC might have to defend itself and potentially settle with those investors? Yes, that’s possible too. Since Peer Street Funding LLC has no other assets besides the investments, any money paid to holders of the 15% of notes that failed would come from the investments related to the 85% of notes that didn’t fail.

If such a scenario occurred—and the investors in the 85% of investments that were not related to the 15% of failed investments lost money—it’s pretty safe to assume PeerStreet itself would collapse, since the reputational damage would be immense. It’s still highly unlikely that you’d lose all of your principal though (and I still think it’s doubtful that the holders of the 15% of failed note would have any recourse to the other assets in Peer Street Funding LLC).

Either way, this isn’t a clear-cut scenario where you are lending the money, and your loan is 100% secured by the property. It also isn’t (as the comment suggested) a scenario where you’re an unsecured lender against a fintech company that could go belly up at any moment. Your note is tied to the corresponding mortgage and your repayment will be linked directly to the performance of that note. PeerStreet has set up a practical way to handle investments at scale, and I can’t think of a better way to do it.

Going forward—more investments in peerstreet?

Over the past year, I’ve enjoyed investing on the PeerStreet platform. They keep it simple. I like the team behind the platform, and I love the returns. So, will I be investing more money on the platform? Possibly, but for now, we have our hands full filling out retirement accounts with low-cost index funds. We could open up a self-directed IRA (which would make sense for PeerStreet since you could shield the gains from ordinary income taxes) but haven’t taken that step yet. Plus, I think my next real estate investment will be with a real estate crowdfunding platform on the equity side. Check back with me in late 2018 to see if we have any additional funds to put on the PeerStreet platform. If we do, I’d gladly do it! I will be rolling all my PeerStreet investments forward as they expire.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.