An in-depth look at hard money loans with Adam Fountain of Broadmark Capital on The RealCrowd Podcast - The Fundamentals of Commercial Real Estate Investing.
Adam Fountain's responsibilities at Broadmark include investor and client sourcing, and transaction management across all of Broadmark's focus areas including life sciences, technology, new media, middle market, real estate, telecommunications and financial services. His current interests include life science companies that have demonstrated proof of concept, particularly drugs with clinical data and devices with at least animal data, and some mitigation of risk, e.g. shortened regulatory paths, 505(b)2, etc.
Areas of interest in technology include SaaS, new media, and any revenue generating high growth companies. Responsibilities also include all activities related to Broadmark's merchant banking function: identifying and qualifying potential direct investments and producing Broadmark white papers. In addition to these responsibilities, Mr. Fountain is a part owner of Pyatt Broadmark Management, LLC and Broadmark Real Estate Management, and responsible for their investor relations and fund management.
Adam Hooper - Hey, Tyler.
Tyler Stewart - Hey, Adam. How are you today?
Adam Hooper - I'm great, and welcome RealCrowd listeners to yet another episode of the RealCrowd podcast. Tyler, who do we have today?
Tyler Stewart - Adam, today we have Adam Fountain, managing director of Broadmark Capital.
Adam Hooper - Yeah, Adam, Stanford educated. Broadmark Capital, and also managing director at Pyatt Broadmark Management, who is a real estate lender based in the Seattle area. We've worked with Adam in the past. Great guy, great firm, done a lot of really good stuff. What were some of the things we talked about today?
Tyler Stewart - Today, we focused on hard money loans and what to look for as an investor into the various hard money loan types out there and how to manage risk through it all.
Adam Hooper - Yeah, that was a big thing. They're a fund, right? So they've got a different strategy than most individuals out there looking at it on a deal by deal basis. I think we thought, this was a good episode and a good issue to discuss because a lot of the volume out there in our spaces on these private loans and single family products so a lot of good information in there. We talked about the market, we talked about some of the benefits or the challenges of doing it. Going alone, you know what happens when things go wrong and how to mitigate some of those risks as well.
Tyler Stewart - That's right. Broadmark's coming to us just after having an article in the New York Times.
Adam Hooper - Yeah. He's a big boy.
Tyler Stewart - He's a big boy so it's fun having him on.
Adam Hooper - Good. Well I think we should get to it here, Tyler. As always if you have any questions, comments, or suggestions out there, listeners, please send us an email to email@example.com. And let's get going.
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Adam Hooper - Well, Adam, thank you for joining us today. Great to have you on the podcast, and look forward to the conversation.
Adam Fountain - Great, you know, it's great to be doing this with you guys. RealCrowd's been a integral part of us growing the two funds we have, and I'm looking forward to launching a fund three on you guys here in the next quarter.
Adam Hooper - Yeah, you go, we'll look forward to that too. So you're in up Seattle. How are things up in Seattle? What's been going on up there lately?
Adam Fountain - Well, I think summer is finally over. I woke up this morning and there was snow on the ground.
Adam Hooper - Oh wow.
Adam Fountain - Which is a little early for us. Fortunately most of us up here are skiers, so you know, it's a good sign for that, but it's certainly chilly outside now.
Adam Hooper - Yeah, we haven't, we're a little south of you here in Portland, we haven't gotten any snow yet. We actually had a pretty good week, you know, we just got over Halloween, and it was almost 60 degrees and sunny on Halloween, that's good for almost November down here.
Adam Fountain - Oh yeah, that's great.
Adam Hooper - So I mean, a lot of stuff going on in Seattle, right? Obviously, Amazon, other tech companies, huge expansions, huge growth up there, market seems like it's doing pretty good this late in the cycle. Things are still going positive up that way, yeah?
Adam Fountain - Yeah, I think really what we've seen as opposed to the last run up in real estate prices in the mid-2000s, price appreciation up here is really being driven by fundamentals. There's a scarcity of housing, the demographics are changing, we're a net importer of human capital, and those people need to live somewhere, and not only are we a net importer of those people, but with the amount of tech job growth up here, largely at the expense of the Bay Area, I'm sorry to say, those are very nice, high paying jobs. So you have a combination of more people coming in, with very nice salaries, in a relatively, at least in the Seattle area, relatively constrained geographical environment. I mean, we're surrounded by mountains and water. It's led to a very attractive market that I think at least from our perspective, we expect to continue, you know, probably flatten out here in the medium term, but I certainly don't see any sort of major correction coming.
Adam Hooper - Well and that's what it seems like it's been hard to peg about this one, is the '05, '06, '07 run up, so much of that was fueled by just ridiculously lax credit standards. And some bigger issues that weren't necessarily, from, like you said, a fundamental standpoint driving that growth and that run up in pricing, where it feels, again, so we just recently moved from the Bay Area up to Portland. Portland relative to Seattle and the Bay Area is relatively affordable, but we're seeing a huge run up in pricing here, too, and so how much of these factors that are, again, fundamental growth based on more sustainable trends. How much more can that push before there's a correction or a flattening? It's an interesting dynamic this time around.
Adam Fountain - Yeah, it's a good question. You know, depending on who you ask, I would say that we're starting to see a flattening out right now, with a trade off between Bay Area real estate prices and the Pacific Northwest. That spread has certainly gotten smaller over the past few years, but setting that aside, we're still seeing tech companies move into the area. You know, Apple moving 6000 jobs up here, Facebook, Google, you know, it's not just Amazon, although Amazon certainly dominates the airwaves. A lot of those tech companies are moving up here, and I don't think that trend will reverse.
Adam Hooper - Any inside scoop on where Amazon HQ 2's going?
Adam Fountain - Ah, no. Jeff Bezos hasn't called me yet this morning. You know, we're tight, so you know, we talk every morning, but not this morning.
Adam Hooper - If he does let us know, we'll break it here on the podcast first.
Adam Fountain - Exactly.
Adam Hooper - So Seattle, and you guys are also active in Rocky Mountain West, Denver area, right? What's the geography you cover in that zone?
Adam Fountain - Yeah, so we have two firstly deed to trust lending funds. The first one, as you'll recall, is based in Seattle, and lends in Washington, Oregon, and Idaho. And our second fund, which was launched in 2014, is based in Denver, and right now lends in Colorado, Utah, and Texas.
Adam Hooper - And that's, I didn't know you guys were all the way down in Texas.
Adam Fountain - Yeah, that's a recent addition. We just expanded Fund 2 to include Texas. Initially, when we had launched Fund 2, we were looking at Wyoming. We also looked at Arizona for a period of time. Arizona's an attractive market, but there tends to be too much capital flowing in from California into the Arizona market, so we weren't able to charge what we like to charge, and certainly Wyoming was never going to be a big part of the portfolio, and we just found it's problematic moving up there.
Adam Hooper - And so how did you guys identify those geographies? I mean, based in Seattle, you know that, that's kind of your backyard. How did you guys identify that Denver, Colorado, you said, Utah, Texas. How did you identify those as new geographies to go into?
Adam Fountain - We looked at a series of criteria, you know, probably starting with the legal environment, how favorable the state law is to lenders versus borrowers. We write only quote-unquote "commercial loans". We'll do a lot of single and multi-family residential properties, but all the loans are technically commercial, so that we don't have owner occupied properties. That allows us to stay on the nonjudicial foreclosure side of lending law, as opposed to judicial foreclosure. Once we've checked that box, then it's kind of a laundry list of okay, what are the demographics? You know, are people moving into or out of the cities? Are there businesses moving in? What type of rates can we charge so that all of our investors continue to generate the same amount of return that they're used to? And then, at the end of the day, one of my partners, Jeff Pyatt, was actually born and raised in the Colorado area. So he knew the area already. That made it helpful, launching a second fund.
Tyler Stewart - Hey, Adam, you mentioned something there, judicial foreclosure? Could you expand upon that? What is that exactly?
Adam Fountain - Sure, so there's two types of foreclosure. There's two types of foreclosure processes. When a lender, like myself, makes a loan, if you're lending for commercial purposes, so to investors or property builders and whatnot, it's a quote-unquote "nonjudicial foreclosure", if you have to foreclose. So for example, the difference in process is instead of going through the judicial process, the court system, it's nonjudicial, so it's a series of gates and time periods and notice periods, but then you go directly to the courthouse steps, where you would literally have a foreclosure auction. In an owner occupied foreclosure, and this is what all of us read about in the 2008-2010 time period, when people were getting foreclosed out of their homes, that foreclosure process is called judicial foreclosure, and it is required to go through the court system in most states. It's a much more extensive process. It takes a lot longer. The differences between nonjudicial and judicial could be six months versus two years. So obviously, as a lender, we're not making money throughout that foreclosure process. We want to write loans that should there be a problem and we have to foreclose, there's an expedited process to take that property back. Because until we can take that property back, we can't liquidate it and get our money back.
Adam Hooper - Now as an investor, maybe looking at this asset class, whether it's in a fund or on an individual loan by loan basis, how important is that to an individual investor, nonjudicial versus judicial? I mean, if something goes wrong, that's a pretty big factor that you kind of need to kind of look at up front, isn't it?
Adam Fountain - It absolutely is. And I think you're touching on something here specifically about how our business has historically been done. Usually, it's brokers going out, finding individual hard money loans, and then syndicating each individual hard money loan. For investors, that's really problematic, because I have to be disciplined as an investor to divide up the pool of money I want to put in this asset class, and then dole that out to several loans over time. And then, even if you're an individual and following that process, it's difficult to get beyond 10, 15 loans, to really start to diversify your portfolio. The advantage of going with a fund like ours is each one of our funds has roughly 100 loans in it today. Investors that come into a fund like ours or different fund, they're basically diversified across all of those loans at once. Now, think about it, when you have a foreclosure process, in a fund like structure, you have a manager, which would be us, to handle that foreclosure process, so yes, you give up some of the return to a manager, but they're handling all of the foreclosures, dealing with lawyers, all the paperwork, the schedules. Imagine, if you're an individual investor, and you're one of 15 individual investors on this first deed of trust, now if you have to foreclose on that property, you have to coordinate across these other 14 people that you may or may not know. I've seen a lot of former hard money investors come to us and say, look, I love this asset class, but doing it on a one off basis with other individuals is problematic.
Adam Fountain - It's far simpler to go to a professional manager, that not only do I get diversification, but the back end problems that will inevitably occur when you're making loans like this, that those are harder to manage on a one off basis.
Adam Hooper - And yeah, that's one of things that we've seen just in our industry in general, at RealCrowd, we've never done individual hard money loans, on a loan by loan basis. Obviously, we worked with you in the fund structure format. That seems like that's one of the challenges that we've seen in the industry, again, from, again, this is my take my RealCrowd hat off, and putting my Interest Head Real Estate guy hat on. You know, we've been in a really really good market since this whole industry has really started. So a lot of people that are getting into this, as investors and are seeing some of the claims made in this industry about the safety of these loans and how they're underwritten or structured, a good market can cover a lot of that up, so I think a lot of investors that are new into this space that probably haven't done this through the last cycle, are in for somewhat of a shock once that market does turn, and some of those challenges that you were talking about that you guys were through, and have seen before in different market cycles, as an individual investor going after these, I mean, that can be just an incredibly burdensome process if you don't have a professional there to kind of help you through that. So when people are looking at this, with the foreclosure side of things, but when markets start to shift, what are some of those things, that as an individual, or as a manager yourselves, what are some of those maybe early signs that things are starting to change, what are those dynamics, and what are some of those bigger points that when those deals start to look
Adam Hooper - like they might be underperforming, or heading in a bad direction, what are some of those things that people can look out for as we get a little bit more mature in this market cycle?
Adam Fountain - Sure. I think what, and again, this is our perspective, our take on the industry, but we are very anti-leverage, and by that mean, but we're a lender. So by that I mean the way our funds are structured, we raise money, we raise equity dollars from investors, and then we only write first deed of trust loans. So we are the most senior lender. And where we don't use leverage, and when many folks out there will and have use leverage, and you can certainly generate a higher return, but where other competitors would use leverage, they would take equity dollars from investors, borrow, cheat money from banks, and then lend that out to new borrowers. The problem with that is, is when the market flattens out, when it declines 10, 20%, your bank that you've borrowed that money from may very well call that money, and now you're no longer in the first position, because you owe somebody as a lender, you owe someone money. And that can lend to a process that quickly spirals out of control. If I'm lending --
Adam Hooper - Let's put some real dollars on that.
Adam Fountain - Go ahead.
Adam Hooper - So if you raise a $200 million fund, you have $200 million of capacity, where you're saying, if you take on leverage, if you raise a $200 million fund, you might lever that to $400 million of capacity.
Adam Fountain - Correct. And where the problem can occur is, let's assume you make a million dollar loan. You've raised $500,000 from investors, and then you borrowed $500,000 from a bank to make that loan to that builder or developer. Now, if that loans goes sideways on you, and you have to take that property back, the bank is going to want its money. And now you have, if it's a construction loan, you have a half finished project, and you have to give $500,000 back to the bank that you borrowed from. So that can eat into any sort of equity cushion pretty quickly. Whereas in a fund like ours, we're lending at a 65% loan to value ratio, and if we take a property back, in theory, we're no greater than 65% of the original appraisal value. So we preserve that equity cushion. We don't owe anyone anything on the loans that we make. If there was a severe correct, in theory, we could take back a property and sit on it for several years. That's the flexibility that you get when not having leverage, and I think as this cycle gets longer and longer, people forget what happens when the tide goes out. You find out pretty quickly who has leverage and who doesn't.
Tyler Stewart - And how, as an investor, looking at this asset class, how do they determine that? Is it just a question they ask? Should that be displayed in the offering documents or the deal summary?
Adam Fountain - Yep, absolutely. It should be the very first question they ask. Am I in the first position? And this isn't to say that lending in the second position or taking an equity position in real estate is not a viable investment strategy. It absolutely is, but what I think is important is that you know exactly if there is leverage on the project, and you're allocating funds appropriately to the underlying fundamental risks.
Adam Hooper - Now let's even maybe take a further step back and go through some naming conventions here. You said originally you're doing, these are commercial loans. Commercial loan versus hard money loan, same thing, different name, can you kind of walk us through just from a basic awareness standpoint, you know, what constitutes a hard money loan versus your traditional bank financing or other sources of capital out there?
Adam Fountain - Sure. You know, hard money, it's kind of a pejorative name for what is, in effect, a private loan. You could go to a bank and get a loan, or you could get a loan from a private individual or entity. Hard money, the connotations are that it's more expensive, that's certainly true. What really differentiates, in our experience, what differentiates someone who needs a hard money loan versus someone who can get a bank loan is cash flow. I would say we have a lot of borrowers with high net worth, low net worth, good credit, bad credit, but almost universally poor cash flow. And since 2008, 2009, there's really been a bifurcation in the credit market, where banks will lend on cash flow, and if you don't have great cash flow, let's say you're a small builder, developer selling four or five houses a year, a bank is going to have a hard time lending you capital. We fill that gap in the credit market as hard money or private loan.
Adam Hooper - So cash flow, you're talking at the asset level, or as a kind of borrower, global level?
Adam Fountain - At the borrower level. So let's say I build town homes for a living. I build four or five of them a year. I only get paid when I sell an asset. And therefore, my cash flow will be quite lumpy, and when a bank looks at that kind of personal P&L from the borrower, they have a hard time lending. So it's really cash flow versus asset backed lenders. Hard money lenders tend to be asset backed, not cash flow lenders, those are banks.
Adam Hooper - And so benefits for a borrower is access to this capital that they need to run their business, and benefits to the lender would then be a higher rate for that risk adjusted stance that they're taking.
Adam Fountain - Yeah, absolutely, and I would add, there's one other benefit to the borrower in that have not only access to the capital, but faster access to the capital. So we have been able to retain many of our borrowers that would otherwise be able to get cheaper bank financing because of our speed. We operate quickly. When our borrowers put in for a construction draw, they know that we'll have an inspector out there, we'll get the inspection done, and they'll have their capital within 48 hours. That's lightning fast compared to what a bank could do, and in a market like where we are right now, if you don't pay your subcontractors promptly, there's plenty of work out there. They can go down the street and start working for someone else, and now where are you as a borrower/developer? Now you have to go find new crews and you're way behind schedule, and that's far worse than paying guys like us a little bit more money.
Adam Hooper - So you get the speed, you get the access, and then you get the convenience of that, but again, you're paying more for it. So what is the difference in terms that you would see, as just a snapshot of kind of today's market, a more traditional bank loan versus more market for these private loans in terms of both duration, pricing, fees, and what does that look like from a borrower's standpoint? Or does it vary across markets?
Adam Fountain - Sure. I would say historically, it goes up and down a little bit, but historically, a 12 month, hard money loan would cost you roughly four points in origination, and let's say 12% interest. Compared to a bank, I've seen banks provide a similar type loan, maybe a two year loan for two points up front, and 7, 8, 9 % interest. Again, their rates are going to vary more on the credit quality of the borrower and the cash flow of the borrower. Whereas our rates are more or less fixed, and consistent across the industry.
Adam Hooper - And is that 12 to 24 month term, that's typically what you're seeing out there for loans that either you originate or, I guess, this type of a borrower would be looking for, in terms of length?
Adam Fountain - Yeah, for the most part. I think most of our loans stay within the 12 month time frame. It's fairly short term, although as we've gotten larger, and the projects have gotten larger, we're able to write an 18 month loan. In order to keep the yields up, though, there tends to be a little bit of sticker shock on the origination fee, so what we end up doing is writing a 12 month loan with a built in extension.
Adam Hooper - And then so you said in your fund, currently you have about 100 loans. If you're doing 12-18 month loans over a five year fund life, that's far more diversification than just the hundred. Right, I mean, that fund must be in and out of many many hundreds of loans over that period of time.
Adam Fountain - Yeah, I would say since 2010 when we got started, we've probably written 800 loans.
Adam Hooper - That's far, far more than the usual would be able to tackle on a loan by loan basis, yeah.
RealCrowd - Thanks again for listening to the RealCrowd podcast. If you like what you're hearing, please visit realcrowd.com to learn more and subscribe at iTunes, Google Music, and SoundCloud. RealCrowd, Invest Smarter.
Lance - My background started with an MBA and a CPA, on the formal education side, and then I worked the industry for 20 years, up to CFO an COO positions, and then I started a recruiting firm for software engineers in 2000, grew it to 60 people, and then sold it in 2007 to private equity investors. You know, at that point, I was looking to build a portfolio of investments and diversify, and that's how I discovered RealCrowd, and real estate crowdfunding in 2014, and I've continued to invest via that avenue since. I've done almost 10 deals through RealCrowd. Some of them end up being a large commitment, cause they're funds, so they're a little easier to put a larger sum into than it is an individual deal, where you have more risk, the funds have their own diversifications. So I try to keep it varied so that diversification is optimized, and have about, almost 10 of them active right now. I look for mainly three things in a deal, and number one is that investment term. I prefer shorter time horizons, two to four years, for example, just because I don't like tying money up for five or ten years. You know, you lose liquidity for a long time, and there's just less options. And then the other thing I really like to see is whether or not the sponsor has significant skin in the game. You know, if they have 25% of the deal equity owned by the sponsor, then that is a real statement of confidence by them, and I love to see that. And then, of course, I do read over the actual narrative of the deal. What's special about it, why the operator has put the deal together,
Lance - you know, there's usually some compelling reasons there that resonate, and some that don't. So that's my due diligence process. So, I would say, well, yeah, right now, I'm scared of retail. I know there's a lot of good arguments why that shouldn't be the case, but I've just watched this e-commerce wave intensify, and for the time being, I would like to steer clear of retail. The number one thing I would share with investors is to take advantage of putting real estate in your portfolio. Most people are big on stocks and bonds. That's what most of the professionals tend to put people in. Real estate's always been kind of tough for the smaller investor to get into. But not anymore. The whole crowd funding, and RealCrowd has made this very easy and efficient for the individual investor to do. Before it came along, crowd funding that is, I had no way of looking at real estate investment opportunities. It was kind of a clubby thing, and I wasn't in the club. But now, I get to see all manner, and now I have relationships with various operators through doing one deal, they will have future deals coming along.
Lance - And you can actually build a relationship. So now I'm kind of like a big shot with the operators that I never would have gotten into had it not been for RealCrowd and crowd funding.
RealCrowd - Thanks again for listening to the RealCrowd podcast. If you like what you're hearing, please visit realcrowd.com to learn more and subscribe on iTunes, Google Music, and SoundCloud. RealCrowd. Invest smarter.
Adam Hooper - So when you guys are looking for opportunities, I know you said historically, on the loan by loan strategy it would be a broker kind of going out syndicating, and then packaging it up as a loan to sell to individual investors. How are people sourcing these? Is it direct relationships? Are the borrowers coming to the lenders? How does that cycle work for sourcing product, typically?
Adam Fountain - Sure. So, at least today, and it wasn't always this case, we probably have 60 or 70% of our borrowers are repeat borrowers. So, they're used to us. They like us, we like them. That makes it really nice, because the scariest loan that a lender will ever make is the first one to a borrower, because you don't really, you're kind of going on a first date with them. For the rest of the portfolio, it's really a mixed bag. It could be, there's a class of loan brokers out there, that bring us opportunities. We used to get referrals from banks, real estate agents. A lot of times we'll get a subcontractor that worked for one of our borrowers. Figured out that that guy got his money from us, so he has another, so that subcontractor has a project on the side, so he'll come to us. Because he found out a little bit of a word of mouth thing.
Adam Hooper - And so then, I guess switching to the borrower a little bit, do you guys just give a loan to anybody that wants to go build a house? What does that look like?
Adam Fountain - Yeah, no. We certainly don't. So first of all, the numbers have to work, the value has to work. It kind of starts with the third party appraisal. We only lend at 65% loan to value ratio or less.
Adam Hooper - Project cost, acquisition price, completed price, 65% loan to value based off of what, value of what?
Adam Fountain - It's really based off of both endpoints. So, today's value as well as completed value. And then our construction loans are set up on a draw basis, so that we periodically inspect and release more funds as the project gets built. But certainly, if a piece of dirt is worth 50 grand, and they're building a 15 million dollar apartment building on it, the first draw is not going to be a million dollars. That'd be crazy. But yeah, so it's really... Yeah, we like to measure both.
Adam Hooper - So you've seen on some other sources for individual hard money loans, you're using Zestimates as the after completed value. And they're basing their value off of a Zestimate, which I don't even know if we can say Zestimate, it might be trademarked. Is that a sound strategy?
Adam Fountain - No. I don't think that's a sound strategy. I mean, we... Certainly for us, as fund managers, we insist on a full-blown third party appraisal. Comparable properties. We meet every borrower, we see every property. And then once we get the appraisal, it really starts, our work starts there, because then we have to look at the comps. We drive the comps that are listed in the appraisal. In terms of due diligence, there's a laundry list of things we collect. We're building the proverbial four-inch thick loan file, that a bank would have on each one of these borrowers. We think that's the only prudent way to do these loans. And you're certainly, you will have some turkeys from now, and now and then in your portfolio. But we have been able to effectively screen out most of those with our due diligence process.
Adam Hooper - So as an investor again, for listeners out there getting into this asset class, you're looking at whether it's a fund or individual loans. What would you say are the, either the top five, or the at least kind of bare minimum diligence requirements that people should be looking at when they're trying to pick either individual loans or opportunities like this?
Adam Fountain - Oh, that's a good question. I would say, probably the appraisal. And you look carefully. Is the appraisal in the borrower's name? Or was it ordered and paid for by a independent party?
Adam Hooper - Which is better?
Adam Fountain - Clearly, I would want an independent appraisal. We always have appraisals in our name. I would look to where I am in the capital stack. I'm a little bit biased, but I always want to be in the first position. I want to be able to foreclose everyone else out. I would do background checks on the borrowers. Both soft and hard. So soft meaning, has this borrower done what he intends to do on this project before? If he builds single family homes, is this his first project for a 50-unit apartment building? That's probably not someone I would want to lend money to, if his background is building single family homes. It's a different skill set. And then in terms of the hard background check, you really want to know who you're giving your money to. And certainly a hard background check will find out any skeletons in the closet, if you will.
Adam Hooper - Now on the equity side, and you know, listeners of the podcast out there have heard us, time and time again with the mantra of, you pick the jockey, not the horse, right? So much of the decisions that people are making and diligence that they're doing, and we're doing, is on the sponsor, and their qualities as a manager. When you guys are looking at individual loans, or investors are looking at loans, what percentage, or what's the breakdown between borrower qualifications, background history, versus the actual project specific? Where do you see that break?
Adam Fountain - Also a good question. I would say it kind of depends on the nature of the, and I don't mean to punt, but it depends on the nature of the project. So for example, if I'm... If I'm lending on a 30-unit apartment building on Capitol Hill, in downtown Seattle, that's an attractive piece of dirt. And let's say, the guy, let's say the guy went through a divorce, he's got crappy credit, and he's worth a million bucks and that's it. And his last million dollars is in this piece of property. I would say, yeah. First of all, I would love to own that piece of property, so if the project goes sideways, I'm happy to take it. And at the same time, this guy's got the last of his net worth in this project. He's going to do whatever he can to preserve the equity he's created. Now, if I have a similar situation where maybe the guy went through a bankruptcy, but he's developing starter homes three hours east of Seattle, in a market that's fairly rural. And isn't seeing any opportunistic growth. Even if that loan meets all of our hard underwriting criteria, I still have to ask myself, is that a piece of property I want to own? And more often than not, in a situation like that, the answer is no. And if the answer is no, if you don't, if you're lending on a piece of property and you don't want to own it, then it's probably not a loan you should be doing.
Adam Hooper - The whole loan to own term was thrown around the last cycle. Whether good, bad, or indifferent. That was a legitimate strategy. If you see an asset that you like, and you have the opportunity to make a loan, and you think there might be an opportunity at the end of the day to maybe take that back, you kind of have to go into these deals with that assumption, right? That's the ultimate downside, is you become the owner of that property.
Adam Fountain - Yeah, I think it is, it's only prudent to lend on properties that you would be comfortable owning. Certainly, we're not loan to own guys. There is a type of lender out there that pursues that strategy, and they count on foreclosing. We actually try to help our borrowers avoid that. We want to be lenders, and lenders only. The times we do have to foreclose on properties, it's always messy, it's always a bit chaotic, and we don't care to go through it more often than we have to. But I think it's only prudent that when you're making a loan, you tell yourself, if you're in the first position, am I okay, am I okay holding this asset? Now if you're in the second position, I think the operative question is, do I have enough capital to take out the first, so I can take back this asset. So it's a little bit different if you're in the second position.
Adam Hooper - So, is taking back a project again, first blush, that's downside, right? Loan went bad, you had to foreclose, you now own it. Is there opportunity in that? Right, if you can go through, and you can complete, work out the deal. Maybe complete the renovations and realize maybe more of a full retail value of that asset, versus what you would have got maybe, on the original debt terms. Is there upside to that downside? Or how do you guys look at that? Is that good or bad?
Adam Fountain - Yeah, there can be upside. It's again, it's messy. I would say it's more neutral at the end of the day. We do charge late fees to our borrowers, we charge penalty interest. We eat into whatever equity is there pretty quickly. But if we have to take back a piece of the property, there's going to be a period of time where we have to hold it. Really what we're looking for is, in a situation like that, just to get our money back. And our fund is structured with the late fees, and the penalty interest, to make sure that we recover our principle. And if we recover our principle, then we see that as a win. Certainly in our past, we've had some defaults and foreclosure that generate a nice little uptick in yield, because we were all able to do it quickly, or what have you. Those are nice to have, but fundamentally that's not what drives the boat.
Tyler Stewart - And when you own a property, what's kind of, the strategy? Are you looking to hold and get some cash flow? Are you looking to sell? What's the broad mark strategy?
Adam Fountain - The broad mark strategy is to get out of the loan, get out of the property as quickly as possible. With a perspective of total return. So, if it makes sense to take a 5% loss on a piece of property and I can sell it tomorrow, versus hold it for a year, and not take that 5% loss, well I can lend the money back out, and generate, call it 11% return from my investors. I'd rather take the loss today, redeploy the capital, then sit on it. Sometimes I don't have that opportunity, you know? There's cases where you find environmental problems that you have to remediate. There's sometimes borrowers do dumb stuff to the property, and you just have to kind of suck it up and fix it. But generally, we like to get out as quickly as possible.
Adam Hooper - And so we talked about a couple different types of borrowers again, the guys that's got his last million dollars tied up in a perfect, you know, a really nice piece of land, versus a guy that's maybe had some troubles, not as desirable piece of land. What makes a good borrower, or great borrower, when people are looking at the different loan options out there to invest in?
Adam Fountain - Sure, good question. I would say certainly I want someone who's competent at doing what they intend to do. If they build town homes, then I want them to be good and proficient at building town homes. But in terms of what make a good borrower, it's what makes any relationship good? It's communication. So, if there's a problem, I want that borrower to tell me about it. There has to be good communication between the borrower and the lender for that relationship to be a successful one.
Adam Hooper - Are there any borrower characteristics that are an immediate no?
Adam Fountain - Yeah, there are a few. Again, as I mentioned, we lend to guys with bad credit. We like to know why someone has bad credit. If they got torched in the downturn, if they went through a divorce. All of those are pretty understandable. If somebody has bad credit because they don't pay their bills, that could be a warning sign. We do, not only do, we do background and credit checks, we do personal financial statements. So we're really kind of looking for indications as to how the borrower would react when things got tough. Various things we've seen financial crimes on background checks. Clearly those are guys that we don't want to lend money to. But in the same respect, if somebody has a misdemeanor for, I don't know, a DUI or something, from 10 years ago. Stuff like that, that's not as much of an issue for us.
Adam Hooper - And now, I guess we talked a little bit about the market earlier. I'd like to go back there before we wrap up today, and get a little bit more time on the market issue and where we see this going. We're what, seven, eight years now into recovery. We've seen a pretty good run up in housing prices. Loans for buyers, right, I'm mean you guys have to at some point look at, what is the end buyer of this product, right? So it's not just the borrower, it's what's the exit for that deal. How does your underwriting, or view on the market just within the cycle, how does that change from when you guys were writing loans back in 2011, 12, 13, to today, and going forward, 2018, 19?
Adam Fountain - I don't think the cycle has impacted how we write loans yet. What we look at a variety of kind of macroeconomic indicators. Affordability ratios. Relative affordability ratios for example, between the Bay Area and Seattle, or the Bay Area and Denver. Demographic movements. We really spend a lot of time looking for indications that a market is starting to get overheated. Days on market, vacancy rates. That's more what we pay attention to. And we haven't, certainly while paying attention to it, we haven't made any meaningful changes to who we're lending to. But I could see that start to happen in the next probably year or two. Maybe we do a little bit less new construction. Maybe do a little bit more bridge lending. But for the most part I would say, it's kind of gone the opposite direction. As we've gotten larger, we're able to write slightly larger loans. And we're really filling a gap in the credit market. Our average loan size is two, two and a half million dollars. It tends to be larger than what an individual mom and pop hard money lender could do on their own. But it's, this may be obvious, but it's far smaller than what any national private lender is willing to do. You still have to do the same amount of work for a loan of that size. If they have to deploy a billion dollars, it doesn't make sense.
Adam Hooper - Have you seen, or have you guys changed, or have you seen in the market any change in pricing, based off of where we're at in the cycle, versus again, two, three, four years ago? That's remained fairly consistent?
Adam Fountain - Yeah, I would say when we started in 2010, there just weren't many people out there doing this. So, we've seen a little bit of compression on the origination fees. Not so much on the interest rate. But certainly the origination fees have come down a bit. I would say, and that's in the markets where we lend. There's various markets around the country that are quite a bit different. Obviously they have a lot more capital, chasing fewer deals. They've seen rates come down considerably. California being one area where that has happened. And frankly, we don't lend, and don't intend to lend.
Adam Hooper - As market tightens or changes, you mentioned you'll maybe pull back on new construction, or look at different strategies. As the market gets more, I don't know if challenging is the right word as a lender, do you look into other geographies? Do you look into different product categories? How does that change your mix of what you guys might be looking at? Or does that change the strategy when the market gets maybe more constrained, I guess, for deploying lender dollars?
Adam Fountain - Yeah, I think it does. But not necessarily negative. There could be a fair number of opportunities out there at simply adjusted price levels. We are expanding. We're launching a third fund into the southeast. I was in Atlanta a couple weeks ago kicking the process off. It's going to lend in Georgia, North and South Carolina, and Tennessee. We think there are, there's still room to expand our strategy. But yeah, I think with the market correct, certainly the guys that are going to feel that first, are the guys with the leverage. Because those banks are going to want the money back. And that's going to severely constrain the amount of new loans that they can write, if they have to pay off their bank. We don't have any constraints like that.
Tyler Stewart - When you see the guys with leverage starting to go down, is that a warning sign for you? Would that change your strategy at all? Or, is that just a matter of those guys taking on additional risk, and so they got hammered first?
Adam Fountain - I think, certainly, you're always, my partner Jeff Pyatt, like to call, likes to refer to us as professional worriers. So yeah, when we see something like that start to happen, yeah absolutely, we're going to want to take a much harder look at our portfolio, maybe we reduce the loan to value of the loans that we're writing. But I think we're pretty happy with where we are in the competitive landscape.
Adam Hooper - Tyler just mentioned this, this risk word again. As an individual investor, clearly they don't have the resources that you have behind your team. You know, when you're looking at loans or sourcing new deals, or originations, or data, or access to this information. How can an investor even begin that conversation? Or, how can they start that process of trying to assess the risk of a loan when they don't have the depth of experience, or knowledge, or even access to the same kind of information you guys might have? Is there anything you see people out there, or would kind of caution, or guide people to do, from a risk standpoint, as you're looking at different opportunities?
Adam Fountain - Yeah, again this is going to show my bias, but I for myself, I would not do this on a one-off basis. I would find a fund. If not the funds we operate, then funds like ours. There are a lot of ways that these loans can go sideways. And I've heard about them in spades with these former hard money lenders coming to us and saying, look, love the strategy, but too much work on the backend when one of these things goes sideways. I certainly have the mindset of diversification is key. And sure, if you have a big enough portfolio, and you can do at least 30 or 40 of these and manage them effectively, there are, I assume there are people out there that do that. But, that's a full time job, if not several full time jobs. And I wouldn't want to be doing that all by myself.
Adam Hooper - We're getting towards the end here, and we don't like to usually get political here on the podcast, but you are probably the closest podcast guest we've had to the single family residency market. Tax program with the mortgage interest, mortgage interest deductions. There's talks in the Home Builder Association that came out and said that might cause some issues for potential home buyers out there. Any thoughts on that? Or is that anything that would impact you guys? Again, looking at the exit for a lot of these loans that you're making. How does that environment for buyers looking at these houses, or single family residences, what's your take on that market, and where is that going?
Adam Fountain - Sure. From what I've, and who knows what will actually going to effect, but from what I've read, I don't see it being that big of a deal. It's basically any thing under 500 grand is not going to be effective, effected. We do a lot of starter home stuff in our portfolio. And everything over a million dollars, there's really no change. So it's only the delta between half a million and a million. And when you actually run the net effect, it's going to cost those homeowners, what? Another five grand a year. You know, if I'm buying a million dollar house, I'm not going to not buy the house I want for a million dollars, if it cost an extra five grand a year.
Adam Hooper - If that's what puts you in the no zone, it's probably a little bit too thin, right?
Adam Fountain - Yeah, exactly. You shouldn't be buying that house. So, I don't see it having a significant impact.
Adam Hooper - Anything else, Adam? Anything we should be talking about that we haven't yet, for this space, or kind of where it's going, or anything you guys are seeing out there in the market, that listeners should be aware of?
Adam Fountain - No, I think this is a great space to be in. I think the fund approach is the way to go. And I certainly want to thank RealCrowd for what you've done in really disseminating information about this space to individual investors out there. Adam, I know you've heard before. We have this little pro bono lobbying effort here at our firm as well. We were pretty involved in the jobs act. And I think, I think RealCrowd is one of the shining examples out there, of bringing niche investment opportunities to more people. And I think that's a huge service to the investing public.
Adam Hooper - Thank you. We didn't even, we didn't have to pay him for that plug. Appreciate that. Again, I think it's, we've been talking for years now, Adam, and it's great. Bringing the access, and giving people, now, especially what we're doing with this podcast, and trying to help people understand that concept of risk, and how to look at these opportunities in maybe a little bit more insight from minds like yours of how to approach these different opportunities. It's been fun. We love it. We have a great time, and we get to talk with people far smarter than I, and share that knowledge. So, we appreciate you coming to the show today, and sharing what you did. That's all for today, folks. If you have any questions or comments, as always, please send us an email to firstname.lastname@example.org. And we'll catch you next week.
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