We here at BanklessTimes are always looking for new forms of alternative finance, as we do not want to become entrenched in one way of doing things. So, why not go tranched instead to mix things up?
Brian Bartaby is Founder and CEO of Proplend, a P2P company based in London and Ascot, England. They connect investors and borrowers directly. Borrowers back their loans with income producing commercial property provided as a security against default.
The loans also come with a unique twist. They are split up into tranches, the French word for slice. Each tranche comes with a different level of risk and a different interest rate which reflects that risk. This allows investors of all risk levels to participate in each loan without having to wait around for a loan which matches their appetite to surface.
Mr. Bartaby spent some time discussing Proplend, the P2P system in the U.K., and the concept of tranching.
Can you explain what a tranched loan is? What makes them different and attractive to the lender?
Proplend is a P2P lending platform where the loans are supported by a first charge over an income producing commercial property. The tranched loan basically breaks the whole loan into three separate ‘sub loans’ or tranches based on loan to value (LTV) levels. Remember property loans are usually expressed as a percentage of the value of the property they are secured against.
The example below shows that each tranche has its own fixed interest rate, a lender can choose which tranche to lend into and how much to lend. The blended rate for the whole loan is 6.5% and that is what the borrower pays.
Tranche C | 66-75% LTV | High Risk | 10% pa
Tranche B | 51-65% LTV | Medium risk | 7.5% pa
Tranche A | 0-50% LTV | Low risk | 5.5% pa
What we fundamentally understood is that not all lenders have the same risk profile or the same return requirements, so what Proplend needed to be able to do is have all of these different types of lender be able to participate in the same loan. By creating the tranched structure, effectively a lender who is low-risk lender and who wants to lend only in Tranche A can participate in every loan rather than having to wait for a loan which is a 50% LTV loan.
The Proplend Member Agreement which is signed by both borrowers and lenders sets out on day one the priority in which the lenders are repaid. In simple terms Tranche A is paid first, Tranche B is paid second and Tranche C is paid third. The property that the loan is secured against would have to fall by 50% in value before it impacts a Lender in Tranche A.
What drew Proplend into this sphere?
I have spent the last 12 years working in property finance and realized I have been putting together senior debt lenders with mezzanine lenders and preferred equity lenders, so I was already doing P2P lending. By standardizing documentation and by controlling the whole loan (the whole loan takes a first charge over the property) it is a safer proposition for all lenders the whole way up the capital structure.
What is the advantage to bringing different risk profiles into one loan?
What we fundamentally understood is that not all lenders have the same risk profile or the same return requirements. What Proplend needed to be able to do was have all of these different types of lenders be able to participate in the same loan. By creating the tranched structure, effectively a lender who is a low risk lender and wants to lend only in Tranche A can participate in every loan rather than having to wait for a loan which is a 50% LTV loan. It means we can now talk to lots of different types of lenders.
We have seen that tranches can be defined by risk. What are some of the other factors that can define a tranch? Term length? Geography?
In our model the tranches are only defined by LTV levels. The factor that will define risk is the blended interest rate that the borrower will pay and how that rate is split across the three tranches. The interest rate that a borrower will pay will be defined by the deal, the borrower, the LTV, the property, the tenants, the leases that are in place and the perceived risk involved in lending to that borrower.
In some parts of the world we are seeing an increase in underwater mortgages once again. Will a heightened risk of default beyond the normal higher level of risk associated with that level scare off investors if the default rate rises like it did six years ago?
There is approximately £200 billion of outstanding commercial real estate debt in the UK which needs to be refinanced in the next three to five years. We understand that approximately 25% of that is in loans in the sub £5m sector, or around £50 billion of loans. Proplend only looks at refinancing existing loans, so we can be very picky and choosy of the loans that we are willing to accept on the platform.
We will never allow lending higher than 75% LTV. In addition the maximum loan is capped by a formula calculated by the current lease income. So a property would have to fall by 25% before the loan principal of a 75% LTV loan is impacted. We are running very tight and cautious criteria on any loans accepted onto the platform.
A better comparison should be made between some of the consumer lending P2P platforms where all the loans are unsecured, i.e. Toms wants a loan for a new kitchen in his house. The rate being offered to lenders for that loan may be very similar to the rate being offer by one of our borrowers and our loan is supported by real asset security along with 6 months of retained interest from the borrower. Consumer P2P platforms generally run a ‘Provision Fund’ which runs at 2% of the loan amount. We will hold in excess of 133% security against a loan and it is ring-fenced to a specific loan not a co-mingled provision fund.
What role does computer modelling play in your risk-assessment process?
Property is about understanding the fundamentals and telling a story, not plugging data into a computer and having it spit out a risk band. It’s been tried before and the people who tried lost money. We use technology where we believe that it adds value to our proposition rather than relying on it to do our job for us.
In the lead-in to the recession we learned many computer models were developed on the assumption housing prices would continually increase. What did model developers learn from that and how have their products changed as a result?
Nothing beats meeting the borrower and walking through the building you are looking to lend on.
Your loans are backed by income-producing commercial properties. Do some types of industries provide more stable backing than others? Which are good? Which are bad? What do you look for?
We are open to all types of asset classes as it will give out lenders the ability to build a balanced loan portfolio both by asset class and by geographic location.
We are looking for a strong experienced borrower first and foremost. After that we are looking at the property in general, the tenants, the tenants covenants, and the leases (length and conditions). If it is an ugly building, with a bad tenant on a short lease then that would be reflected in the interest rate the borrower would be expected to pay.
How important is it for the Proplend application and decision process to be as fast as possible?
There is a fine line between speed of funding and doing the job properly. There are payday lenders in the UK that will put money in your account in 15 minutes from the application but they charge around 3,000% pa – they need to charge that as they know they cannot do the right level of due diligence in that short a time.
I do fundamentally believe that it takes too long to refinance a commercial property and that is partly because we draw in other professionals to assist us with the due diligence process, valuers and solicitors and are therefore relying on their timing rather than ours. What we are looking to do is work out where we can reduce the funding time for borrowers whilst not increasing the risk to lenders that any corners have been cut.
Borrowers always want the money as quickly as possible but they are usually slowing the process down by not providing the information required in a timely fashion.
You retain six months interest on draw-down and keep it to cover delinquent payments. Are there other steps you take to protect the investor?
Apart from the due diligence that we carry out before the loan request is listed live, we feel that the six months interest is a good protection. The borrower only has to miss two monthly payments for the loan to go into default and at that point they risk losing control of their property.
As of April 1 the Financial Conduct Authority is the regulator for P2P platforms. Will that have any effect on the industry?
The FCA has taken on a huge remit in not only taking on the regulation of what was the Consumer Credit Licence but also the P2P industry and other sectors that fall under the crowdfunding umbrella. Initially it has given the new industry a badge of respectability but at this stage it is difficult to comment on how effective the FCA regulation will be.
There is some concern that, given the rapid nature with which P2P is evolving, that the next planned FCA review in two years is too far off and will stifle innovation in the interim. In your mind is that a legitimate concern?
I don’t think so. There is huge political pressure for this new industry not to be stifled as it allows hard cash to get directly into the hands of entrepreneurs and SME’s who will hopefully provide the jobs and growth that this country needs. The government has directly lent approximately £70m via P2P platforms.
There is an element that is skeptical of crowdfunding because they feel the companies have not done enough to protect investors from fraud. Have companies done enough or are these criticisms accurate?
I cannot really comment on crowdfunding as although part of the same ‘alternative finance family’, secured P2P lending is a very different and transparent business model. Personally I feel much more comfortable offering lenders a lower but risk adjusted interest return which is supported by a real asset and an existing income stream.
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