It’s been said that in the U.S., “soccer is the sport of the future and always will be.”
The point being that some trends remain just that, like a wave that comes closer and grows larger but never crashes on the beach.
At HCG, we have been talking about and investing in the trend of digitalization of private debt for more than six years. We have called it inevitable and we have predicted that it will sweep over a wide range of sectors, from real estate and higher education to more narrow slivers such as litigation finance.
So, as we look ahead and explore new investment opportunities in the growing world of digital finance, it is gratifying to note the accomplishments in one sector we can now consider fundamentally digitalized. The business purpose residential real-estate loan market, colloquially known as “fix and flip”, has grown from a plethora of local, fragmented analog lenders and borrowers dealing with each other on a bilateral basis to an organized ecosystem centered around a group of web-accessible digital marketplaces unlimited by physical geography. The old adage that “real-estate is local” can now be appended with “…and funding is global”.
In just a few years, micro and opaque niches have been replaced by a national, transparent and institutional quality market. And most of the main constituents – borrowers (fixers), loan originators, and loan investors – have benefited. Even the ultimate buyer of a fixed home is better off as renovated properties are creating affordable new housing that otherwise would require work that would be too cumbersome for a new home buyer.
Before the introduction of digital marketplaces, fix and flip property entrepreneurs had limited options to finance opportunities. To participate, they either had to invest significant personal capital or be willing to borrow from “hard money” lenders. Banks would not lend against these deals because they were either prohibited by regulation or because they could not sell the loans into the Fannie Mae and Freddie Mac1 funding programs. Digitalization has lowered the average borrowing costs on a specialty fix and flip mortgage as a direct result of increased efficiency and transparency. It has also democratized access to funding: a real project with a true positive ROI can get financed whether it is a borrower’s first or fiftieth project.
Similarly, digitalization has expanded the investor base looking to purchase fix and flip loans. The same three investors who used to provide financing to home buyers in a twenty-mile radius of Southern California are now funding borrowers across the country. Four-inch thick files of paperwork are now bits and bytes that can be accessed on a laptop or tablet and shared instantaneously by everyone involved in a transaction.
Moreover, digitalization has streamlined and improved the credit underwriting process. Property valuation, for example, has evolved from an arduous, month-long process of manually gathering local information to a refined extraction of precise information from an enormous pool of data fed by websites such as Zillow and RedBell. As a result, the time it takes to issue these specialized mortgages has been reduced dramatically from 3-6 weeks to under 2 weeks.
Additionally, lenders and borrowers no longer have to guess the costs of a rehab project. They can now look at large, current data sets to better triangulate what it will cost to repair a roof in California based on the prior 100 similar projects funded over the last 3 months. This data, in the hands of trained appraisers, can produce a reliable valuation in a fraction of the time. Lastly, investors, particularly institutional investors, can now enjoy web-based property level reporting, including detailed drilldowns and pictures of construction in progress, ultimately delivering greater accountability.
Outcomes: Institutionalization and Professionalization
In our view, the byproduct of digitalization in these markets is professionalization and ultimately institutionalization. As previously noted, valuation, product placement, servicing, and reporting have seen remarkable upgrades with the onset of digitalization. For example, the introduction of formal valuation committees and chief credit officers to the underwriting process gives institutional investors and banks comfort to participate in the fix and flip ecosystem. Today, banks and established asset managers are some of the largest buyers of loans originated by these digital real-estate platforms. We believe that market depth and transparency have increased the number of high-quality loans, reducing default rates and improving outcomes for investors.
We see the impact of these advances and the maturation of this market evidenced by the number of companies that have joined in and are succeeding in this sector. LendingHome, PeerStreet, Lendinvest, and Fund that Flip are some of the digital platforms that have anchored the sector’s ecosystem and are gaining ground in the U.S. and U.K. It is also encouraging to see traditional analog players like Anchor and Genesis expanding into the digital realm and, in the case of Genesis, being snapped up by the likes of Goldman Sachs’ Marcus.2
These digital platforms are leading the charge in converting the home mortgage and fix and flip market from a cumbersome, fax machine-dependent analog hell of paperwork to a simple, straightforward, transparent, and completely digital experience. And the acceptance and growth of their businesses have been stunning. It took CEO and founder Matt Humphrey and his team at LendingHome almost three years to originate their first $1 billion in mortgage loans for homeowners and real estate investors. Last December, the company announced that it had originated its second $1 billion in less than 12 months.3 LendInvest in the U.K. is another example of a company that has evolved from pure brick and mortar to almost entirely digital over the past three years. And the market has noticed. After facilitating more than $1.3 billion in loans since inception, the company reported 20% growth in 2016, and LendInvest was named the most valuable tech company at the prestigious Investor Allstars event in London last November.4
So will this acceleration of acceptance and growth continue? We think so. More data and transparency should, in our view, continue to drive improvements in underwriting and servicing, empowering investors to conduct deeper and more precise due diligence. With near real-time data and continuous updates, investors will likely be able to detect and analyze the smallest changes in market trends. In the past, this data would have been isolated in pockets that didn’t espouse transparency (e.g., hard money lenders, or specialty finance companies). Today, multiple data service providers offer information in innumerable reports and formats, driving a “professionalization” of the monitoring process. Before this data was available, a chief credit officer would have had little empirical evidence to work with; now real-time data can be converted to knowledge and real-time decision making. Furthermore, greater transparency will continue to help originators and investors price risk and more objectively track performance relative to initial assumptions. Ultimately, we believe the combination of these factors will drive continuous improvement in pricing models, leading to higher quality loans.
Some have raised a concern that this sector may be getting overheated because it may be attracting too much capital. Perhaps, but our view is that the presence of experienced credit and risk departments, combined with near real-time data, should help digital platforms detect signs of overheating earlier than they would have prior to digitalization. Platforms can monitor negative trends to modulate their origination activity. Similarly, mortgage investors who also have access to similar data could choose to hold back allocating capital to the sector and seek more attractive risk-adjusted returns elsewhere.
The Next Wave
The digitalization wave has crashed on the beach and millions of borrowers are diving in to finance new homes and investment projects in the same user-friendly way they buy shoes or book travel. Additionally, they can track the progress of a project the way they track a package on its way from the store to their front door.
So, what’s the next wave? Certainly, this sector will only become more sophisticated with Fintech players further refining their back-office capabilities and making the user experience even more intuitive and, yes, enjoyable. We expect to see this approach spread to every nook and cranny of the entire loan cycle, from origination and servicing through securitization and property management. We also see machine learning coming into play over the next few years, taking advantage of the explosions of data to further improve risk pricing.
At HCG, we will continue to explore the frontiers of the post analog world, looking for the right opportunities and, more importantly, the right teams to take full advantage of them.
As for U.S. soccer, we remain optimistic. A January 2018 Gallup Poll showed only soccer and hockey increasing as the sport Americans named as their favorite to watch.5 Baseball, football and basketball had all declined. Another flipped trend?
HCG has been a pioneer in digital finance investing since 2012. We believe that foresight, the ability to look ahead at critical issues around evolving fintech, credit underwriting, regulation and financing markets, is essential to effectively navigatethe challenges and opportunities of this nascent industry.