Why Aren’t LTVs “Guarantees”?

4thWay received an email from a user asking about a property loan that is on the verge of suffering confirmed losses for lenders. He said: “What happened with their LTV guarantee on that one?”

LTV is short for “loan to value”. It means how large the loan is compared to the property the borrower has put up as collateral to back the loan.

So, take a £60,000 loan secured on your behalf against a borrower property that has a current valuation of £100,000. That loan has a 60% LTV.

You would expect that the sale price of the property would more than cover the loan you made. And, absolutely, that is what happens in most cases.

But it's not a guarantee. It can go wrong. And it does go wrong.

Anyone lending through the disgraced providers FundingSecure or Lendy seven years ago can tell you that. Because in some cases even apparently property-backed loans can cause lenders considerable losses across an entire portfolio, not just once in a while.

Even property P2P lending companies that have high-quality loans and top-notch operations will sometimes not be able to recover your full lent amount. The risk of incurring some losses from bad debts rises during economic or sectoral crises that impact any particular borrower segment or set of borrowers.

But, aside from a borrower selling at a distressed price during a massive property-market crash, how might that go down? Rather – how has it happened before?

Let me give you five real examples from five different P2P lending providers. I won't name the providers on this occasion. They do grant 4thWay almost complete freedom to report on the information and data we gather from them. But reporting on individual loans is a bit more of a grey area, as we can't reveal too much that might identify the borrowers.

These examples are all representative in that they show some of the many different ways that property-backed loans end up going wrong.

Losses from an enduring crisis

This is a case that is currently in its final act.

With this one, lenders are first in line to be repaid – so-called “first chargeholders”. This means that lenders through the P2P lending website will get their money and interest back first, even if the borrower owed money to banks or others as well.

Nevertheless, it's not going to go well for the online lenders when the dust fully settles.

The borrower's commercial premises had been earning a decent income from the many people working in the surrounding office buildings. However, after the pandemic, the number of office workers in the area just never recovered.

The value of the borrower's property went down a lot, because its value was in large part supported by the income it could produce from local workers that used its services.

Indeed, the loan will end in a loss when it's fully resolved.

The property had been valued at about £4.4 million. That valuation was on the assumption that additional development work would be completed on the property – which had a valuation substantially over £3 million to begin with based on the income from local workers.

Instead, the property is now valued at around £1 million – but lenders have lent a total of nearly £3 million.

So that's one way a starting LTV of 66% can turn into a loss of around two-thirds of your money.

Borrower bankruptcy, prison sentence and failed planning permission

On a tenanted property that was for both residential and commercial purposes, the borrower was made bankrupt owing lots of entities tens of millions of pounds. He went to prison for trying to cover his back and hold onto his wealth.

The property's value had been supported by an expected increase in rental income due to improvements the borrower was going to make, but planning permission was never received.

Furthermore, in the expectation of those property improvements, tenants had been cleared out, lowering rental income during the loan term.

The property could not be sold for its full valuation, so lenders got back 85 pence in the pound on what was supposed to be a 75% LTV loan.

In other words, the LTV would have had to have been just 63% for lenders to get all their money back. (Because 85% of 75% is roughly 63%.)

High reward… but high risk

A residential development project initially thought to be worth close to £20 million had a senior bank lender at 70% LTV. That's around £13 million that was being lent by a bank to the borrower.

Lenders through a P2P lending provider were sitting on top of that, i.e. they were lending in the same property project but in a much riskier position than the bank. In return, if all had gone well, they would have got much higher returns.

Those individual P2P lenders lent around half a million pounds.

The development suffered massive cost overruns and planning delays before later being valued at about £2 million less than planned.

All that combined to wipe out the individual P2P lenders completely on this one.

Even the bank, which, as first chargeholder, was due to get paid its loan back plus interest first, received no interest and took a haircut on its loan.

Fraud and incompetence

One P2P lending provider that is now closed (with all lenders getting all their money back) was totally out of its depth.

It was clear to my colleagues and I that, from the beginning of our first call with the management, they literally didn't know what they were doing and had no competence in this space.

(It's become harder – although not impossible – for such providers to get regulatory approval since then, because the Financial Conduct Authority has built up its processes and knowledge in this still relatively new field of P2P lending. The FCA has now rejected around 300 applications to open P2P lending platforms.)

The P2P lending provider approved a property loan, but it failed to do even the most basic fraud controls to prevent the borrower running away with the money.

The directors, although not wealthy people, repaid lenders personally on that loan in full. They were genuinely mortified about their error.

However, if P2P lending providers follow simple, standard legal and technical steps, then the risk of this sort of fraud should be very low and should normally even be covered by professional insurance.

When an aborted development makes a property less valuable

A developer wanted to create nearly 20 new homes. To that end, it had borrowed nearly £700,000 from a total planned borrowing facility of £1.5 million through the P2P lending platform.

Yet, at that point, the P2P lending provider refused to raise and release any more of the funds to finish the job.

The provider had found that, not only had there been cost overruns, but the borrower repeatedly broke promises and tried to go off the plan for the property.

The P2P lending company therefore called in LPA receivers. (LPA receivers are specialists who manage or sell properties if a borrower defaults on key terms of the loan agreement.)

In the end, a deal was done to sell the property to a financial institution that was lending to the same borrower on the same project. But the sale was agreed at a substantially discounted price.

Lenders through the P2P lending provider got back less than 70p in the pound. That's even though they had lent less than 30% of the hoped-for sale price of the development.

The hoped-for sale price of a prospective development is called the “gross development value”. When you measure the loan amount against this, you often call it the loan-to-gross-development value – or LTGDV – which is a specific kind of LTV used in development lending.

Indeed, despite lending less than half the planned total facility, lenders got back less than the original property valuation prior to the development works starting.

That is not completely unusual in development lending – not least because partially developed sites can lower the value of the land or property for the buyer.

How to strikingly reduce the risks in property lending

1. Aim to be first in the queue for repayment

It's not a coincidence that most large losses occur when lenders aren't first in the queue. You can therefore weight your property lending towards loans where the borrower grants you the benefit of a first charge on the property.

Still, that doesn't always put you first in line. A few P2P lending companies go on to split lenders into segments and rank lenders based on those segments.

For example, you might have tier A and tier B segments, with tier A lenders being repaid first, even though tier B lenders are protected by the same charge granted by the borrower.

When that happens, the tier B lenders receive higher lending rates in compensation, but make sure that you understand how any tiering works in all your chosen P2P lending accounts.

2. Go for low LTVs

Sorry for spelling out the obvious, but if you and other lenders are collectively lending £60,000 on a £100,000 property, that's safer than lending £75,000 on the same property. (All else being equal.)

Very broadly speaking, a cap on LTV of around 70%-75% is often appropriate, with an average LTV of 60% or less.

Some providers do a lot better than that:

• Proplend* (read Proplend Review) offers what it calls its “tranche A” lending, which is all capped at just 50%.
• Loanpad* (see Loanpad Review) sets its own cap at 57%, with the average being under 50%.
• HNW Lending* (read HNW Lending Review) has a cap at 70%, but the average is 44% (although perhaps half of its loans are not first charge).

3. No weird stuff

When choosing lending accounts and loans, you want to get the sense that most of the properties securing your loans are easy to value.

We're talking straightforward flats rather than football stadiums. (The latter has happened in P2P lending.)

For the most part, straightforward property lending is what you get. I guess that's simply because most buildings in the UK are “normal”, everyday buildings that professional valuers find easy to put a price on.

But, especially when it comes to development lending, the simpler it is, the better. Simple renovations, like Loanpad typically does, or at least standard residential property developments, like CapitalRise* (CapitalRise Review).

4. Spread your money widely

Sorry to long-term readers who might have read this tip once too often, but 4thWay research finds far too many readers still don't spread across enough lending accounts or loans to contain the risks.

That's even though diversification is by far the most important part of your lending strategy.

Having at least six lending accounts and many hundreds of loans reduces the risk of making an overall loss to a much tinier fraction than if you just have one account and a handful of loans.

Take care not to put too much money into any one loan, too.

Some providers give you either instant diversification as soon as you put your money in or offer lots of new loans to lend in each month. See Which Platforms Currently Have Lots Of Loans Available?

5. Go for variety

Particular types of borrower can suffer more from each downturn or economic shock. Most recently, for example, of all property owners, it was property developers who had the worst situation due to such things as labour shortages and high inflation.

So certainly you want to mix it up with a blend of development lending, bridging lending (short-term property loans) and loans against properties being rented out.

P2P lending directly to homeowners on their own homes – such as straightforward homeowner mortgages – is rarely available in this space, but you might keep an eye out for it too.

But that's not quite enough variety by itself. Within each borrower segment, there can be differences.

For example, borrowers letting out commercial properties might have held up pretty well during and after the pandemic, but not all have pulled through with ease.

For example, since the pandemic, four million square feet of offices in London alone were sold** with the intention of converting them mostly into homes or hotels. Such sales often came at cut prices.

And that was after office tenants had already abandoned the properties, making it harder for borrowers to meet monthly loan payments.

So you want to ensure that the types of properties, or types of developments, you're lending to differ as well. In location, size and scale, and how the buildings are used.

Furthermore, as each P2P lending provider has its own unique, idiosyncratic type of borrower or property, which may or may not be hit even harder during a particular economic shock, it's one more reason to look for very different providers to lend through.

6. Discount the risk when doing property-development lending

In the lending accounts where you're providing the funds to do full-on, major property development works, presume, until demonstrated otherwise, that there's more risk embedded in the LTVs than there would be with other kinds of property lending.

That's because, in most cases, the LTV you're quoted will be the LTGDV – based on the hoped-for sale price when the works are completed.

So, all else being equal, a 70% LTGDV loan is not as safe as a 70% LTV loan for a non-development.

Also, although you might lend in the first tranche of a development, that doesn't mean those of you in the first tranche will get repaid first before anyone else. Later tranches to the borrower could well be pari passu. That means that, if the development goes really wrong, then any partial repayment will be shared between you and lenders in later tranches too.

Finally, sorry there was a lot of jargon in this piece; I'll try harder!

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Which Platforms Currently Have Lots Of Loans Available?