Development Lending: “Last Six Months Have Been The Worst, Including The Pandemic”

Two platform heads have recently mentioned to me the surprisingly large tremor caused by Trussonomics on development lending, which is still having knock-on consequences.

But that's far from the only thing to hit this sector: the continued loss of construction workers from Brexit, recent high inflation, ongoing materials shortages, rising interest rates and the pandemic all caused property developers a level of strain not seen for a long time.

Some of the consequences of these overlapped and they have continued to play out long after media interest in many of those wider stories has waned.

The consequences are finally coming to a head in P2P development lending. Clearly, it all impacts the level of risk in outstanding loans.

As the CEO of one P2P development lending provider just put it to me: “The last six months have been the worst for a number of years, including the pandemic”.

What's going to happen now?

It's not any part of 4thWay's work to predict macroeconomic misfortunes like that long list in my opening two paragraphs. (Thankfully, since that's ridiculously difficult.)

Rather, we want to ensure that lenders using a basket of lending accounts that are highly rated by us have a very large margin of safety against losses when huge misfortunes do arise.

That means that across your lending accounts and loans, you can still expect to come out with positive returns, even in the event that borrowers are suddenly hit by something huge and terrible that makes it harder for many of them to repay their loans on time.

With the increased risks caused by this wave of coinciding blows, you may be wondering: do 4thWay's specialists still have full confidence that lenders who are spread across rated lending accounts – and that have a lot of development lending – are well protected?

The answer is a categorical Yes and the facts and data very strongly support this Yes.

From 0 to 69 in 14 months

Let's look at the recent numbers for CrowdProperty (its January dataset), as on the surface it doesn't look pretty: there are now 69 loans or development tranches that are at least six months behind schedule or that have actually turned into a bad debt, which requires more action to recover.

In the data CrowdProperty (read CrowdProperty Review) provides to us, it automatically calls all these loans “defaults” – bad debts – although in reality many of them are in perfectly reasonable shape, with plenty of cover remaining and the expectation will be for the developments to be completed and sold in due course.

However, to put the 69 into perspective, it had 226 live loans and tranches 14 months ago, and was reporting to us zero loans that it was classing as “default” in its submitted data. Now, there are 367 loans, and it's classing 69 of them as bad.

How surprising was this?

For many lenders, this will probably look sudden, I guess. They will have seen an increasing number of their loans fall later and later, and be wondering what on Earth is going on.

However, at 4thWay, we had already been treating pretty much the same proportion of loans as bad debts in our core tests for well over a year, so this hasn't snuck up on us in the least.

Indeed, despite CrowdProperty's technical classifications in its submitted data, lenders looking in from the outside will be glad to know that CrowdProperty was not unaware of difficulties within individual loans in that batch, so it wasn't taken by surprise.

Partly the increase is that its definitions in the data it submits to us have probably been tightened up. Even so, adjusting for that, it's seems likely that it would internally have considered no more than 25 to be bad 14 months ago using the same definitions, which is still a lot less than 69.

What should you expect from those loans and what if there's a lot worse to come?

Many of these loans require closer watching, but will still ultimately recover in full. They are not “red alerts”, but more an amber let's keep an eye on it type situation. However, with some of them, I strongly expect lenders will indeed face some losses. A 20% loss on one loan would still likely see lenders' annualised return for the year drop by somewhat less than one percentage point if they're spread across 25 loans.

If a major recession and property crash was to happen now, even in these already stressed conditions, you'll see more loans take longer in the coming months, and CrowdProperty acknowledging that more loans have turned bad and require action.

Nevertheless, CrowdProperty lenders' cover against losses has not been greatly dented by the existing trials. So we calculate lenders overall will remain robustly positive if there are additional stresses from a plausible disaster scenario. Lenders have a large margin of safety remaining.

That's fairly representative – even in higher-risk development lending

Looking across all the P2P development lending companies that provide 4thWay with detailed data, documentation and access to their key people, CrowdProperty's story is pretty representative. All are doing at least as well.

Visit Loanpad* (see Loanpad Review) lenders for example still have ridiculously large defences against loss. And Invest & Fund* (see Invest & Fund Review) loans haven't even been falling late.

But that is not to say it's comfortable for lenders if you've not armed yourselves with knowledge. Where lenders are doing junior, riskier, very high-rate mezzanine finance the potential for losing out on individual loans is higher.

I'll give you one more example case for this, namely CapitalStackers* (read CapitalStackers Review).

Of the 64 loans CapitalStackers has ever approved, 22 are still live, and nine of those are now more than 180 days past their intended repayment dates.

14 months earlier, it was two out of 18 live loans that were running this late. Of all the loans that have already been repaid, just six out of 42 went this late before lenders got their money back (plus interest earned up to the date of actual repayment, as usual).

But even here, 4thWay rated P2P lending companies are cautious when it comes to building in leeway for construction delays, cost overruns and property sales delays. CapitalStackers is especially cautious. Rightly so, due to lenders' riskier position in the “stack” of loans.

The impact on those existing nine loans is therefore looking extremely well contained.

CapitalStackers projects that lenders might suffer some loss of interest on two loans. And CapitalStackers itself, along with its directors, might lose money on one of those loans, but not lenders through its platform. Although it projects all these losses with cautious modelling and the result might well turn out better.

It's only the lenders who decided to take the very riskiest slice of those two loans (slices four and five) who currently appear to be at risk of losing interest. These lenders were being paid 25%-30% interest for the additional risk they had taken, so the interest they are earning across their basket of highest-risk loans – which generally all pay over 20% – provides very good cover.

Most lenders will also be lending lower down the stack too (safer slices of the loan), where they still earn double digit returns but with a sharp drop in risk.

If a recession-and-property crash combo were to hit tomorrow, lenders would be sensible to assume they will suffer pain in individual loans, involving loss of both interest and lent money in some of them. You are, after all, focusing on the riskiest part of development lending.

However, with the quality of the loans, the leeway built into them, the abilities of CapitalStackers' people, and the extremely rewarding interest rates, I have no doubt that the losses will be contained and that most lenders will be breathing a sigh of relief at the end.

These periods happen in property development from time to time

These cycles are usual, which is why good lending businesses plan for it to happen.

Don't get me wrong. Returns can obviously fall further if a disaster piles on top of the existing situation and that applies most in the highest-risk lending.

And certainly some lenders will panic-react, which can lead to you doing things to yourself that cost you money or cause you losses, even though simply holding and waiting would have been sensible and satisfactory.

That panic is in part driven by how smoothly lending has gone over the past 10-20 years in this space. In many cases, you're psychologically anchored to your loans being repaid on time. When you're starting from a very low point in terms of late or bad debts, it can seem frightening when the number leaps upwards.

Especially with many of you seeing your number of late development loans tripling or quadrupling and then dragging on over the past year or so.

But that doesn't mean that higher number hasn't been well planned for and built into the lending models. They clearly have been. We see it in the data, the documentation, the plans and the processes that 4thWay-rated lending accounts have in place.

While few people look forward to crashes and recessions, anyone with a good basket of these lending accounts remain in excellent shape to weather the additional losses.

Bear in mind that I assume that you have taken your own responsibility to spread your money across many loans seriously, as anyone who doesn't take this simple step puts themselves at a considerably greater risk of losing money, regardless of whether the P2P lending provider is good or not.

And if there's no recession or crash?

The backlog of issues I listed at the start is already beginning to filter out.

As a development lending CEO said to me: “But the green shoots are coming through. We remain upbeat. Yes, loan-to-property-value ratios are stressed, but there’s enough conservatism built into our modelling for us to remain positive.”

I wholeheartedly agree.

Pages linked to above

The Inaccuracy Of Property Price Forecasts

Further reading

90%+ Loss Shows Difference Between Property Investing And Property Lending.

Peer-to-Peer Lending Vs Other Investments.