Focusing on the Collateral

The company was launched with the premise of 2008, says Peltz.

LOS ANGELES—Private lending in the commercial property arena has gone mainstream, yet with that increasing acceptance has come a heightened element of risk. “The largest segment of private lending is unsecured and many investors neither understand what they own nor what happens in the event of a default,”  says Harlan Peltz, co-executive chairman of iBorrow LP, a Los Angeles-based direct lender specializing in private money loans collateralized by commercial real estate. “The risks are far greater for unsecured versus secured private loans. These differences are not properly priced and may not be fully understood by investors.” Peltz and iBorrow’s other principals believe the issue will continue to escalate as more borrowers seek loans outside of the traditional banking system. “Furthermore, the advent of electronic lending marketplaces has the potential to cause borrowers and investors to view lending as a fun videogame rather than real business, which requires serious scrutiny,” Peltz says. Founded in 2012 as Eagle Group Finance, the company does not currently offer an online lending platform. Peltz shares insights into the current lending environment, and why a more cautious approach is warranted. An edited version of this conversation appears below. GlobeSt.com: Is the prevalence of unsecured loans a function of the current market or something that will prevail regardless of what cycle we’re in? Harlan Peltz: If you think of most lending as occurring through traditional lenders—banks—these are all unsecured loans. There’s collateral in there somewhere, but the lending decision itself is based on the credit score and the cash flow of the borrower. Private lending just picks up on those themes. It’s much easier to do underwriting that way than it is to really get into the weeds and understand collateral. It’s also easier to grow that business. It’s much harder to look at collateral through the lens of the security. I also think that there’s a belief that it’s safer to look at the credit score and the cash flow, that it’s more predictive. GlobeSt.com: Yet the credit score can turn around fairly quickly as cash flow declines in the event of a general or property-level downturn. Peltz: That’s our issue with looking at it that way. We think that changes to collateral value occur much more slowly than changes to your credit score or cash flow, because they’re primarily a backward-looking indicator. They don’t tell you what’s about to happen to somebody. When there is a hit to cash flow, which hits credit score, it happens quickly. If you can understand the dynamics of a marketplace in terms of where the property sits and the drivers of those changes in value, they’re a lot slower to change than somebody’s cash flow or credit score. GlobeSt.com: Currently we’re in a very active lending environment, especially in certain asset classes. At the same time, underwriting has loosened. Would you argue that lenders should move in the opposite direction, as though we’re in a tight lending environment? Peltz: The problem is that you can’t really change your stripes. If you’re a cash flow- or credit score-based lender, suddenly starting to look at things through the lens of collateral is not an easy thing to do. It’s a totally different skill set, and really undermines the things you’ve been saying to the market. So moving from one bucket to the next, from unsecured to secured, is a very unlikely type of change. But the other type of change is that within whatever type of silo you occupy, whether it’s unsecured through cash-flow/credit-score analysis or secured, you do need to be a lot more judicious about the approach you take if you have an opinion about the credit cycle and their opinion is that things are getting a little more dicey. That’s certainly our opinion. We don’t come at this from the standpoint of technology people or entrepreneurs, but people who have been operating in the financial markets for a period of time and who have seen the credit cycle. The credit cycle is unmistakable: every 10 years on average, you have an event. We haven’t had one since 2008. It’s been a very robust environment, and that robust environment is part of what contributes to the risk. If you think back to 2008, you’ll remember that people were appalled and shocked that banks were largely compensating originators based on originating loans, regardless of whether the loans paid off or the borrowers had the ability to repay them. So there was a really bad incentive structure that contributed to the problem. I don’t think we have the same issue today, but we’re eight years into this credit run and at some point, we’re going to have to back up from that. If people haven’t already become more judicious, they really should start now. When we started our business, we really started with the premise of ’08. We tried to look at all of the significant issues that arose out of ’08 and account for those in our underwriting. That means the opportunity set for us isn’t as big as for somebody else, because we’re not doing equity, mezzanine or junior loans. We’re only sitting at the top of the capital stack. We also never lend on raw land that’s unentitled; that was a huge problem in ’08. We don’t do residential loans; we know that over time, that market is far more cyclical and less stable than commercial. We’re also active only in states with non-judicial foreclosure rules, so were there to be a problem, we could capture the asset on a fairly perfunctory basis. The other thing we do is to lend at very low loan-to-value ratios. And our value is not just a broker’s opinion, but really the liquidation values—what we think we could sell the asset for quickly in the event of a default. Defaults aren’t the issue for us—we’ll have very few defaults—it’s the recoveries that we’re focused on. GlobeSt.com: So while some potential opportunities are eliminated in your business model, so too are a number of potential risks minimized.]]] Peltz: That’s exactly right. Roughly $350 billion of private commercial lending occurs annually. But it’s a meaningless number, because it has no bearing on our business. When you account for the fact that we don’t do mezz, we don’t do high LTVs and we don’t lend in certain states, you start to skinny it down for our business model—it’s not that big. But the flip side is that we’re not going to be caught off guard and have our portfolio frozen.