Real Estate 101: What Is Peer-to-Peer Lending?

By: , Contributor

Published on: Jan 13, 2020

Peer-to-peer lending matches real estate investors who need funding for a project with those who have the capital to invest.

As an investor you may have heard of this type of financing and wondered, "What is peer-to-peer lending?" Peer-to-peer lending (P2P), also known as social lending and crowdlending, gives individuals and businesses needing to borrow money direct access to funding from other individuals and investors. That allows them to bypass traditional financial institutions -- which often have more stringent credit requirements -- with easier access to the financing they need. Meanwhile, it provides those with funds to invest with the potential to earn higher returns.

Initially, the P2P marketplace focused on individual borrowers who wanted to consolidate debt, such as credit cards, as well as those needing money to cover large expenses like a medical bill or unexpected home repair. The crowdfunding market, however, has expanded into other areas, such as providing loans to small businesses as well as real estate investors.

Here's a basic primer on real estate peer-to-peer lending.

What is real estate peer-to-peer lending?

Peer-to-peer real estate lending enables businesses and individuals needing funding for projects, such as a house flipping or ground-up construction, to access it directly from investors rather than going through a traditional lender like a bank. Those types of projects tend to be harder to finance due to the risks involved. Another benefit of these loans is that they typically close quicker and can offer more flexibility and a lower interest rate.

Investors, meanwhile, can potentially earn a higher return on their capital compared to other similar debt-like investments such as government or corporate bonds. Further, real estate peer-to-peer lending has a lower risk profile than other P2P options because physical real estate secures these loans as collateral. In contrast, most other P2P loans are unsecured.

How does real estate peer-to-peer lending work?

A real estate investor who needs money to fund a project, such as a fix-and-flip, has traditionally relied on banks or hard money lenders to provide them with capital. If the borrower didn't meet their stringent guidelines, those funding sources could deny their applications. That left them with few alternatives other than borrowing money from friends and family or maxing out their credit cards.

Those borrowers, however, can now apply for loans through several crowdfunding platforms, which will review the application and underwrite the loan, often using a letter grading system. A grade-A loan, for example, has the least risk and therefore the lowest interest rate. Meanwhile, those graded farther down the alphabet are riskier and thus carry higher interest rates.

These platforms then make the loans available for individual and institutional investors. Once enough investors subscribe, the loan can close and the borrower can draw the funds for their project. They then repay the loan according to its terms, which can be interest only or a lump sum of principal and interest upon the sale of the property or subsequent refinancing.

What are the major real estate peer-to-peer lending platforms?

Several crowdfunding platforms focused on the real estate peer-to-peer lending market have popped up in recent years. Many, however, only allow accredited investors -- those who meet strict income (at least $200,000 annually for the past two years) or net worth (more than $1 million, excluding primary residence value) guidelines -- on to their platform.

Here's a look at some of the largest peer-to-peer platforms focused on the real estate sector:

  • Fund That Flip: Fund that Flip is an online investment platform that sources, underwrites, and originates residential real estate redevelopment projects with experienced developers. Accredited investors, meanwhile, are able to purchase a Borrower Dependent Note (BDN), which is technically unsecured, but each debt offering does have a first lien position in the underlying property.
  • Groundfloor: Groundfloor originates loans primarily used by real estate investors to buy, fix, and flip properties, though it also offers new construction loans as well as short-term financing for those who want to purchase and renovate properties they intend on renting out and refinancing. Groundfloor loans carry interest rates from 5.4% to more than 10% and typically mature in six to 12 months. The company pre-funds the loans and then converts them into securities called Limited Recourse Obligations (LROs), which it sells to both accredited and non-accredited investors (except those who are residents of Nebraska).
  • LendingHome: LendingHome is the largest hard money lender focusing on both fix-and-flip and rental loans. It offers starter fix-and-flip borrowers with rates as low as 7.5% on a 12-month term. It then sells these loans to accredited investors.
  • Patch of Land: Patch of Land is a crowdfunding platform that originates, underwrites, and services real estate loans, mainly single-family or small multifamily properties, small mixed-use, and small commercial real estate. It offers this debt, backed by first-lien positions and personal guarantees, to accredited, institutional, and international investors. Loans terms are 12 to 24 months with rates starting at 7.5%.
  • PeerStreet: PeerStreet is a marketplace for accredited investors, funds, and institutions to invest in high-quality private real estate loans. The company doesn't originate loans but instead vets those originated by others before making them available to its investors on its crowdfunding platform. Most loans, secured by the first lien on real estate, offer short durations of six to 24 months and yield between 6% and 9%.

Several other P2P-focused platforms focused on funding fix-and-flip loans or ground-up construction have started up. Most of them, however, only allow accredited investors and have a limited number of open investments.

Meanwhile, real estate crowdfunding platforms also offer investors the opportunity to buy shares of non-traded real estate investment trusts (REITs) that focus on investing in a portfolio of short-term real estate debt securities. These REITs will invest in real estate-related debt and debt-like instruments (such as preferred equity) used primarily to fund development and redevelopment projects. As such, they enable investors to buy a portfolio of crowdfunded real estate debt.

What are the biggest risks of peer-to-peer real estate lending?

Using a peer-to-peer lending platform to finance a real estate deal can allow a borrower to quickly access capital for investments. However, these loans have several drawbacks, including that they have short payback periods. Because of that, if a real estate flipper or developer runs into a lengthy project delay, such as problems obtaining permits, bad weather, or contractor issues, they could default on their loan, which could cause them to lose their entire investment in the project.

One of the greatest risks for investors who lend money to a company or individual, on the other hand, is that the borrower could default on the loan. When this happens, an investor can lose money.

The default rate on loans made by P2P lenders tends to be higher because they focus on providing funds to borrowers with higher risk profiles, such as those with lower credit scores. However, there is a notable difference between unsecured social lending made by a P2P platform like LendingClub (NYSE: LC), for example, which doesn't use collateral to secure loans, and those backed by real estate.

The only thing backing loans for things like debt consolidation and home improvement projects is a borrower's ability to repay. As such, if those borrowers can't make their payments, the loan servicer might need to write off the remaining loan balance. If that happens, the investors can lose a substantial portion of their initial investment in a loan since there is no collateral securing the debt.

I can attest from personal experience that some P2P loans made through Lending Club can lose close to 100%. Because of that, investors often earn less on a portfolio of loans purchased through a P2P platform than the implied interest rate, which has been my experience with Lending Club.

Real estate-backed P2P loans, however, are less risky than unsecured ones because the borrower must put the property up as collateral. As such, if the borrower defaults, creditors can sell the property to pay off the loan. Creditors with first-lien positions get paid first and could make their entire investment back if the property sells for a higher value than the loan amount.

Meanwhile, losses tend to be a much lower percentage of the initial investment than with other P2P loans.

In my experience investing with Groundfloor, one recently defaulted loan still delivered a net recovery of 89% of my initial invested capital. Because of high recoveries like that, my actual returns have come in higher than the expected return.

Another notable risk for both borrowers and investors with peer-to-peer lending is the possibility that the P2P platform could go bankrupt. If that were to happen, an investor could stand to lose their entire investment in a worst-case scenario, while borrowers would lose a funding source. There is an elevated risk that this could happen given that the social lending sector is relatively new -- the first one launched in 2005 -- and most platforms aren't yet profitable. If a significant economic downturn occurs, causing default rates to skyrocket, financially weaker platforms could potentially go out of business.

Given this risk, investors should limit the capital they allocate to P2P loans as well as on P2P platforms. Personally, I've limited my platform risk by keeping my total investment per crowdfunding platform to less than 1% of my invested capital.

Peer-to-peer real estate lending: A potential option for real estate investors who need or have capital

The social lending market emerged to fill a gap between the traditional banking sector and demand for loans from individuals and businesses that needed money but couldn't get it from those financial institutions. It aims to match borrowers at higher risk of default with investors willing to accept that risk in exchange for the potential of earning higher returns.

The P2P real estate lending market, meanwhile, brought that same model to the property sector. As such, it enables borrowers to quickly access capital for their projects. Investors with money to lend, meanwhile, can potentially earn attractive returns with a bit less risk than with other P2P loans since physical properties act as collateral backing these loans.

While the sector is still emerging, it's beginning to play a vital role in providing both access to capital and more opportunities for real estate investors.

Become A Mogul Today

Real estate is one of the most reliable and powerful ways to grow your wealth - but deciding where to start can be paralyzing.

That's why we launched Mogul, a breakthrough service designed to help you take advantage of this critical asset class. Mogul members receive investing alerts, tax optimization strategies, and access to exclusive events and webinars. Past alerts have included investments with projected IRRs (internal rates of return) of 16.1%, 19.4%, even 23.9%.

Join the waitlist for Mogul here and receive a complimentary 40-page guide on a NEW way to build wealth. Join waitlist now.

FREE - Guide To Real Estate Investing

Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.