Assessing 2nd-rank rank mortgage investments
What is a secondary-rank mortgage?
Secondary rank mortgages quite often appear on real estate crowdfunding platforms, especially in Germany, but investors are sometimes unaware how to properly evaluate these investments and the risks involved.
Mortgage - is collateral of real estate which is pledged against borrowed capital. It is divided into primary and secondary ranks, which indicate which investor or institution is the first to recover the money. Typically, a first-rank mortgage holder in large projects is a bank or other large financial institution, while the second-rank mortgage is charged by crowdfunding platforms or other institutions.
Why is it needed?
The immediate question might be, why do you need crowdfunding platforms to provide additional funding? Why can't the banks simply provide the full funding needed for the project? The answer is simple: banks usually have strict requirements of the maximum amount of capital they can provide based on the Loan-To-Value (LTV) index. Depending on the country, the LTV index limits vary, but bank loans generally do not exceed 60% of the total project value.
Long-term loans issued by banks have low-interest rates, and if the owner of the property pays such a loan for a long time, he may decide to sell his property later and may need additional capital for renovation to increase property value. For example, in a situation where a bank has provided a €3M loan to the borrower of a €5M property, the LTV ratio of the original mortgage would be 60%. Therefore, if the borrower would be in need of additional €600,000, he should look for alternative lending providers such as crowdfunding platforms.
How to assess risk?
This €600,000 loan would add an additional 12% to the value of the loan and increase the total LTV to 72%. However, this figure should not be worrying at first glance, as it represents a small percentage of the total loan value and the second loan is usually short-term. When assessing the borrower's ability to fulfil the obligations of the second loan, it is worth paying attention to the purpose of the loan. Real estate development loans, especially in the early stages such as land developments, are riskier and should be analysed looking at existing sales and reservations.
Existing tenants = lower risk
However, if the property is already built and has tenants which generates rental income the risk is naturally lower. Assessing risk in such a scenario, one should look at the property’s profitability which helps to evaluate liquidity. If we continue with the previous example, where €5M value property is generating a net rental income of €350,000 or 7% annual return, it’s always helpful to check what would be the return for primary and secondary mortgage holders. You can do this with a simple formula: €350,000 (rental profit) / €3,600,000 (sum of primary and secondary mortgages loan values) * 100 = 9.72% net yield.
This step is important to assess the liquidity of the real estate, which helps to understand whether after a takeover of the asset it would be difficult to find a buyer and repay both mortgages to the investors. In this scenario, selling real estate with profitability above 9% shouldn’t be complicated.
Also, if in a given example the bank loan would have an annual interest rate of 2% - €60,000, then real estate owner, could fully pay off the secondary-rank mortgage at a 6% annual interest rate in less than 30 months. Although this option would not be the most attractive for investors, the chances of losing the invested capital in such a loan would remain extremely low.