How to prepare for defaults?

Audrius Visniauskas
Audrius Visniauskas
January 20, 2020

Last week, S&P500 reached a record high once again, which is an indicator of the bull market we are currently living today in. However, this will not last forever and sooner or later the recession will begin. Although real estate crowdfunding doesn’t have a direct correlation to the Stock Market as REITs do, the general real estate market has a direct correlation to the overall shape of the economy and this is where we should be cautious. At the end of the day, crowdlending hasn’t been stress-tested during a major recession yet, however, we can take the best practices of lending and investments from previous recessions to build a portfolio which would be ready for the downturn.

What is the default?

Default is the failure to repay a debt including interest or principal on a loan or security. A default can occur when a borrower is unable to make timely payments, misses payments, or avoids or stops making payments. Defaults are inevitable and even if the originator did not have them before, it is not a good indicator that this will not happen again.

How the fixed-interest and equity loans default process looks like?

Fixed-interest loans are deemed lower risk compared to equity. This is due to the reason, that with fixed-interest loans, the developer provides guarantees such as property or credit mortgage, or personal guarantees. Therefore, when the developer defaults on the obligation to pay back the funds, the originator has the right to take over the assets, liquidate them and try to pay back the funds to investors.

Equity loan investments can yield greater returns than loans, but at the same time, they have a higher risk. This is due to the fact that the borrower doesn’t provide any guarantees, but instead, investors become like a co-owner of the project and participate in both potential upside and downside. Therefore in the market downturn, the investments can have a negative yield, which is very important to understand, before making the decision to invest. When the equity investments default on the term, usually term is being extended, that investors would not incur capital lost and property would be sold in a more favourable market situation. 

What could be the best strategy to prepare for them?

We keep repeating ourselves with this, but we believe that the best investment portfolio consists of at least 100 investments and it includes not only all types of deals but also it is diversified by the term-end dates. For instance- if you intend to invest 10,000 over the next year, why not to break it into 100 investments and have at least 100 of them.

Diversification by time is often underlooked factor, as many tend to invest in short-term loans with a duration shorter than 12 months. Which is neither wrong or right, the only thing which you have to take into account is that in a situation where recession would take place during the next 12 months, most of your portfolio will be exposed to it. Therefore if you include longer-term investments you could have lower exposure. 

Have cash-flow: rent or in other words buy to let investments. You may wonder why is it so important? The answer is simple, they make a monthly cash-flow and if they’ll most likely remain to do that, during the recession. This might help you to avoid having a negative portfolio yield. The most probable cash-flow you can have from investments with long-term lease agreements or short-term vacation rentals. The returns yield could drop during the recession, but in a regular situation, they will not default nor make a negative yield. Because of the historical stability of these instruments.

Portfolio’s balance

You are probably already familiar with the concept of a portfolio’s balance from investing in stocks. In a sense, the stocks play offence and the bonds are on defence. A portfolio needs those bonds to be considered a balanced portfolio. The bonds can provide ballast for the stocks—they work like shock absorbers since they tend to perform well when stocks don't. And bonds allow us to dial-up or dial down the risk level.
* Further reading about what is a balanced portfolio more in this brief article, or a long article and here you can find Ray Dalio’s famous “All-weather portfolio”.

The same way you can perceive Fixed-Interest loans & Equity as Stocks due to their upside potential but at the same time potential riskiness during the recession. While buy to let investments which are cash-flow can be interpreted as Bonds.

Finding your own balance

There is no single silver lining in finding what’s right for you, as your appetite for risk can vary greatly from others, but there is one thing you should always have in mind. Portfolio balance should be constantly adjusted according to economic cycles and the distribution of your rent and fixed-interest and equity loans should be adjusted accordingly. Success in investments should not be measured by short-term investment yields, but by long-term performance, taking into the account defaults and capital loss. 

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