Following our last two secured loans offering blended gross returns of 5.5% and 14% respectively, we thought it would be worth re-visiting the subject of how Proplend determines its loan interest rates.
Recently we were pleased to receive a mention in a Peer to Peer Finance News article about the highest paying Property IFISA of 2018-19. But whilst we’re proud of the tax-free returns that we’re making available through our Innovative Finance ISA, we’re just as proud of our record of no loan defaults or investor losses to date.
For us, loan pricing is all about risk-adjusted returns and placing ourselves in the shoes of our Lenders. When considering a loan request, we aim to agree a security and pricing ‘package’ that we believe will be acceptable, whilst also being a fair reflection of commercial terms. We would never put a loan on the platform for funding that we believe bears too high a risk of defaulting, just as we would never post a loan that we didn’t think we could fully fund at that rate.
Our decision to list a loan on our platform is a reflection of our assessment, following comprehensive due diligence, that a borrower (and their loan requirement) is creditworthy. And generally speaking, the higher interest rate, the greater the risk of the loan. The range of interest rates available on our platform should therefore be interpreted as a range of lending opportunities of differing risk and circumstances.
Bridging Returns vs ‘Mortgage’ Rates
Don’t be surprised if you see a Tranche A investment for one loan with returns that exceed Tranche C returns of another loan – this despite the capital exposure for the former being capped at 50% and the latter between 66 and 75% LTV. The simplest explanation for this is likely to be that one loan is a short-term bridging arrangement, while the other is a longer-term arrangement for 3-5 years.
Borrowers would typically expect to pay around 1% per month for commercial bridging finance for a term of 6-18 months – whether through a bank or peer to peer lender. Borrowing rates may tend to be a little lower for banks, while P2P platforms typically pass on more of this interest direct to the Lender. Alternative finance providers have emerged to fill the riskier, yet still creditworthy, sub-£5million commercial lending space vacated by the banks – rewarding their participating Lenders accordingly.
For commercial mortgage lending, there is significant value is in the leases and the security that the tenancy brings. With a bridge loan there’s usually no income to provide the added confidence or interest serviceability. And although we require large interest reserves in these circumstances to at least cover the monthly payments, it may be harder to refinance or sell if they don’t achieve their objective.
So, whilst a 12-18% rate for bridging would be common, a similar rate for a commercial mortgage would not be. The circumstances of such a loan would make it likely to be an investment only appropriate for the more risk-tolerant, high net worth individuals. Circumstances that would make it unlikely to be a good fit for our platform. Rates that you would expect to see for unsecured loans, not secured ones like ours.
Loan Security and Credit Risk
All Proplend loans are backed with a first legal charge over UK commercial property, at no more than 75% loan to value. Most of these securing properties have income producing leases in place covering interest payments at least 1.25 times, and normally other security like personal guarantees, debentures and interest reserves are in place too. So, as well as reflecting the lending circumstances, loan interest rates will also represent the creditworthiness of the borrower and the security they are willing and able to offer.
An experienced commercial property investor with a proven track record and strong credit history not only gives us the confidence to offer terms but can also reduce the perceived risk of the loan defaulting. This may mean we can offer lending at rates lower than our benchmark, particularly where a quality tenant and long lease are also in place. The location and condition of properties, all of which we visit before making a loan available for funding, will also be considered.
Underwriting and Tranching Variances
No two loans are the same and every platform uses its own underwriting models, so even where two platforms offer both secured Bridging and Mortgages, there are likely to be variances in pricing. We pride ourselves on the comprehensive due diligence and complex data modeling processes that enable us to confidently assess risk – but remember they are educated estimations. It’s not an exact science.
These same processes enable us to ‘tranche-up’ a single loan into up to three LTV-based investments. Tranche C is last in line to be repaid and they have less of an LTV-buffer should the securing property need to be sold. It enables individuals with different attitudes to risk to participate in the same loan, but of course it’s only fair that those taking the greater risk to be compensated with suitably higher returns.
So, when we underwrite loans we price not only the loan as a whole, but also the appropriate rate payable to holders of each Tranche in that loan. For our most recent loan for example, this meant Tranche C investors will receive twice the rate that Tranche A will receive.
Why Choose a 6% Return When a 12% Return is Available?
Simply put it’s likely to present a lower risk to your capital. But individuals could also invest in the same loan for very different reasons. For some, a relatively low-risk and returning P2P loan may represent an increase in risk and return of their overall investment portfolio. For others, investing in lower returning loans helps de-risk or rebalance their portfolio a little.
Some of our Lenders are of a mind that a 6% loan part and a 10% loan part achieves their target return of 8% and allows them to build a diversified portfolio of loans quicker than waiting to invest specifically in 8% loans. Many routinely invest in each loan that becomes available on the platform, while others wait for those handful of loans that they really like and invest more.
We typically quote a range of returns available through our platform of 5-12% p.a. after fees but before bad debt and taxes. If you’d have invested in every loan opportunity we’ve offered since our launch in 2014, not only would you have helped fund over £35m of lending and over £75m of property, you’d also have earned an average of 8.5% p.a. (gross) based on the blended rate for each loan. This at under 58% LTV.
Not Covered by the FSCS – Capital at Risk
The fact that peer to peer lending is not covered by the Financial Services Compensation Scheme and that capital is at risk must come into the equation when pricing loans on our platform. Savings and Investments that carry no capital risk are likely to offer a correspondingly lower rate of return – but don’t fall into the trap of thinking they carry no financial risk at all. Cash returns earning less than inflation (currently around 2.5%) are effectively losing value – even where returns are paid tax-free through a Cash ISA!
Final thought …
It’s up to you to decide which combinations of loans and tranches will provide you with the returns you’re looking for, at a risk level you’re comfortable with – particularly within the context of your overall portfolio.
We appreciate that not every loan will be for every Lender and developed our tranching system because we understood that Lenders don’t all have the same attitude to risk. When comparing returns available from different loans, ask yourself if you’re comparing like-for-like? Do you understand and are you comfortable with the reasons why a higher rate is higher?
Chasing double digit rates as standard with little regard for the specifics of the lending opportunity can be a risky strategy, even where you’ve done your due diligence on the platform and they have a good track record. Diversifying across a range of loans with varying returns may be a more suitable strategy for many, with more risk-averse individuals perhaps more comfortable with the lower returning loans.
Related to this post …
Want to find out more about P2P Lending and the Innovative Finance ISA?
We have a raft of information available about peer to peer investing in our Investor Help Centre. Alternatively, browse our comprehensive IFISA guide to find out more about tax-free investing through a flexible ISA.
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