Different Lending Rules?

With the emergence of online real estate investment trusts, digital marketplaces and crowdfunding platforms, private lending and private equity are colliding as never before. Some companies turn to private equity or venture capital to run their businesses and develop new products and technologies. Others rely on private lending, or debt, to participate in the showcase of marketplace opportunities. 

But several characteristics distinguish mortgage lenders from private equity and venture capital investors. Investors have many choices and an ever-growing list of strategies and tools to navigate. The choices are even more evident with the rise of the unicorn.

Over the past few years, startups valued at or above $1 billion have been dubbed a typical Startup owners value the cache that comes with the $1 billion valuation, and investors are attracted to companies with promising futures, as judged by the investment market. The mindset of the equity investors that fund unicorns differs greatly from that of other sources of capital — including the private lenders that back a substantial number of commercial property deals. 

As a commercial mortgage broker, gaining an understanding of the differences between equity and debt financing is essential, if you are to guide your clients toward the right choice in raising money for a company project, expansion or acquisition that involves real property.

Discounting Profit

Among the startups that attract the attention of equity investors, those deemed to have the highest value are not necessarily the most profitable. Some of the most publicized and highly valued startups, such as Uber or Airbnb, operate at substantial losses. 

That does not mean the notable investors who own a piece of the companies are clueless. But it does mean they have very different standards and have a different view of potential rewards than do senior-secured lenders.

Even when the portfolio companies of a venture capital concern fail to make money, the investors can look to the large valuations of those businesses — valuations often driven by the companies’ brands and customers. An equity investor, such as a venture capitalist, must have enough foresight to invest in companies — whether they are technology startups or commercial real estate enterprises — that can maintain and increase their valuations through the next round of financing, or via an initial public offering (IPO) of stock.

If a project funded by a private loan shows losses, however, a secured lender will typically foreclose and attempt a workout that preserves principal. In lending, valuations are closely tied to exit strategies, because borrowers must demonstrate cash flow or an upside that leads to refinancing or an asset sale. 

Value Judgments

A lender has a role in monitoring a borrower’s finances. Rarely, however, does a lender cross the line to help the borrower make decisions that might affect property valuations, because the borrower may claim the lender was at fault if the project fails.

A venture capital company is in the trenches with the company, usually having some form of control, doing what it can to pump up the value of the investment. Overvaluing pre-IPO startups, however, causes problems later when retail and institutional investors base eventual stock purchases on the same assumptions. 

When market corrections occur, most investors suffer losses — sometimes the loss of their entire investment — and those holding commercial real estate securities are no exception. Although the stock market is the primary exit for unicorn companies, sales of stock are precarious because reaction to overvaluation slows the market. Without a thriving stock market, routes to profitable exits are narrow.

Lenders rely on several methods to determine the value of underlying collateral. These include broker price opinions, comparable market analysis and appraisals. Income-generation economics and sales comparable’s are usually better indicators of value than is an asset’s replacement cost. The likely “as-is” sale price of a foreclosed property is typically the best metric. 

Even when a collateralized asset is valued inaccurately, however, at least the real property still exists. Real estate is unlikely to ever lose its entire value. Assigning value to tangible assets stands in stark contrast to valuation methods applied to emerging companies by equity investors.

“Assigning value to tangible assets stands in stark contrast to valuation methods applied to emerging companies by equity investors. ” 

Lenders accustomed to standard loan-to-value ratios find it difficult to comprehend valuations assigned to startups, some of which will never turn a profit. Valuing a company in the billions of dollars because it is selling a lot of widgets or signing up millions of users, even at a huge loss, is of little relevance to a lender that is relying on that business to make regular loan principal and interest payments to assure the health of its own business model.

Differing Risk Standards

In commercial real estate lending, there are different asset classes and risk pools that determine pricing and terms, regardless of the commercial enterprise involved. In equities, there seems to be less continuity from one industry to another. If a startup tech company is entering a hot market, and the founder has a history of creating high-value startups, investors will likely flock to that tech company regardless of the granular economics that might torpedo the value of a startup in another industry.

Lenders underwrite in units. What’s the price per square foot? What are the rehab costs per unit? How many lots need to sell to pay off the loan? Reliance on these easily quantifiable numbers highlights another major distinction between private lending and equity investors — who not only bid-up the price of companies that show no sign of turning a profit, but also are apparently unconcerned when startup CEOs collect hefty bonuses based on a company’s unicorn status. 

Some venture capitalists admit that, in some cases, companies determine how much money they need to raise and how much equity they are willing to part with, then merely apply some simple math to calculate the company’s value. Still, the various valuation methods applied in that world are ambiguous. Many valuations are the result of “buzz” or “interest,” as opposed to hard asset values or earnings. 

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Lenders make loans that are intended to enable commercial real estate borrowers to succeed. The concept should be the same when a venture capital company extends equity to a startup, especially because venture capitalists normally dictate the company’s decisions. 

The business model employed by venture capital companies, however, seems to be based on a gamble that one of 15 or so portfolio companies will rise to the top and become a unicorn, and that successful company’s performance will offset the more modest successes (or losses) of others in the portfolio. In baseball terms, a venture capital company looks for a chance to hit a grand slam once every few games, while lenders seem content with bunts and singles, and consistent scoring, in almost every game.