Many of our investors ask us "What happens if a GROUNDFLOOR loan that I invest in goes bad? Will I lose my money?"

Ensuring you don't lose your principal is the number one concern of any investor in any asset. Everyone wants to be repaid every dollar of their hard-earned money that they put in. Not all investments are equal from this perspective. In fact, for a given property or company, investing in debt ("lending") is always less risky than investing in equity ("owning").

Why is that? The answer lies in the very nature of what debt is and the rights that come with it, compared to equity. This is finance 101. Unlike most forms of equity investments (such as stock in a company or shares of a Real Estate Investment Trust), debt is always due to be repaid in a certain manner, at a certain time, under the terms agreed between the borrower and the lender. In real estate, sometime before the loan is due the borrower usually repays it by selling the property associated with the loan, or by borrowing money on a new loan to "take out" the old one.

If all goes well, there's plenty of money to go around at that point. Loans are repaid, with interest. There's enough money to pay the equity owners back for what they put in too, plus to reward them for their risk by paying them everything that's left over.

What about when things don't go well? What then? When a borrower violates a loan agreement by not repaying her lenders as agreed, that's known as a "default." Real estate lenders (GROUNDFLOOR included), usually require property to be pledged as "collateral" as a condition of making the loan. The lender has the right to "foreclose," or assume legal ownership of the collateral in the case of default. A "lien" is the legally-recognized way of recording this right. Many people have unfortunately experienced this with a bank using its lien to foreclose on their own home as collateral in response to non-payment of the mortgage or some other default.

Owners of equity are usually left with nothing in the case of default and foreclosure. They lose all of their principal. Lenders, however, stand the best chance of getting theirs back. Aside from the government, or any contractors or employees with money due to them, lenders are the "first in line" to be paid from the proceeds of taking ownership of the collateral and selling it. In many situations, there are multiple lenders. Each lender has a place in line relative to the others.

GROUNDFLOOR does not offer equity in the projects we finance. All GROUNDFLOOR investments are opportunities to participate in loans that are secured by property as collateral. We offer two types of loans, based on the type of collateral we hold:

  • Senior Loans (example: 1429 Allene Avenue) are the very first in line. If they are not repaid as agreed, we have the right to foreclose upon and then sell the property. In this case we would use the proceeds of the sale to repay all of our investors in that loan.
  • Mezzanine Loans do not provide GROUNDFLOOR with the legal right to foreclose (since that belongs to whomever provided the senior loan, typically a bank). Instead, when the collateral is sold we have the right to be repaid only if the holders of senior loans receive everything they are owed. We would be repaid out of what is left over, if anything.

For more information check out our FAQ on secured lending.

To get back to your money, and the point of investors' main question: How much risk is there that you could lose your principal? That answer depends on the following factors:

  • the seniority of the loan
  • the amount borrowed
  • how much you believe the collateral is worth, and
  • how much it will cost to foreclose and sell the collateral if necessary

Let’s use the $60,000 loan on 1429 Allene Avenue as an example. If the borrower, John Mangham, defaults on his loan, then GROUNDFLOOR would foreclose on the house since it is a senior loan and we have a first lien on the property. There are costs associated with a foreclosure. For example, S&P estimates these costs to be 26% of the loan amount. So, for our example property the cost of foreclosure could be $15,600 (or more, or less).

Then there is the cost of selling and marketing the house. For our example, let’s use a commission rate of 6%. We could further assume, based on sales of comparable properties, that the house sells for $120,000 (again: or more, or less). The sales and marketing costs at 6% would then be an additional $7,200. So from our sale of the house at $120,000 less foreclosure costs of $15,600, and less sales and marketing costs of $7,200, there would be $97,200 left to repay GROUNDFLOOR investors and any other transaction costs of the sale. GROUNDFLOOR investors expected to receive $60,000 back on the original investment plus 12% annual interest or $3,600 over six months for a total return of $63,600. In this example there would still be $33,600 ($97,200 - $63,600) of cushion to pay costs. So long as you believe that the value of the house is worth more than the total costs of foreclosure and sales and marketing ($15,600 + $7,200 = $22,800 in our example), then you can be confident that all your principal and interest will be repaid.

Illustrative Example of a Loan Default on 1429 Allene Avenue:

Proceeds from sale of the house

$120,000

Less foreclosure costs

($15,600)

Less Sales & Marketing Costs

($7,200)

Remaining capital to repay GROUNDFLOOR Investors

$97,200

Less Principal owed to GROUNDFLOOR Investors

($60,000)

Less Interest owed to GROUNDFLOOR Investors

($3,600)

Remaining cushion

$33,600

But how can you know how much a house is worth? That's a subject for a future post. Every loan we offer comes with information to help you decide for yourself. We also encourage researching websites such as Trulia and Zillow to help you reach your own conclusions. Whether investing in debt or equity, every investor must come to his or her own determination of value. Until next time, we hope this discussion has been a useful start to understand the risks of investing and how to begin assessing them.

Let us know what you think of this post and any questions it leaves open for you down in the comments below. We'll answer and appreciate the opportunity to get into the conversation with you!