Understanding debt ranking and loan security.

EstateGuru loans are backed with real estate and in general with 1st rank mortgage. When you make the decision to invest in debt or loans, it is vital to understand the risks and be aware of how the security issued against your investment will function should something go wrong.

Not all debt is created equal, and this is generally denoted by the debt ranking system. In this blog, we will look at the type of rankings one generally encounters in the peer-to-peer property loan sector. For convenience sake, we have listed them from safest to most risky.

Senior debt

Senior debt, also known as first-rank debt, is debt that takes priority over other more ‘junior’ debt. It will usually be secured by real estate collateral that is judged to hold more value than the debt and, in the case of default or liquidation, is first in line to be repaid. In the case of EstateGuru loans, senior debt is secured with a first-rank mortgage.

And when we are talking about collaterals in EstateGuru, then we mean real estate assets. This should be clear as companies can also give inventory, accounts receivable,  machinery as collateral (commercial pledge), but in case of liquidation only real estate has a high value.

What this means in practice is that, before we release any funds to a borrower, they have to go to the notary office and enter into an agreement with our security agent to create a mortgage on real estate. This mortgage will be held until the loan is fully repaid. In the case of default or non-payment, this arrangement allows us to initiate enforcement proceedings and take possession of the collateral issued against the loan. This real estate collateral can then be auctioned or sold to recover investor funds. This form of secured senior debt is considered the safest for investors, but conversely, it generally comes with a lower rate of return than the more risky types of debt listed below.

Subordinated debt (mezzanine)

Subordinated debt holders are generally provided with security other than a first-rank mortgage. This may vary from second-rank mortgages to equity in the borrower’s business to equipment or other assets. Should a loan go into default, holders of subordinated debt will only be repaid after all obligations to senior debt holders have been met. The higher risk profile of subordinated debt means that investors usually expect better returns on their investments. EstateGuru has only few loans with second-rank mortgage on real estate.

Equity

Investing directly into a company with the intention of sharing in profits or revenue might be a good idea if the business or project is successful, but if things go wrong it is important to understand the ranking that equity holders have in the repayment hierarchy. When a company is liquidated, senior debt is repaid first, then subordinated debt. Only once these higher debts have been paid fully can any money or funds left be distributed to direct investors or equity holders.

If you look the latest news in Estonian crowdfunding scene, then mainly subordinated and equity investments have defaulted on our competitors’ platforms and loss of capital is probably inevitable.

How this works at EstateGuru?

When a borrower approaches EstateGuru for a loan, one of our first tasks is to carry out a thorough risk assessment. We look at the business plan, the track record of the borrower, and analyse whether their project meets our strict viability requirements. Once we are sure that our stringent standards have been met, we will consider the value of the collateral offered. As we operate in the property field, the collateral against most of our loans is usually the property being developed, but we accept also other real estate properties. This is where we calculate Loan to Value (LTV).

While a property may, in theory, be worth €100 000 it would be very risky indeed to offer a loan for that full value. So we generally aim for an LTV ratio that we are certain can be recouped at auction.

The fact that we secure loans with a first-rank mortgage means our investors hold seniority when a borrower goes into default and are first in line to recoup their funds from the sale of the collateral. By holding to this practice and managing the LTV tightly, we have been able to operate for over four years with zero loss of funds to our investors.

In all cases where a loan has gone into default, we have managed to recoup all funds, and while defaults on loans obviously cause distress to any investor, the security offered by debt seniority should always provide them with peace of mind.