Spread or 1st mortgage: which is the best method?

But what methodology actually works best to make a better return, and most importantly, without hassle? Spread or 1st mortgage? Let’s try to look at this more analytically. Suppose you have these 4 situations:

In the table above you can see that all options assume a deployed amount of €1,000,000. In one loan, or in 50 parts of €20,000. The average interest rates mentioned are derived from what we currently see in the market.

1st Mortgage as collateral on loan

Okay, now to collateral:

The 69% Loan To Value with a 1st mortgage does not mean that there cannot be a write-off. We are currently seeing all kinds of risks and valuations in the market not only in project finance. Without properly interpreting this as a funder, that 69% still doesn’t say much. A proceeds of € 950,000, = in a foreclosure sale scenario or sale in a foreclosure auction is no exception with a valuation of € 1,450,000. In other words, in this example, you won’t get €50,000 of the loan back. A low LTV does not always say it all. We prefer to focus on healthy cash flow so you don’t have to foreclose. But that’s another blog….

Back to collateral. I mention here €1,000,000 of collateral in the financing without a 1st mortgage. By this we mean collateral in the form of pledging inventory, machinery, accounts receivable and stock, but also, for example, a guarantee from the entrepreneur. Not the best collateral in a foreclosure scenario!

Experience shows that out of this €1,000,000 in collateral, you will get back about €400,000 in a foreclosure scenario. So then you book off 60% of your loan upon foreclosure of the collateral.

And then what does spreading do?

Suppose you have 50 loans of €20,000. In any case, a write-off of this 60% on every €20,000 loan is not going to happen. But what part of those 50 loans did? This depends very much on the quality of the selection, the analyses at the loan origination and the management during the loan.

Historically, we know that in a downturn, 1 to 3% of borrowers per year get into trouble. Suppose; we calculate with 2% per year and 60% amortization of your loan and you have sufficient spread. Then, relative to the case with 1st mortgage, the interest rate would have to be about 1.7% higher to compensate for that higher risk of write-offs. In the market we now see differences of 2 to 3% higher interest rates. In the example above, we assume 2.5% higher interest rates. And then, in the spread variant without a 1st mortgage, a better return still results!

Conclusions

• The likelihood of being written off on a loan secured by a 1st mortgage is not as high, but the impact can still be high. The “yes condition” arises here because on the front end you need to be able to properly interpret your collateral and estimate a value in an alternative scenario.
• The probability of impairment in a portfolio of loans is high, but the impact of the impairment on the entire portfolio is small. The Yes provided here arises because you need to be able to professionally manage the front-end selection and management during the loan. Those who can properly price the higher risks of loans without collateral into the higher interest rates can make additional returns on them.
• Having a 1st mortgage and having a spread is of course an excellent investment option for parties who do not want to run any risk on the principal ánd do not want any variation in the annual return.
• No 1st mortgage and no diversification: The risk of depreciation here is so high that as an investor you have to know very well what you are doing and what risk you are willing to bear relative to what return.