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Wall Street Journal / Biz - Money

Wall Street Is Getting In On the House Flipping Game

Residential transitional loans have become a lucrative and growing niche of finance in recent years, and Wall Street is aiming to cash in.

John Beacham formed Toorak Capital Partners to buy high-interest, short-term loans extended to house flippers.

KKR & Co. is raising its bet on high-interest, short-term home loans, the latest sign that Wall Street firms are aiming to cash in on the risky but lucrative house-flipping market.

Borrowers of residential transitional loans—or flip loans, as they are better known—use the money to buy a property, renovate it and then try to quickly resell at a profit. They have become a lucrative and growing niche of finance in recent years. Nomura Holdings Inc. estimates that flippers will borrow some $15 billion this year, nearly 25% more than last year.

KKR is the latest example of Wall Street’s growing interest in the area. The private-equity house is boosting its commitment to Toorak Capital Partners LLC, a New Jersey concern that buys up loans made to home flippers and other residential-rehabilitation specialists from originators throughout the U.S. and the U.K. Toorak has been able to so far buy more than $1 billion of this debt.

KKR had previously invested $75 million in equity in Toorak. Now, the firm says it is increasing that to $250 million.

Goldman Sachs Group Inc. is another big financial player that has entered the business of writing and buying flip loans.

Toorak and other firms like it buy flip loans from originators, often online operations like Peer Street Inc. and LendingHome Corp. Those companies have backing from Silicon Valley venture firms Andreessen Horowitz and First Round Capital, respectively.

These loans command juicy interest rates of 8% to 12% and often have maturities of around 12 months, though many borrowers repay earlier. A one-year U.S. Treasury, by comparison, yields, around 2.27%.

But flip loans come with risks. If a renovated property doesn’t sell for a higher price or the borrower can’t refinance, the lender may wind up owning a house. That can happen if the housing market sours mid-flip, if remodelers misjudge their costs or the tastes of potential buyers, or if appraisals value properties too richly at the onset.

Because home prices have risen steadily since 2012 and new construction hasn’t flooded the market with inventory, flippers haven’t had much trouble repaying loans in recent years.

So far defaults have been few. Window Rock Capital Partners LLC., a private investment firm that focuses on real-estate-backed credit, took possession of only four properties and has yet to record any losses on roughly 200 flip loans that it has bought, said Jeffrey Pettiford, head of business development.

But today’s crop of loans have yet to be tested in a down market.

Wall Street firms are betting that home prices can keep climbing. They reason that home construction alone won’t meet the demands of a huge generation starting families and buyers whose credit has recently recovered from the foreclosure crisis. They also reason that there are plenty of house hunters who would struggle to get a loan to remodel or repair an older home on top of a mortgage.

The wager by KKR and other big investors also depends on the continued demographic shift to big cities, where houses tend to be older and more in need of upgrades than those in suburbs and swathes of the Sun Belt.

In 2017, Memphis, Tenn., was the U.S. city with the highest proportion of sales involving a flipped house at 12.8%, compared with a national average of about 6%, according to ATTOM Data Solutions. Flipping activity also peaked last year in Cleveland, three Wisconsin cities and along the Interstate 35 corridor in Texas, according to ATTOM.

In the years leading up to 2007’s crash, speculators flipped droves of homes. They often took on second and third mortgages to buy them while doing little more than pounding for-sale signs into the lawns.

That strategy backfired spectacularly when home prices crashed and over-extended flippers couldn’t sell them.

Following the meltdown, big investors gobbled up nonperforming loans and foreclosed homes. Some of the houses were spruced up and sold while others were turned into rentals. In recent years, flippers have shifted from homes in financial distress to those suffering physical deterioration.

Renovations can be as simple as replacing worn flooring or as involved as adding entire new floors, from replacing outdated kitchens in suburban homes to gutting inner-city brownstones and converting them into small apartment buildings.

Historically fix-and-flip jobs have been funded by regional investors, known as “hard money lenders.” Toorak Chief Executive John Beacham said that left open an opportunity to institutionalize the business. He took a similar approach to the rental-home business as a senior banker at Deutsche Bank AG’s commercial real estate lending business.

“The market has been local lenders, usually not banks, lending inefficiently,” he said.

Flipping Fever

The year in which the greatest portion of home sales involved flipped properties in the country's 174 largest metropolitan areas, since 2000

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Source: ATTOM Data Solutions

Flip loans are more like collateral-backed business loans than months-long mortgages. Lenders provide a large disbursement up front, followed by smaller distributions as construction milestones are met. Underwriters must not only appraise the properties that serve as collateral but also estimate the after-repair value as well as judge the borrowers’ rehab plans and their ability to perform the work on time and on budget.

Loan buyers say they buy loans that are usually 75% or less of a property’s value to give wiggle room in case the market sputters. As well, originators often earn a portion of the interest paid by borrowers to encourage them to make sound loans. And loan buyers say they avoid rookie renovators inspired by the scores of television programs that have fueled a national infatuation with flipping.

“People think, because of the flipping shows, that this is an individual thing you can do,” said Rob Bloemker, co-founder of 1Sharpe Capital, which has raised about $1 billion since last fall to buy flip loans. “We only buy loans from people who have multiple successful investments in their past.”

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