Learning subordinate risk from behind the senior lender or from being the senior lender first

Question

For anyone allocating capital to private lending for the first time, there are two common paths into it, and they teach different things. Option one is small gap pieces behind other people's hard money loans. Yields quoted for this kind of piece are often in the low to mid teens plus a point or two, the pieces are small enough that a total loss is survivable, and the position forces real fluency in intercreditor language, payoff order and exits, because the money's safety depends on all three. The drawback is learning subordinate risk with no baseline for what a normal loan looks like when it performs without incident. Option two is a year in first position on smaller, plainer loans at lower yield. This shows the whole file, gives control of the payoff, and teaches how borrowers behave when a rehab runs long, before moving into gap pieces already knowing what a senior lender does when things slip, which is exactly what a junior position sits behind. A third path some suggest, putting money in a bridge fund and reading the reports, has real appeal for time-constrained investors but teaches comparatively little about the underlying risk. Starting in first position on plain, well-documented loans is generally the sturdier education, since the person who has stood as senior lender understands, viscerally, what a subordinate position is actually exposed to.

nicole_adeyemi · Answer

Be the senior first. The thing you do not know yet is how much slack there is in a construction budget, and you only see that from the seat that funds draws. From the junior seat you get someone else's version of it, written by a person with a reason to make it read well.

tonyv88 · Answer

Ask any property manager who stabilizes buildings on bridge money what breaks, and the answer is the exit date. Permits sit and the last tenant takes six weeks to place, or the appraiser comes in under. None of that is fraud and all of it moves the payoff out by two or three months. If you are junior, that is when you find out whether your extension and cure language means anything. So whichever seat you start in, ask the borrower what happens if the refinance is 90 days late and see whether they have an answer or a mood.

mikeoconnell7 · Answer

A slightly different frame. The senior seat teaches underwriting. The junior seat teaches documents. You will need both, and documents are the cheaper thing to learn late.

samantha_ruiz · Answer

Borrower here, a few deals in. I've used gap money twice. The lender I'd want to be is the one who called my contractor before funding and asked when he'd last been paid. That guy priced me higher than the other quote and I took his money anyway because he closed in five days.

The rest of it, first position versus second, mattered less to me than whether the person understood a rehab schedule. You can learn that from either seat, but you can't learn it from a fund report.

derekj19 · Answer

@mikeoconnell7's split is the useful one. I'd add that being senior on small loans has a boring advantage: when something goes wrong you can act, so you learn what acting costs. Junior, you mostly learn what waiting feels like.

megan_doyle15 · Answer

If you're the senior lender on a small loan, are you the one who has to deal with the second lien holder asking for notices and cure rights? Is that a headache you'd be signing up for on purpose? I haven't done any of this before, so bear with me on the basics.

diane_kowalski · Answer

@megandoyle15 not dumb, that's a real cost of the senior seat. You get consent requests, payoff statement requests and someone else's lawyer in your file. Some private seniors refuse junior liens outright for exactly that reason, which is worth knowing before you plan a gap lending business around them existing. @soniaalvarez, my own bias is patience, so I'd say do a couple of small first position loans that are boring on purpose and let the gap opportunities come to you. The pieces you're offered before anyone knows you tend to be the ones nobody else wanted.

brandonlee36 · Answer

For a small portfolio, the thing that breaks at scale is almost always cash timing rather than value. Rehab funded in arrears while the tax bill comes due, or insurance lapsing on a vacant unit. That's the demand gap capital is filling, so if you want to understand what you're pricing, go look at four borrowers' actual bank timing rather than their spreads. The seat matters less than whether you know what the money is late for.

Learning subordinate risk from behind the senior lender or from being the senior lender first

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