During the recent financial crisis real estate values dropped about 40% from the peak to the gutter. Part of the reason the fall was so steep was that many real estate loans were set at 75% or more of market value. There was simply no way to avoid lenders taking losses. Lenders’ losses were then exacerbated by a few other factors, such as residential loans that were made at 80%, 85% or even 90% of market value, so that the original margin of safety for the lenders was very slim. Additionally, many loans were made to borrowers with poor credit; and in the case of commercial real estate loans (my area of focus) some loans were for development of high rise buildings and subdivisions that only made sense under very optimistic assumptions.
Today’s real estate loan investments are not immune from losses; however, having learned some lessons from the recent turmoil, a new canon is in place to mitigate that risk. First, another 40% drop in values from today’s much lower values is unlikely; second, lenders now limit their loan amount to 60% or 65% of current market value; and finally, most lenders require a personal guarantee and require that the borrower have good credit and a good balance sheet.