Many investors believe that diversification is a good way to preserve wealth, but that specialization is the best way to build wealth. Lenders, regardless of strategy, are constantly walking the tight rope of trying to barbell risk and measured or methodical growth with ingenuity and production. With so much uncertainty and change anticipated in the housing market, the question is more important now than ever – which is a better strategy: Diversification or Specialization?

Let us look at the pros and cons of Diversification versus Specialization (or Concentration) in the Business Purpose Loan Lender space. Different lenders have varying ideologies, strategies, and business models in how they define what they want their deal flow to look like. Given the current market environment and sharp increase of rates, which lenders are better poised for the potential tumultuous months ahead? Specifically, when it comes to diversification versus specialization, we will explore the following categories: Geography, Borrower Base, and Loan Product.

Geography

Lenders specializing in certain markets have more expertise since this is their focus. These lenders can stay abreast of changing legislation and requirements for items such as permitting, inspections, etc., and can manage the risk associated with the resulting changing timelines or costs. Because they are usually in closer vicinity, they can see projects in real-time at a minimal cost and typically do not need a lot of overhead to manage their business or allocate resources to this purpose. These types of lenders also can build valuable relationships with local vendors and municipalities. However, focusing on only one market (or a limited number of markets) may oversaturate the lender’s exposure if there is a downturn or softening in home values on a local level, which will directly affect their deal flow and may extend timelines on their loans exiting. In a strong and competitive market, it may be difficult to win shares if there are other lenders competing in the same space for the same borrowers.

Lenders who diversify their portfolios by lending nationwide or in many markets are unlikely to be experts everywhere and need to spend capital to stay up to date on micro-level changes in the regulations and timelines. As a result, the lender may be subject to unnecessary risk and forced to react to issues instead of proactively managing them. On the positive side, exposure to multiple markets can balance any potential risk of individual market downturns or market softening because these lenders lend more expansively across the country. This allows lenders to capitalize on growing markets and protects against isolated downturns.

Borrower Base

There are benefits to creating many deals from a limited number of borrowers. Lenders can focus on understanding each borrower’s business and provide great customer service as they have fewer clients to manage. There is also a cost-benefit for these lenders, as repeat clients with multiple loans will likely require less effort with each individual loan since the company is already familiar with the client. However, if a borrower hits a rough patch or is struggling with projects/investments, the lender may have significant exposure to potential losses if the client/borrower cannot exit the loan successfully or rehabilitate their situation.

For lenders who loan money to multiple or many borrowers, there is less time with each borrower and fewer opportunities to understand their business. It is more difficult for these lenders to be bespoke or make specific concessions/exceptions because they have an array of borrowers across many geographies. Therefore, there is likely less flexibility for individual borrowers with lenders whose strategy is diversification across their borrower base because it is not sustainable to be bespoke and still be able to grow when there are many loans to many borrowers as opposed to only a few borrowers. But having this level of diversification potentially insulates the lender from a larger default exposure risk. If one borrower defaults, it is less likely to affect other loans in the lender’s portfolio. And it can also assist the lender with education in those specific markets and a network of resources to help manage any problem loans in their portfolio.

Loan Products

Lenders can offer a limited number of products or product classes of many. If a lender chooses to focus on only a few products or one product class, they become an expert in that product and can quickly make changes and customize as the market moves. On the negative side, market volatility in the secondary market and investor appetite for specific product types can vary and shift. If secondary market pricing, availability of capital, and investor appetite is waning on a specific product or asset class, if a lender only specializes in one or few products, this could severely impair deal flow. Lenders who offer multiple products or product classes can be somewhat protected from market volatility and balance the lender portfolio with other product types to help insulate the lender’s deal flow by altering its overall product composite. But too many product offerings can stretch resources thin and require personnel to be trained on multiple guidelines and products, which can be difficult to manage and is more susceptible to error.

So, to revisit the initial question – Diversification versus Specialization: Who is better poised/positioned to weather the potential storm ahead? Will it be one or the other, or do both strategies have enough pros to outweigh their cons? Or is there a balance with diversification in some areas but specialization/concentration in others? The real answer is that there is no magic bullet, and lenders must continue to balance specialization and diversification to stay relevant. In this market environment, it is evident that at a very minimum, the lender needs to be nimble to have controlled growth balanced against the risk to ensure deal flow is both profitable and but risk adjusted.