Making Strides

This piece originally appeared in the May 2023 edition of MortgagePoint magazine, online now.

It’s no secret—we’ve all seen the headlines and experienced the fallout from the difficult rate environment, declining real estate valuations, and depressed mortgage originations.

Though it’s an exceptionally challenging time for the industry, the fact is, many properties will be sold this year—and next.

The National Association of Realtors (NAR) is forecasting a decline in existing home sale volume by approximately 7%, but still forecasting 4.8 million homes to be sold. The Mortgage Bankers Association is assuming that interest rates will continue to impact mortgage origination volumes and is forecasting $1.9 trillion in mortgage originations for 2023, which, while down over 50% from $4.4 trillion in 2021, still represents a fairly typical year for mortgage volumes.

In the grand scheme of things, the mortgage market, while down, is not going to disappear. The need for mortgage loans is not going away, nor is demand for technology and digitalization. The pandemic caused consumers to behave more digitally—and they emerged much more mobile-friendly.

This caused banking, ecommerce, and fintech to make great strides in digitization—and now real estate and mortgage are following suit. However, these sectors are still in their infancy in terms of true digital adoption with considerable opportunity ahead.

How Is Digitization Being Accelerated and Funded?
Throughout its history, venture capital has often been associated with innovation, disruption, and technology. It takes many forms and offers new points of view, perspectives, and provides financial resources for industries undergoing significant change.

Specifically, venture capital investment is accelerating digital adoption in the mortgage and real estate industry by giving it considerable attention and bringing capital to areas that have not historically received significant funding. The mortgage and real estate sectors are benefiting from a new wave of best practices gleaned from other industries that underwent digital disruption—and are just now being funded—which, in turn, is increasing competition and inspiring more and faster innovation.

Proptech emerged as its own investment category in the mid-2010s and has been rapidly growing due to the continuous influx of venture capital dollars. With approximately $2 billion invested in 2015 to approximately $12 billion at its peak in 2021 according to Keefe, Bruyette & Woods (KBW), there was the explosion of venture capital funds and firms focused on investing in real estate technology companies such as Airbnb, OpenDoor, Zillow, Better, and Porch. Last year, venture capital investing in proptech was approximately $9-10 billion based on KBW’s research.

The U.S. proptech sector represents a large ecosystem of start-ups and rapidly growing companies that offer technology-enabled and/or innovative products, services, and business models across various aspects of the residential and commercial real estate markets. It encompasses technology that supports various areas within the real estate industry including searching, evaluating, financing, building, closing, and managing a property, loan, or investment.

Over time, as more customization has entered the market, it has broken into various, nuanced subcategories including residential real estate technology, commercial real estate technology, construction tech, green-tech, and mortgage tech.

How Proptech Is Paving the Path to Digitalization
There are five key areas where proptech is advancing digitization in the mortgage industry:

1. Driving efficiencies and cost savings for lenders through technology, AI, and machine learning: Proptech firms are introducing technology that can significantly increase productivity improve efficiencies and save lenders significant time as they can automate workflows that have typically been manual, ultimately reducing costs.
2. Generating new revenue opportunities: Proptech companies are innovating in areas where they can engage with new customers in different ways and provide integrations with third-party vendors to bring additional revenue-generating opportunities to existing customer portfolios and platforms.
3. Facilitating compliance in a highly regulated industry: Mortgage technology companies are helping lenders navigate the complex regulatory environment by providing the data, systems, and analysis necessary to better manage compliance and monitor the regulatory environment.
4. Delivering self-service models through disintermediation: Proptech technology companies and fintechs have continued to build self-serve products for borrowers and customers, disintermediating various steps within the real estate process. At the same time, these technology businesses have enabled legacy mortgage and real estate companies to gain a better understanding of their customers and provide a better user experience.
5. Providing greater access to and an enhanced consumer experience for new generations of homebuyers: As millennials increasingly engage in the home purchase journey with 43% of homeowners being millennials according to the National Association of Realtors (NAR), technology companies continue to develop digital capabilities to accommodate the demands of this new generation of homebuyers. Tools are also being introduced that inject more fairness into the mortgage underwriting process and which utilize alternative data sets to help increase homeownership access.

Why Now Is the Time for Digital Adoption in the Mortgage Industry
Even as the mortgage sector experiences one of the most difficult origination environments of the past decade, several significant themes are emerging that support the growth of digital adoption.

First, over the past decade, there has been a distinct shift from bank to nonbank mortgage lending. Independent mortgage banks (IMBs) originated approximately 66% of loan volume in 2021, up from 27% in 2011 as banks reduced their mortgage footprint.

However, unlike larger banks, IMBs often are not in the position to build out the technology they need themselves and are reliant on third-party software vendors to support their innovation. They are also able to move more quickly and are more entrepreneurial as a sector yet are still seeking economies of scale with industry platforms versus customized platforms. Ultimately, IMBs are uncovering opportunities to be more efficient and are more open to adopting technology.

Second, recent layoffs in the mortgage industry will continue to drive the need for technology to solve internal gaps. The Mortgage Bankers Association’s (MBA) analysts are predicting jobs will decrease by 25-30% from their peak and thus far through January 2023, mortgage companies have only eliminated approximately 12% of their workforce.

IMBs are doing what they can to retain loan officer, processor, and underwriter talent, but more than likely they will need to continue to cut. Technology will be needed to solve gaps in these organizations to ensure they are compliant and produce a positive customer experience.

Third, the all-in cost to produce a mortgage has risen fairly dramatically over the past few quarters. According to the MBA, net production income for a mortgage turned negative again in Q3 2022 for the second consecutive quarter. Total production costs have increased to approximately $11,000, up from approximately $8,000 in 2020-2021 as loan officers and nonproducing direct employees have become less efficient as loan volume has fallen.

For mid-sized IMBs, production costs are approximately $10,000 per loan with 55% of those costs in sales, 23% in fulfillment (processing, underwriting, and closing), 5% in production support, 11% in corporate admin, and only 7% in technology. This means there is a significant opportunity to address efficiencies in the sales and fulfillment areas with technology. Look for automation to occur “behind-the-scenes” to replace manual processes like the ”stare-and-compare” and guideline processing, and exception management.

Why Being an “Insider” Is Key for New Incremental Innovation
In the beginning, proptechs had some success in direct-to-consumer and marketplace models by creating major consumer demand for new categories in real estate (think Airbnb, Zillow, OpenDoor, Angi, and WeWork). They were providing innovation as outsiders and significantly disrupting the status quo and other traditional business models.

More recently, new venture-backed proptechs have been providing ”incremental” innovation by taking on industry incumbents with new and better technology. Instead of solving specific gaps, they have been going head-to-head with other players to build easier-to-use, more intuitive, and cheaper alternatives. However, they have struggled to secure market share because they are unable to successfully navigate the complex real estate ecosystem.

While the Total Addressable Market (TAM) is very large, having inside knowledge and a thorough understanding of the inner workings of the existing tech stack is incredibly important. Additionally, as referenced before, only about 7% of mortgage origination production costs are for technology, so developing solutions that can build-on to the existing infrastructure is key.

Venture Capital Funding Innovation
Often, innovation needs to be fueled by capital. Venture capital can provide capital and expertise to early-stage and start-up companies emerging in proptech.

Innovation and capital are needed to solve the specific needs in the market that incumbent and legacy real estate businesses are not solving—driving efficiencies through AI and machine learning, providing new revenue generating opportunities, better managing compliance, disintermediating legacy systems, and providing access to new homeowners. However, to invest in this space, specific and insider market knowledge is required, and this is when venture capital can play an important role, assuming that investor is also an insider.

Tech companies that are run and advised by insiders who understand the market, key players, real estate process, mortgage origination, incumbent landscape, and regulatory environment have a much higher likelihood of building a sustainable business in the sector. There have been several cases where proptechs have raised significant capital with a “big idea” but have lacked the ability to navigate the complete ecosystem within mortgage and real estate. As many investors are pushing their portfolio investments to find profitable growth, gaining traction quickly and getting the support from the venture investor network can make a big impact.

The implications of having knowledgeable insider investors are also critical to potential customers of these emerging companies. Given that many start-ups still ultimately fail, lenders and clients need confidence that their vendors have staying power and a path to being profitable. There have been numerous examples of start-ups running out of capital more quickly than forecast and in the B2B business environment, this really jeopardizes the ultimate customer.

Technology buyers want to avoid patronizing companies that lack the wherewithal to survive market fluctuations and build a sustainable business. Buyers must understand the financial position of their vendors, as well as the goals and position of the capital sources for those investments. Lenders, too, should research the proptech companies they are partnering with, know where their capital is coming from and be comfortable building a direct relationship with that source of capital.

Building a Successful Partnership Through Commercialization
Given the nature of the industry, the complexity of real estate, and the need for inside knowledge of the ecosystem and key players involved, finding a venture partner with deep industry relationships is critical. A strong venture partner will ensure that the product solves specific gaps within the industry yet also interacts within the constraints of the incumbent technology companies, assist with the commercialization phase of growth to scale the start-up’s team and go-to-market efforts, position them with key customer accounts and facilitate strategic relationships to provide pathways for an eventual exit.

For example, one of Rice Park Capital Management’s (Rice Park) first investments was in Blue Water Financial Technologies (Blue Water). Blue Water was founded because the market lacked digitally enhanced tools for identifying, trading, and hedging mortgage servicing rights (MSRs). Based on Rice Park’s experience in MSR and the early stage of the company’s evolution, we invested capital to support the team’s growth and product development and made introductions to what we believe to be key industry counterparts. Ultimately, because of our deep relationships in the industry, Rice Park was approached by Voxtur Analytics as a potential acquirer of Blue Water as Voxtur was seeking to build out their capabilities in the secondary market. We believe the key to this acquisition was Rice Park’s ongoing partnership with Blue Water through the commercialization of their product and role leading the negotiations for the $101 million sale to Voxtur.

We believe the future of proptech within the mortgage and real estate sector is bright. These companies serve an industry that is ripe for digitization and poised to embrace it—especially given current market dynamics.

However, to usher in real disruptive innovations, these tech firms will need the financial support of lenders and venture investors that understand the needs in the marketplace, know how to collaborate with the gatekeepers, can manage the regulatory challenges and constraints, and navigate the many nuances of the mortgage and real estate industries. That is the best way to ensure proptech’s long-term success.

This information has been prepared by Rice Park Capital Management and is subject to change at any time without notice. While all of the information presented herein is believed to be accurate, we make no express warranty as to the completeness or accuracy of the information. Past performance is no guarantee of future results. Rice Park Capital Management is an Investment Adviser registered with the U.S. Securities & Exchange Commission. This article does not constitute an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or any other product or service by Rice Park Capital Management LP or any other third party regardless of whether such security, product or service is referenced in this article. Furthermore, nothing in this article is intended to provide tax, legal, or investment advice and nothing in this article should be construed as a recommendation to buy, sell, or hold any investment or security or to engage in any investment strategy or transaction.

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