Learn the intricacies of commercial private money and fund more deals

Richard Zahm, principal, Second Angel Bancorp

As published in Scotsman Guide's Commercial Edition, May 2007.

The biggest reason for not following through on a fundable loan is inaccurate placement. Brokers cannot connect a particular scenario with an appropriate lender.

But there are private lenders that are willing and eager to review and finance even unusual deals.

The failure to fund often comes from brokers' misunderstanding of what private lenders are, how they operate and what their limitations are.

What brokers often don't realize is that compared to wholesale lenders, many private lenders have wider discretion on property types and loan situations. This makes them similar in many ways to hedge funds.

A hedge fund is a privately placed pool of capital that allows a fund manager wide investment discretion to use alternative investment vehicles. These include virtually everything except stocks, bonds and mutual funds. Hedge funds, enjoying light regulatory oversight, invest in a range of securities to increase expected return while reducing risk. In some ways, private lenders can resemble the "hedge funds of the mortgage industry." Once this critical element is grasped, everything else can fall into place for brokers. Private lenders' motivations, organization and operations can become more clear.

How they work

Hedge funds use more-complex investment approaches than those used in other parts of commercial real estate investment. Many funds guard their "secret investment approach" or "black box" paradigms and formulae even from their investors.

These funds are exclusive, private and often not publicized. Discerning how their funds are used often can be tricky for investors.

Hedge funds come in two flavors:

• Directional funds: These grab headlines for posting double and triple returns compared to the stock market. They're aggressive and volatile.
• Absolute-return funds (nondirectional funds): These are designed to generate a steady return no matter what the market is doing. Slow and steady, they're favorites of conservative investors who want low risk and can give some return in exchange.

Commercial real estate-related private lenders fall into two categories:

• Those that invest directly into real estate ownership structures, such as real estate investment trusts, tenancies-in-common and individual developments.
• Those that invest in the financing underlying the ownership. These are mortgage funds or mortgage pools.

Mortgage pools are absolute-return funds. They're the real estate branch of the hedge-fund family. Comprising portfolios of residential and commercial properties, investor returns hover around 10 percent. They have done so through a variety of economic cycles.

A mortgage broker or mortgage bank serving as manager of the fund underwrite the loans within a pool. Originations come from brokers or occasionally from the managers themselves.

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