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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   January 2015

Private Money Saves the Day

Alternative lenders keep capital flowing when traditional sources scale back

For commercial real estate and mortgage markets, the past decade and a half has been defined by extreme instability, with borrowers and lenders alike bracing for abrupt swings from game-changing highs to crushing lows. It has indeed been the best of times and the worst of times.

In the years leading up to the Great Recession, the commercial lending market was bursting with easy capital. In this optimistic environment, the market mood was light, regulations were lax, and private and institutional lending sources were plentiful. But when the bubble burst in 2008, institutional lenders were quick to batten down the hatches. Suddenly the money stopped flowing. Because these institutional lenders made up a major share of the lending market, their hasty retreat effectively sucked the capital out of it.

This shook the real estate and mortgage markets to their cores in a way that hasn’t been seen since the Great Depression, but the pullback of capital stopped short of leading to their demise. Fortunately, smaller private lenders stepped in to keep the gears of the economy’s real estate sector from locking up completely.

Filling the void

Thanks to private lenders, the commercial lending market found a natural balance. When traditional lenders backed away, private lenders seized the moment and stepped in to fill the void. Private money — gathered from private individuals, pension funds, individual retirement accounts and other sources — provided much-needed capital. 

Private lenders were well-positioned to grease the frozen gears of the real estate market because they were more comfortable with a higher degree of risk than traditional lenders. Private lenders were able to loan capital to entrepreneurs based primarily on the ultimate value of a property rather than on an individual’s credit history. Distressed properties could also be saved because private lenders favored shorter-term investments, and therefore found distressed properties tantalizing.   

The efforts of private lenders played a pivotal role in pulling the commercial market from the ditch. In 2012, privately funded multifamily property loans in the U.S. grew 22 percent over 2011, and privately funded loans for retail properties increased 17 percent. Private loans to owner-occupied borrowers or homeowners, however, were more limited because of the cumbersome regulatory environment, which remains in effect.

History

Although the recent tumultuous turn of events in the real estate market may seem like a one-off, there are historical parallels between what is occurring now and what happened when private lending first became part of the U.S. real estate landscape. Going further back in the history of banking reveals that reliance on banks to backstop real estate loans is actually a relatively new way of doing business.

Historically, almost all loans were transactions between individuals, not institutions. In fact, traditional banking was once considered a much less reliable mechanism for powering the economy, subject to collapse whenever there were periodic shortages of hard currency. Banking as a regulated body has suffered many fits and starts over time, with regular boom-and-bust cycles throughout the 19th and 20th centuries. During these cycles, private lending helped pick up the economic pieces.

Private lending also has a habit of going where institutional lending fears to tread. During the California gold rush, private-money lenders stepped in and essentially funded the state’s birth. Private lending likewise powered similar western expansion in the U.S. because settlers always preceded banks.

More recently, in the 1950s, private money helped rescue the mortgage market when banks ramped up credit checks, making it harder for average Americans to finance home purchases. And private money also filled a gap left by traditional banks that shied away from lending on properties —  including multifamily — located in inner-city, low-income neighborhoods.

The value of equity

Private lending was able to lead the recovery after the 2008 meltdown because it is fundamentally different from traditional mortgage lending. Most significantly, private loans are typically based on the amount of equity in a property, rather than on the borrower’s individual credit score or debt-to-income ratio.

Many real estate developers and small-business owners saw their credit histories take a beating in 2008 and beyond, and soon after banks decided to lend only to borrowers with spotless records. Private lending sidestepped this quagmire because private investors were more concerned with seeing a solid plan for a good rate of return on investment (ROI) than credit scores.

The private lender, by nature, looks more at the overall deal, offering a tailored approach rather than simply tallying a credit score. Because private loans target a low loan-to-value and mainly look at quality, consistency and potential net operating income from the property,  these lenders could absorb more risk regarding the borrower’s credit score than could traditional mortgage lenders. These lenders also look at ROI within a few years, not within a few decades.

The uptick in capital from private lending kept afloat many businesses and investors that might have otherwise drowned in the market during tough times. After market improvements, private lenders looked to sustain their relevance by joining forces, brainstorming new ways to serve the market and seeking legislative improvements to foster further recovery.

Going forward

The commercial real estate market is now on the rise, with private lenders continuing to provide a new pathway for capital to flow, even as traditional lenders reenter the picture. In the next couple of years, there could be increased opportunity for private lenders as commercial mortgage-backed securities mature in high numbers, requiring bridge loans for transitional properties that do not qualify for permanent institutional financing.

The economic recovery has inspired many new private lenders to enter the market. At the same time, existing lenders are adding staff and aggressively pursuing mortgages to keep up with this new paradigm shift in lending at a time when banks and other large mortgage lenders are often shedding jobs. Private-money lending is now poised to assume a much more significant and respected seat at the U.S. mortgage table, having proven its worth in times of crisis.

The slow, steady recovery has shown that the new landscape of the  commercial market will little resemble the status quo before the economic meldown. The guardians of traditional capital are still hesitant to put their full financial weight into commercial lending because of the current regulatory environment, creating a market rife with opportunity for commercial investors.

History shows that there is an ebb and flow of capital in any economy, as well as an ebb and flow of the power  of private lending. After the Great  Recession, it appears that private lending is ascending once again to a position of prominence in the economic landscape. 


 
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