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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2015

Nonbank Lenders Take Center Stage

Nontraditional lending sources offer originators an array of deal-financing opportunities

During the past seven to eight years, there has been a slow evolution of the commercial real estate financing process. This change was so gradual that it remained unnoticeable, except to those few individuals who had constant, direct contact with the principal players in the process. The featured individuals and entities in this transformation are private lenders, which operated outside the limelight in the prerecession era. The Great Recession, however, proved extremely beneficial to these lenders for several reasons.

A major change resulting from the difficulties that struck the global economy during the downturn was the imposition of various new limitations on the big banks. The restrictions, designed to prevent another financial collapse and taxpayer bailout of the banking system, are embodied in the following: the Dodd-Frank Wall Street Reform and Consumer Protection Act in the U.S., the Basel III accords that affect banking activities on a global scale and the domestic self-regulatory provisions instituted by the banking industry itself.

The net result of these measures is that banks today have significantly less capital available for investment in commercial real estate projects, and a new marketplace has developed that is ripe with possibilities for funding projects of all sizes and types. This means many new opportunities now exist for commercial mortgage brokers to secure funding for projects that once would have been virtually impossible to finance, except possibly through the most expensive hard money sources.

New institutions

The new order in the financing of commercial real estate stems from the fact that pension funds, insurance companies, family businesses, endowments, sovereign funds, individuals with ultra-high net worth, investment banks, domestic and international commercial banks, and other major financial institutions around the world have found a better way to invest their capital.

They provide funds to a select group of private nonbank lenders that function as decisionmakers regarding the disbursement of these large sums of money. These funds are pooled by private lenders that can then draw on them once a suitable project has been identified for investment. The value of some of these pools can total well into billions of dollars, and access to these funds allows the private lenders to finance projects of substantial size — frequently worth several hundred million dollars or more.

These private lenders are not subject to the risk- taking limitations that have been imposed on banks, so they are in a position to fund projects that banks would never consider — and also can offer higher loan-to-cost financing than is common among banks. This is mainly because the private-lending structure inherently reduces the risk to investors by syndicating funds from multiple sources to accumulate the backing necessary to fund individual projects. Should a project default, the individual sources of the funds have much less exposure, because of their limited  financial participation in that particular project.

There are some natural human tendencies that slow this inevitable evolution a bit. People are often resistant to change, and this portion of the industry was ravaged in the early days of the recession by phony private lenders and con artists who took advantage of unsuspecting clients by charging upfront fees. They would subsequently disappear or simply find reasons to deny the loan based on “due-diligence” findings. The stigma of their activities remains, with borrowers being skeptical of anyone requiring fees to be paid  before loan closings.

Other borrowers are under the erroneous impression that paying these fees for third-party due- diligence activities guarantees a loan closing. These third-party fees for valuation and due-diligence processes are necessary to compensate the individuals who perform those activities. They are the equivalent of paying for an appraisal for a purchase or refinance of a residential property. Costs involved in determining a value for a large-scale commercial real estate transaction — during which not only property values, but also business-operation, general-market and economic analyses must be reviewed — are substantially higher than for a simple residential appraisal. And there can be no guarantee that the project’s operations upon completion will satisfy the requirements of the lender. These upfront expenses, therefore, are costs of doing business and should be expected by borrowers. The burden of proof that the project will be profitable enough to cover debt service with suitable margins is squarely shouldered by the client.

Many qualified borrowers today are clinging to the fact that “in the old days” they did not have to pay any fees to obtain loans from banks. There were several  financial reason for this. First, banks would require borrowers to open bank accounts for the financed project. This would generate millions of dollars for the bank over the life of the loan and the banking relationship. Banks also are insured by the Federal Deposit Insurance Corp., so they had a back-up guarantee of funds to replace losses in their operations. Third, when all else fails and banks still lose incomprehensible amounts of money, the government steps in to bail them out, and sometimes does that at the taxpayers’ expense.  The private lenders that are the funding sources today that have replaced banks do not have the luxury of being  able to lose money and have it replaced by other entities — such as the government or the public.

Commercial brokers would do well to explain to their clients that each private lender has its own application and underwriting process. The vast majority of them have applications that must be fully completed before the lender will even consider reviewing a project for potential financing. There is a strong resistance to this somewhat tedious process, especially among developers that have had previous successes and have been able to establish a reputation for their accomplishment. These customers are new clients to the nonbank, however. A client’s refusal to comply with that nonbank lender’s requirements will simply result in that lender not moving forward to finance the project.

In many cases, this is a tremendous mistake, because that lender to which the initial deal presentation was made could be the best source of funding for that individual project. The next suitable funding source will probably be less beneficial to the borrower. Regardless, the process with the second lender will be virtually identical to the process with the first.

Best option

Brokers have the best chance of success if they present their client to the most appropriate funding source first. If the brokers have done their homework and the client is cooperative, this should be the only necessary presentation.  Nevertheless, the broker should have a suitable backup funding source with similar terms for the borrower, just in case. The presentation should be planned out before the initial meeting with the first lender. The goal is to ensure that the borrower’s progression through the various steps toward funding is as seamless as possible, without unnecessary delays.

These new private nonbank lenders are offering every type of loan product, service, arrangement and combination financing that banks offer — such as asset-based, nonrecourse loans as well as short-term, 100 percent equity financing on new construction projects. Another common offering is 90 percent or higher loan-to-cost debt financing on cash-flowing acquisitions or projects with superior income potential. Many funding options typically require minimal cash outlays by the principals, while granting them total project ownership.

Debt/equity financing stacks, creative structuring in cases of senior mezzanine and subordinated debt, equity capital with reasonable participation parameters, joint ventures, bridge loans and high-leverage financing are all available through nonbank lenders as well. Secondary-market options also are on the table, such as private-label commercial mortgage-backed securities for portfolios of qualified, stabilized properties that have been financed by nonbank lenders.

The list of financing methods goes on. There is a funding source for every type of commercial real estate deal. Even venture-capital projects that can be presented properly can be financed. This new face of the commercial mortgage industry, which has been regarded in the past as a temporary adjustment to difficult times, is becoming more permanent with each passing day.

Commercial mortgage brokers should contact previous clients with projects they have been unable to finance, even those who were turned down as recently as six months ago, and explore with them the options for nonbank financing. There are newer, more innovative funding opportunities in existence today. The growth, popularity and functionality of nonbank funding sources will continue to expand over the next several years,  so now is the perfect time for brokers to position themselves to take advantage of this new wave of opportunities. 


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