As interest rates remain relatively high and banks limit their lending volumes, it’s no surprise that originations have slowed. Bloomberg recently reported that commercial bank lending dropped by nearly $105 billion in the last two weeks of March 2023, the largest such decline in Federal Reserve data going back to 1973. Commercial mortgages accounted for more than one-third of this decrease.
“While a price premium will be paid, there are many reasons that a broker would advise their borrower to consider a private lender. These include a quicker approval and funding time frame.”
This type of news can leave mortgage brokers scratching their heads as they try to figure out how to best adapt to a changing market. Sometimes overlooked by brokers is the fact that strategic relationships with private lenders may become the new standard, both as a reliable lending source and a way for brokers to diversify their own investment portfolios.
Private lending explained
Private lending refers to a type of mortgage financing in which individuals or private companies lend money to borrowers rather than traditional institutions such as banks or credit unions. Instead of having a fixed interest rate or terms as bank loans do, the terms of private loans are negotiated directly between the borrower and the lender. This can provide greater flexibility for the borrower in terms of the leverage, interest rate, repayment schedule and collateral.
The use of private lending sources can be beneficial to commercial mortgage brokers whose clients may not qualify for traditional bank financing for a variety of reasons. While many banks and other conventional lenders have stringent guidelines — e.g., minimum debt-service-coverage ratios or seasoning requirements — private lenders tend to be extremely flexible and often provide loans that banks would not typically fund.
Brokers choose to work with private lenders for a number of reasons, including when there is a short time frame to close, the property is in distress or the borrower has a lower credit score. To compensate for their flexibility and greater risk tolerance, private lenders charge higher interest rates (commonly between 10% to 12%) than traditional lenders.
Costs vs. benefits
While a price premium will be paid, there are many reasons that a broker would advise their borrower to consider a private lender. These include a quicker approval and funding time frame.
Because private lenders have autonomy, they don’t have mandated underwriting guidelines and are opportunistic in nature. They are able to approve loans much more quickly than traditional banks — frequently within a matter of days. Additionally, since private lenders tend to fund directly off their balance sheets, it is common for them to fund deals without the third-party reports (such as appraisals or environmental studies) that banks require.
There is also term flexibility. While traditional lending sources typically stick to five-, seven- or 10-year terms with standard amortizing schedules, private lenders can be flexible to meet the needs of the borrower. Examples include a 12-month loan with interest-only payments or a 24-month loan with no prepayment penalties.
It also tends to be easier to have a direct conversation with a private lender. These are typically smaller organizations that cater to brokers with individualized attention, including direct communications with decisionmakers. This can be helpful for brokers whose borrowers don’t quality for traditional financing or when the deal in question involves a property in transition.
Sourcing the funds
There are two common ways that private lenders are capitalized. The first is through a bank line of credit, which utilizes a financial concept of earnings from a spread. With this method, a private lender might borrow $10 million from a bank at a 5% interest rate, lend it out at 8%, and keep the 3% difference as their profit or spread. This method has been used for decades, but as rates have increased and banks have limited their lending activities, private companies are having a difficult time using this method.
Another way that private lenders raise capital is through individual investors, family members and friends who are looking to diversify their portfolios. Similar to stocks and bonds, individuals can actually invest in commercial mortgages by owning either partial shares or the entire loan. This type of investment offers an opportunity to earn stable returns with relatively lower risk compared to other types of investment vehicles.
The process of investing in private mortgages can vary depending on the investor’s preferences, appetite and available opportunities. Generally, it is done through a mortgage fund, which is set up for the purpose of pooling investor capital and lending it out. The fund does all the work associated with the loan, including origination, underwriting of the property and borrower, conducting due diligence, closing and servicing. Additionally, if an issue arises, the fund will be able to lead any foreclosure process, which can be complex, arduous and require out-of-pocket costs.
A mortgage fund allows individuals to be passive while enjoying the benefits of mortgage investing. In exchange for leading the process, fund managers receive their compensation through upfront fees or an annual spread. If a broker is looking to secure a loan from a fund, they should make sure to do their homework on the company and its leadership team. Meet with them in person and ask them to provide examples of loans they’ve closed, the number of loans in their portfolio that have defaulted and how they’ve handled foreclosures in the past.
Mortgage broker tips
In a new market where debt financing is harder to originate, mortgage brokers can stay ahead of the curve by sourcing a private lender database, understanding their lending programs and knowing each lender’s due-diligence requirements. Having foresight on these items will allow mortgage brokers to match borrowers with the appropriate private lenders.
While there are many private lenders available, they each have their own criteria for property types they lend on, available terms, rates, leverage amounts and even borrower requirements. As a mortgage broker, it is imperative to understand each lender’s guidelines to present them with the right types of deals and borrowers.
Remember that the last thing private lenders want is an inbox full of deals that do not meet their lending guidelines. Understanding each lender’s criteria will streamline the origination process, allowing for faster lender quotes and smoother closings.
Real estate is a relationship business, so mortgage brokers need to develop personal relationships with lenders through educational phone calls, in-person meetings and — most importantly — the delivery of high-quality loan scenarios. Brokers should strive to go above and beyond to assist lenders during the due-diligence process. This includes presenting a complete deal story, providing all required documentation, and coaching borrowers on expectations and loan requirements. The brokers who are willing to put in the extra work to achieve direct relationships with lenders and perform during the closing process will ensure successful times ahead.
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To thrive in a changing economy, commercial mortgage brokers must be able to adapt to a new norm in which private lenders will be a top choice for borrowers in need of capital. It is worthwhile for brokers to get to know multiple private lenders and understand their programs, origination processes and management teams. Additionally, for brokers looking to diversify their own portfolios, consider an investment in a private lender with a proven track record, an experienced management team and strong underwriting