In the past decade, the private lending industry — once a financial Wild West of nonstandard lenders, products and terms — has evolved into a more stable market. This change is due in large part to a number of major players creating better underwriting standards, providing efficient access to funding in the capital markets and offering overall support for the institutionalization of the sector.
Despite this increasing normalcy, noninstitutional funding — which ranges from individuals to large hedge funds — remains and will always have a place in private lending. It’s imperative that commercial mortgage originators understand the ebbs and flows of the capital markets as well as the growing impact that institutional lending has on the entire industry, even if their own capital sources are noninstitutional. If brokers don’t pay attention to what’s happening in the capital markets, they are missing information that is crucial to their business.
Institutional investors (which include banks, credit unions, insurance companies, mutual funds and other players) control a significant amount of all financial assets in the U.S. and exert considerable influence in all markets. According to the Securities and Exchange Commission, institutional investors own about 80% of equity market capitalization, while a report by Boston Consulting Group indicated that institutional investments reached $61 trillion (or 59% of the global market) at the end of 2020. Institutional capital can often effect changes in a space that otherwise wouldn’t be possible and enable transformative changes that only come when capital can be consistently delivered at scale.
Given the breadth of players in the private lending and real estate investment spaces, it’s true that not all money comes from institutional sources. Instead, it may come from smaller pools of cash, such as friends, family members or local lenders. But as with other industries, chances are good that the capital behind a deal can trace its roots to an endowment fund, commercial bank, mutual fund, hedge fund, pension fund or insurance company that has its own obligations and stakeholders.
Institutional control
The truth is, institutional capital drives the cost of lending for everyone, regardless of whether they use the institutional method of funding or not. The interest rate, leverage and basic underwriting requirements for a given industry are driven by institutional demand, and increased supply can drive rates down. The private lending industry is no different.
In the mid-2010s, lenders typically made traditional 30-year loans to homeowners at rates of 3% to 4%, while investors in need of short-term bridge loans to expand or rehabilitate the same home would be charged 10% to 12% — if they could secure funding at all. Despite significant borrower demand and need, banks would not provide this funding due to adverse regulatory treatment and perceived credit risk. Borrowers had to turn to a patchwork of local lenders that offered nonstandard loans with typically unfavorable terms.
The truth is, institutional capital drives the cost of lending for everyone, regardless of whether they use the institutional method of funding or not.
In the past several years, due to the infusion of predictable institutional capital, loan coupons have decreased the cost of bridge loans. According to a Toorak Capital Partners report on more than 17,000 bridge loans, the average interest rate has fallen from 12% in 2016 to 8.5% in 2022.
Loan structures have become more borrower friendly, loan-to-value ratios have rightsized to market levels and there has been an increase in the number of larger lenders. One thing that is clear from the falling prices of bridge loans is that these changes have made the market highly competitive. Borrowers now have many more options to choose from and private lenders have become increasingly reliant on efficient institutional capital.
Plugged in
If loan originators aren’t plugged into the capital markets and well informed about these requirements, they won’t have the same type of knowledge of market rates that are available to competitors. It’s likely that they will feel pressure to adjust their own terms to remain competitive with the rates that are being impacted by institutional capital. Brokers who resist such changes have likely seen a decline in business as their clients are seeking capital elsewhere at more competitive rates.
The influx of institutional capital also has led to consolidation and corporate shifts in the private lending market. In February 2021, for example, Pacific Western Bank purchased Civic Financial Services. A month later, Patch of Land rebranded to Patch Lending. Over the past two years, Redwood Trust has announced a strategic investment in Churchill Finance and the acquisition of Riverbend Funding.
Historically, the business-purpose residential real estate lending industry operated outside of the traditional financial system. Many banks wouldn’t lend money on single-family homes or multifamily properties that had a construction element, due to adverse regulatory treatment. The government-sponsored enterprises Fannie Mae and Freddie Mac tend not to fund this type of asset class either, so there’s historically been a funding hole that has been filled by local private lenders that frequently raised money from friends, family or other noninstitutional sources.
Prior to institutional capital playing a bigger role in private lending, the market was highly fragmented and lenders basically could dictate terms to a borrower. This frequently entailed high interest rates and unfavorable terms, with many unscrupulous lenders looking to “loan to own” and hoping to foreclose at the first opportunity so they could acquire the property being used as collateral.
In the past, many borrowers seeking these loans had poor credit and limited access to competitive financing options, so noninstitutional lenders (often known as hard money lenders) were often a lender of last resort. The influx of institutional capital into the private lending space has helped to standardize the space, lower rates and create better terms for borrowers. It also has dispelled some of the negative connotations that previously existed due to associations with the hard money label and unscrupulous lenders in general.
Changing language
As the industry continues to evolve and associations with hard money fade, commercial mortgage brokers may feel increased pressure to change the language they use to describe their products. This may be the case even if they don’t directly utilize institutional capital.
Leading lenders in this space don’t use the term “hard money” to describe themselves to their investors or Wall Street. This is because institutional capital doesn’t want to be described in a way that is historically associated with pawn shops and payday lending companies. Today, this term is often downplayed, if used at all, in the descriptions written by major private lenders to describe their companies and products in corporate communications.
RCN Capital, for instance, refers to itself as a nationwide, private direct lender. On its website, the company writes that its loans are “often called hard money loans, can be used for the purchase or refinance of non-owner-occupied residential and commercial properties, financing of renovation projects and bridge funding.” Lima One Capital, meanwhile, avoids the hard money moniker altogether and describes itself as “one of the nation’s premier private lenders for real estate investors.” These are only two of the many examples available.
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While noninstitutional capital remains, originators need to understand that the wide array of funding available from institutional sources means that they can no longer use strategies from the past. Instead, they must meet or beat market rates or terms.
Wall Street’s avoidance of hard money and associated negative connotations also means that industry players need to change how they describe themselves and their products. Due to effects from the capital markets, it is no longer business as usual for mortgage brokers or the industry as a whole. Since they still compete for borrowers even if they don’t use institutional capital, they ignore the effects of institutional capital at their own peril. ●
