Robert Withers | February 2018
Most of us remember the Great Recession of 2007-2012 and, more specifically, the crippling financial crisis of 2007-2008. One of the largest—if not the largest—contributors to this event was the U.S. subprime mortgage crisis.
During this time, we experienced “a perfect storm” of falling real estate values, tightening mortgage lending practices, and the evaporation of both market liquidity and consumer confidence in our real estate and financial markets.
At the very heart of the mortgage crisis was the reality that this industry—along with Wall Street itself—had become extremely careless due to their voracious appetite for mortgage lending volume and sector-centric, higher-yield investments. The demand for “alternative lending products” had become massive, and delivering this volume and high-yield paper was produced by entertaining and ultimately funding mortgage loans with collateral, credit or income levels not acceptable to the traditional purchasers of both residential and commercial real estate loans. The “underwriting” standards of these loans deteriorated as the demand for volume increased due to the demand for higher yield investments, exacerbating the problem.
We all know what happened next: everything came crashing down. The administration at that time responded with several compliance and regulatory changes, including the Dodd Frank Act, HERA, etc. Then the Commercial Real Estate industry made a groundbreaking, positive discovery: There was a market craving alternative finance products. And within that, there was a market to not only keep them for investment-grade assets, but also for sale into secondary markets. Although these loan types/products had been available for some time prior to the crisis, this corner of the industry began to expand outside the traditional lending sources to embrace new, creative methods/practices as the residential mortgage industry seemed to be over-compliant and onerously regulated.
So, let’s say you are a small- or medium-sized investor/developer focused on investing in, for example, a residential subdivision, multifamily, mixed use, retail shopping center, or small industrial investment class real estate. Currently, if you build any of these types of properties, you’ll find it difficult to secure construction financing. If you are purchasing or refinancing an existing property and have less than a perfect credit package, or if the property isn’t “stabilized,” conventional lenders will balk at providing the necessary monies.
Fortunately, Alternative Lending options are now available. Let’s discuss four of these types of CREF lending practices: Checkbook Lending: Me, you and the guy next door; Mortgage Pools: Making the PM business a business; Private Equity Real Estate Lending and Crowd Funding.
Check Book Lending
• Has been around for many years.
• Historically used for facilitating sales of CRE during times when financing was difficult to obtain.
• Used as a method of financing to facilitate purchase money loans between buyer and seller.
• Rates are typically priced 6%-8% over prime.
Your neighbor next door or at your club or church could be a private lender. Anyone with investable cash or held in a self-directed IRA with the right guidance and counsel can become a private lender. And, with long-term savings rates as stunted as they are now, more and more individuals are becoming private lenders.
CRE Mortgage Pools
• Managed pools of money invested in commercial real estate loans.
• Investors can be individuals, self-directed IRA investments and smaller investment real estate companies.
• Requires participants to be “qualified investors” meeting minimum income and net worth requirements.
• Rates are typically priced 4%-6% over prime
Private Equity Real Estate Lending
• Involves acquisition, financing and ownership of individual or portfolios of properties.
• Financing activities can be a mortgage pool model, but are used in mainly larger deals by more sophisticated investors (pension funds, mutual funds, etc.).
• Rates can vary depending on quality and strength of credit and collateral.
• Relatively new funding model, unregulated and fragmented.
• Online pooling of small amounts of capital from investors to fund mortgages or projects some secured by real estate.
• Popular for short-term bridge financing; fix and flip loans.
Basically, alternative lending sources in the CRE markets are here to stay—and for several very good reasons. First, they afford financial solutions to small, medium and large real estate investors/developers to finance projects, from a fix and flip to building a large mixed-use or multifamily project. Real estate developers are always seeking capital, and alternative-lending markets will find creative ways to supply this capital.
Alternative Lending markets focus on the underlying asset of real estate and the conservative valuation of this asset—and rightly so, as conventional banks are hamstrung by compliance and regulatory constrictions. Alternative Lending emphasizes the “make-sense “aspects of a transaction.
Makes sense, right?