July 9, 2018
At one time, if a multifamily investor needed financing for a project, he or she would have turned to a commercial bank. If all went according to plan, that investor would have walked out with a construction or investment loan.
Today, that multifamily investor might take the same steps, and end up with an approval for a lower amount, or even potentially have the loan declined. Rather than putting the construction or investment project on hold, which might have happened in the past, that investor might turn to a private lender for financial assistance.
Private lending is sometimes known as “shadow banking” or “alternative lending.” In many cases, this type of financing can be helpful for multifamily buyers and builders that otherwise might not qualify for a traditional loan. The concept is becoming more mainstream, but borrowers need to do their homework and understand the issues before going the private financing route.
What It Is
Before delving into the caveat emptor of private lending, it’s important to understand what, exactly, it is. Private lenders are non-institutional entities that issue debt, which is secured by the properties through notes and deeds of trust. Meanwhile, “institutional” lenders are banks, insurance companies or pension funds.
Private lending isn’t new, though it has become popular over the past decade. Partly because of the 2007-2009 recession, commercial banks, insurance companies and other traditional lenders have become more conservative with underwriting standards. In addition, banks, especially, are subject to capital requirements under the Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), and High Volatility Commercial Real Estate Regulations (Basel III).
Fewer loans from traditional sources created a financing vacuum, in which private lenders found opportunity. In 2011, the top three banks provided nearly 50% of all new loans, according to market share data from Mortgage Daily. By 2016, this figure dropped to about 21%. Additionally, six of the top 10 lenders in 2016 were nonbanks.
The Issues with Private Lending
On the surface, private lending products can be an ideal alternative for investors rejected by banks or insurance companies. Such loans are geared toward riskier projects, and can be more flexible, with faster approval processes and less stringent parameters. A traditional lender might examine a loan applicant’s credit score and past multifamily projects. Meanwhile, the private lender might be more interested in the property’s pro formas, rather than the sponsor’s credit scores.
But the borrower needs to be wary of the following issues.
Higher interest rates. Because the private lender assumes more risk, the cost of capital can be higher, and not by just a few basis points. Some private lender loans can be double the more traditional mortgage rates, sometimes ranging from 12%-20% higher.
Shorter terms. Private-lender loans aren’t geared for long-term investments. The typical payback period is months, rather than years. Furthermore, short-term loans could lead to refinancing more short-term loans, meaning an endless cycle of loans.
Uncertain regulation adherences. Private lenders, as financiers, are subject to Dodd-Frank restrictions, as well as other rules and regulations. Still, in some cases, private lenders might not be held to the stringent licensing requirements that loan originators, mortgage brokers or mortgage lenders are. Alternative lenders also might not be exempt from routine regulation, such as banking exams.
That said, the private lending sector, as a whole, can be a viable option for financing. Reputable lenders, in fact, are applying for state licenses and promoting bank loans. On the flip side of the coin, banks are turning to private lenders to help clients that otherwise don’t qualify for a traditional financing product. By combining non-traditional debt with a traditional bank loan, risk is spread between two parties, and the sponsor ends up with more affordable financing.
“Obtaining financing continues to be a complicated and dynamic process. Credit parameters change in response to markets, and owners or acquirers would do well to stay current on the evolving nature of financing,” said Daniel Cunningham, senior vice president of East Coast agency originations at PNC.
He noted that multifamily investors should understand the project and necessary resources before considering a financing strategy. If a multifamily project (and sponsor) requires longer-term debt and can pass underwriting requirements, a traditional lender should be the first stop for financing.
“When working with a bank, the sponsor ends up with more than a loan. The borrower builds a relationship,” Cunningham said. “That relationship can mean additional financing for future investments, along with products and services private investors might not have.”