Key Trends Driving Investors Away From Traditional Lenders In 2019

POST WRITTEN BY

Evan Gentry Forbes Councils Member

Forbes Real Estate Council | COUNCIL POST

Real Estate

CEO and Founder of M360 Advisors. Gentry is an entrepreneur and innovator in bringing together technology, real estate, and investments.

When commercial real estate (CRE) property owners turn to nonbank lenders for financing, they often pay a premium interest rate on their loans, even when they own high-quality assets and have solid business plans in place. There are many reasons why creditworthy borrowers with strong track records and desirable assets turn to nonbank lenders, and collectively they create an attractive fixed-income investment opportunity.

Larger and savvy investors have taken advantage of this for years. Insurance companies, which are typically loss-averse investors seeking stable cash flows, provide about 15% of the capital in the nonbank CRE market annually, according to Mortgage Bankers Association's Q4 2018 report. Other investors in the space include high-quality institutions backed by real estate investment trusts (REITs) and family offices. Creditworthy borrowers are willing to pay a premium to nonbank lenders because the bank lending landscape has changed so dramatically since the 2008 financial crisis.

As founder and CEO of a direct lender with more than 20 years of experience in real estate, lending and investment industries, I’ve witnessed how the CRE loan space has evolved over the years. My experience underwriting and structuring CRE loans has enabled me to examine the value of tailoring a loan offer to a borrower in a way that increases the likelihood it will be repaid and the lender will recover its capital. From this vantage point, I see these broad trends driving borrowers toward nonbank lenders, creating high-yield credits that are senior in the capital structure and backed by strong assets and stable cash flows:

Regulatory Constraints

While banks haven’t been specifically regulated out of the CRE markets, they’ve recognized that one of the best ways to deal with enhanced regulatory scrutiny is to employ standards without deviation. For example, banks demand specific loan-to-value ratios, occupancy rates and average lease lengths. Projects that don’t conform in all respects are often rejected and sometimes not even evaluated by the bank’s underwriting team, despite the existence of significant compensating factors. We now see standards so stringent that landlords who took out bank loans 10 years ago are finding that despite strong performance, banks will not refinance their projects.

Timing Issues

One of the primary factors that often disqualifies assets from bank financing is the longevity and stability of tenants’ leases. If a large portion of tenants have fewer than 10 years on their leases, a bank may reject the application even though most CRE assets — especially larger buildings — typically have a mix of lease maturities across the tenant base. A landlord can negotiate extensions of leases to push them to 10 years, but tenants often see a landlord under pressure and use that to negotiate a better deal, which can diminish future cash flows.

A property owner may turn to a nonbank lender who can take more time to reconcile the potential issues of leases expiring through mitigating factors. Another timing issue that nonbank lenders can solve more easily is a change of title control, such as when one partner buys out another or a partner seeks to add equity to the project. These changes often require financing quickly, so a nonbank lender’s ability to close in half the time of a typical bank can be critical to getting the deal done.

Also, 1031 exchanges, where a partner defers recognition of capital gains while swapping one property for another, must be executed according to strict timetables. Because Internal Revenue Service deadlines are unforgiving, paying a higher interest rate to a nonbank lender that can close on time is often well worth it to achieve the tax savings.

Investors' Desire For Flexibility

Once made, bank loans are inflexible, which can be challenging in a market as fluid and opportunistic as CRE. Banks maintain strict prepayment penalty terms that can sometimes hold for five or more years. A nonbank lender can set more reasonable terms, including setting prepayment penalty terms for as little as six to 12 months, based on their assessment of each project or business.

Risk Level Compensation

The downside often associated with investing in CRE loans is the illiquidity of the investment, because loans are typically held to maturity and are paid off as borrowers refinance or sell the property. This can be mitigated by proper structuring of the loans and investment vehicles.

Because most bridge loans are one to three years in duration — compared to five- to 10-year bank loans — the length is more bearable to many investors. Additionally, institutional funds can structure their portfolios so that some loans mature every month or quarter, generating cash as they roll off that can be used for investor redemptions, as necessary.

When structured properly, investors can generate attractive returns on individual loans/assets while retaining favorable liquidity at the portfolio level. Investors in real estate debt ultimately have multiple ways to be repaid. These include monthly interest payments and payoffs for performing loans, and on occasion by foreclosing and selling the property of non-performing loans — typically collecting property cash-flows in the interim — which can often result in additional income beyond the loan balance.

Nonbank Loans Carry Their Own Risks

There are disadvantages to choosing a nonbank lender for a CRE loan. It’s probable that some family office and hedge fund lenders, for example, may not have sufficient commercial real estate expertise. They may not know the markets or sectors in which they’re underwriting loans and therefore may not be structuring the best loans for borrowers’ needs.

Likewise, there are advantages for investors doing business with regulated entities such as banks. Borrowers who make the cut often can get a better interest rate from a banking institution. Banks can also offer borrowers ancillary services that a nonbank lender cannot, such as checking accounts.

All told, it’s best to do your homework to find lenders with extensive experience who know how to underwrite and structure a loan. Look for those that can offer flexibility and move quickly without sacrificing underwriting quality and that can document financial stability.