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Currently there are hundreds of non-bank real estate lenders, many formed just in the last few years. In an effort to gain market share, some have relaxed their lending criteria and, in certain niches, high leverage is widely available. Just as the financial crisis wiped out a large number of non-bank lenders, the next downturn will lay many such lenders low, reducing the number of players greatly. For a preview of who is most likely to succumb look for lenders offering high leverage to less experienced borrowers. Call it “optimists lending to optimists.” Often these originators are backed by large credit funds looking to aggregate loans. If such credit funds can’t get a flow of loans from the best lenders, they have shown that they are willing to move down a notch and work with originators who have less diligent underwriting.
Banks’ only advantage in real estate lending is the rate they can offer. However, the cost of this attractive interest rate comes from the huge extra costs required to deal with a bank. Many real estate investors and developers prefer to have fewer people devoted to dealing with their lenders, even if it means paying a somewhat higher rate. There is no rule stating that banks and other depository institutions need to be the most active real estate lenders. There is plenty of investor capital available to fund non-bank loans, even without deposits at banks, savings and loans, thrifts or credit unions.
The global bond market is estimated at $100 trillion. The U.S. bond market is about $38 trillion, according to the Bank for International Settlements. Many investors understand the risks of holding bonds today, especially in a rising interest rate environment. Investing into loans backed by real estate that investors can touch and see—especially for short maturities during which the risk of a dramatic market drop is lower—is attractive by comparison. If even a small fraction of this bond market capital makes its way into the non-bank real estate lending sector, that can lead to dramatic growth of the sector.
Many lending niches have seen a trend toward securitization as volumes increase. Examples include sub-prime auto loans, consumer loans such as those originated by online credit marketplaces and longer-maturity commercial real estate loans which end up in CMBS instruments. For short-term real estate loans, and especially smaller balance loans, the costs of securitization may outweigh the benefits. Securitization offers the benefit of more uniform underwriting. However, a credit rating can be obtained without creating a bond or paying an underwriter, both of which reduce yield to the investor. Increasingly, allocators of capital such as insurance companies, pension funds and endowments, as well as the pooled savings of individual investors, will partner directly with the highest quality originators of such loans, to create income-producing investments with a margin of safety, without the added cost of creating and distributing bonds.
We have already seen this trend emerging as Mesa West was acquired by Morgan Stanley and on the smaller balance end of the spectrum, Genesis Capital was acquired by Goldman Sachs. Banks don’t have the right culture to nurture a non-bank lending business that moves very quickly and lends to real estate entrepreneurs and investors, many of whom lack secondary or tertiary sources of repayment. However, banks do have a low cost of capital and a desire to participate in this growing industry, so they are natural buyers of non-bank lenders that achieve scale.
One thing that makes non-bank lenders valuable to borrowers is their ability to cut through red tape and make decisions with less than full information—sometimes with a lot less. Borrowers treasure being able to talk to a decision maker who can quickly discuss a loan with other members of investment committee to provide a fairly reliable “yes” or “no” answer early on in the process. For large bridge loans, this can work as the dollars of interest income justify the responsiveness of senior people. However, for smaller loans, a local decision maker is required. Once lenders have been acquired by a larger, regulated institution, it is unclear whether they can come up with a system to be highly responsive like an entrepreneurial lender, while also checking all the boxes required by headquarters.
Many non-bank lenders who focus on larger loans have made due with just a handful of offices—or sometimes just one or two—located in the major coastal cities. They lend nationally, but only on larger loans, where they can afford to fly in a team to understand each loan request. For smaller balance loans—those below $10 million and especially those smaller than $5 million—the best lenders will choose to hire fairly senior people in each market where they lend, to meet with borrowers, see their projects and also to work out loans that become non-performing.
Interest rates in Japan and Korea are even lower than in the U.S., in part because these societies are not increasing their populations and the economy is growing more slowly as a result. If a given return on invested capital of, say, 5.0 percent may be attractive to U.S.-based investors, it is even more attractive to investors from mature economies such as these. U.S. non-bank loans secured by real estate may offer a very appealing option for such investors, given the perceived stable nature of the U.S. economy and rule of law, whereas other faster-growing economies such as China and Russia have more uncertainty and single-party (or single-person) control.
While retail locations may add cost to a lender’s business model, they also add visibility with the business community and general population. Just as banks have branches and even investment companies such as Charles Schwab and Fidelity have added street-level walk-in locations, the top non-bank lenders may have retail branches in the cities where they are most active. These branches could even play a dual role, serving investors who participate in non-bank lending funds.
Banks and their lobbyists are increasingly complaining about what they perceive as the “unlevel playing field” between banks and non-bank lenders who face much lighter regulation. The difference in regulation has a strong justification in that banks have access to deposits that are insured by the FDIC, which is ultimately backed by taxpayers. However, it is likely that as the non-bank lending industry grows, banks will have some success in placing more of a regulatory burden on non-bank lenders, if only because their lobbying resources are so substantial, and because memories of the financial crisis will eventually fade, which may allow banks to get some relief from their own regulators.
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