What Does That Mean for Private Lenders and What is Going to be Affected?

As of this writing, Jerome Powell informed the world that the Federal Reserve was raising the federal fund rates 75 basis points (bps) or 0.75%, bringing the total charge to 1.75%.  The go-to primary inflation control valve of the Federal Reserve, the federal funds rate is the interest rate that banks lend to other banks overnight. The federal funds rate has been used as a measuring stick that flows through the rest of the economy.

Why Does This Matter? A (Very Short) Primer on Capital Markets

Most of the large aggregators in the private lending space obtain their capital through flows to Wall Street. Wall Street takes these lending products, securitizes them and puts them on the market. In short, the securitizers are selling these pools of loans, and buyers on the open market are purchasing these notes for return on investment.

When these notes are purchased, they are aggregated into a weighted average coupon, and that rate is the effective rate of return on that investment.  The driving force of any investment, therefore, is whatever the rate of interest or rate of return the product yields.

Depending on the securitization product, these rates can either be a fixed rate or variable rate. During times of uncertainty, variable rates are typically used. During good times, fixed rates are typically used. However, there is always that time in between certainty and uncertainty where you still have fixed rates, but the interest rates are rising fast. Which is exactly where we are at today.

If Rates Are Uncertain…What Do We Do?

Most lenders have switched to variable rate products as a direct result of not knowing where the end will be with interest rates.  Even on a temporary product like bridge loans, there are going to be very few fixed rates because of how rapidly the rates are adjusting even today.

Securitizers are not going anywhere; however, they are not immune from the rates increasing either. They also will see rapid fluctuations and their buying power and the products that they will buy and/or offer.

The best thing a private lender who wants to sell to aggregators can do is pay attention to how quickly the market is shifting and ensure that the products they originate will be something that can be sold tomorrow.

That means that some securitizers are not going to buy until (1) they understand where the market is going and how they fit within it, and (2) where they should price their product.  Since securitizers focus on different products, let’s break this down.

What Product Is Going to Be Purchased for the Rest of the Year? Eliminated? Repriced?

Buckle your seatbelts because it is going to be a bumpy ride. At the time of this writing, half of the securitizers have paused buying until the above two things happen. Further, there are going to be significant changes to how certain products are bought. Let’s discuss those each in turn.

DSCR

DSCR products were all the rage the last few years. For those of you not familiar with that product, DSCR stands for debt service coverage ratio, and was really used for people with portfolios of single family residences, or portfolios of multifamily residences, that could afford the debt service coverage of any product. For the last few years, these have been historically low, and priced just north of bank products. As a result, the delta between price and rate lent at have narrowed more and more.

As a result of the last few rate increases, the flow of DSCR products is trickling to a minimum, with the majority of DSCR loans being offered by a small group of lenders. This is because there is only so much rental income from buildings, and at least in California, with set rent control, inflation is outpacing rent control such that there is uncertainty about these products being paid.

Long story short, the opportunity for DSCR is narrowing to the point of extinction for most lenders.

Bridge

Bridge loans are not going anywhere. They are absolutely a necessity to the real estate market and as such, there will always be a market for them. However, what will not be natural to the bridge market is there will be a lot more adjustable-rate notes for a bridge. Typically bridge loans are fixed because they are of a temporary or very short nature. However, with the Federal Reserve raising rates as fast as they are, there is a lot of uncertainty in the market such that bridge loans will probably switch to an adjustable-rate product. How often rates will adjust remains to be seen, as some lenders may decide to adjust more frequently than others.

This will be true regardless of whether this is in the commercial or consumer bridge space.

Non-QM Consumer

Non-QM consumer loans are seeing ARMs come back in demand.  This space is likely the least changed by the rates as it is the most used to switching between ARM and fixed products.  Because they are consumer, most of these already had ways to deal with adjustable rates as well as ability to repay provisions. These will be the least affected by a product standpoint, but the most affected by the rate increase because these are the home buyers that are entering the market and buying up new properties.

New Construction

Out of all the categories, new construction is probably the most uncertain. Not only do you have increasing rates, but you have a confluence of both increasing prices in labor and certain materials (equipment, most goods) and decreasing prices in others (i.e. lumber), as well as an uncertain future and need of the building to be constructed.

This space will likely continue on in an adjustable-rate world, but you may see a lot of restrictions on future product until some of this become certain again.

So….What Do We Do?

In times like this, we have seen private lenders turn to an older way of doing things. High-net-worth investors need yield to offset inflation. This is the time where a lot of private lenders start their own funds and obtain investments from high-net-worth investors, family offices, and other places to have direct access to capital.

Further, we see clients fractionalize trust deeds, offer participation loans, and provide other unique raises of capital to fill the vacuum above. Unlike COVID, however, we see this as a temporary pause in the market and will likely pick up again, albeit in a reduced form with different emphasis in different products, when the securitizers have repriced and started to buy again.

If you are concerned about how these changes might affect your business, Geraci LLP is uniquely suited to assist lenders with loan documentation, business structures, litigation, and more. Contact us at https://geracilawfirm.com/ for more information.

By Anthony Geraci, Esq., and Melissa Martorella, Esq.