The industry is focused on strengthening itself rather than rebuilding.

On March 19, 2020, California announced the nation’s first statewide shelter-in-place order. Within weeks, 44 more states followed suit. The national economy was effectively shut down. In the private lending industry, where we think of ourselves as insulated from Wall Street’s whims, we were quickly reminded how much we’re still tied into the capital markets.

Funded largely by bank lending lines, REITs quickly came under margin call pressure as the value of their assets fell as a result of needing to sell both quickly and during a time of limited liquidity. Uncertainty around the true value of a real estate loan rippled out to the private lending world, so our industry was effectively shut down as well.

For a few weeks, conversations among lenders, capital partners and private lending insiders were not about when the industry would return to normal but rather if it ever would. Wall Street asset managers expressed similar uncertainty, questioning whether the price of homes had plunged 20% overnight.

Fast forward to today: Private lending is coming back already, the value of real estate stayed firm and the industry is focused on strengthening itself more than rebuilding. It’s time to look forward.

Getting Serious About Stability
An overarching theme around the industry is stabilization. For some of the world’s largest institutional investors, that means they have been focused on moving their credit lines to non mark-to-market (MTM) structures. Note that MTM is a method of measuring fair value of the assets on a credit line and may require the line’s borrower to provide additional collateral (i.e., meet a margin call) if the value of the assets on the line is marked down. Non-MTM lines are more expensive, but they’re more stable.

For lenders, and even some aggregators, stability has meant raising new funds that they themselves control. Internal funds will seldom provide the same level of liquidity or profitability as tying into the capital markets, but they can serve as welcome ballasts during times of uncertainty and a demonstration of reliability to partners. For many, that feels a bit like going back to “old school” hard money lending practices and filling the vacuum left by institutional investors with more expensive capital from family offices and high net worth individuals.

The capital markets can be fickle. As Noah Martin, the CEO of Direct Access Capital, said: “Capital markets are a pendulum. For RTLs, institutional capital overreached in a race for market share. Shocks to the credit markets have caused capital to retreat from RTLs as fear and losses have pushed the pendulum to the opposite extreme. The industry needed a correction, and a little creative destruction will help price discovery of the equilibrium that appropriately reflects the risk/return model of the asset class.”

Pendulum Swings
With that in mind, here are a few places we see the pendulum swinging as we get back to work:

• Institutional Investors // Wall Street’s top institutional investors are getting ready to reenter the private lending market. Although rates certainly matter, their primary focus is on credit.
• Valuation // Valuations have generally held up, but volume is down significantly, so there is still some uncertainty. Even with experienced borrowers, skin in the game is key and that requires (1) more conservative LTVs and (2) a strong allergic reaction to placing the value of a property above its recent market-clearing purchase price. Beyond valuation, the key area of focus is liquidity, both for markets and for borrowers.
• Liquidity (Market) // Private lending has done well when financing the typical “down the fairway” home rather than the McMansions. A huge force driving that success is liquidity. Liquidity means we’ve got certainty of a sale and that we have data to back up the borrower’s ability to deliver on ARV. When valuation is less certain, investing into markets that move homes and backing typical rehabs and properties is paramount.
• Liquidity (Borrowers) // For borrowers, lenders (and investors) need to see greater interest reserves and ability to meet the capital needs of any project. The likely outcome here is experienced borrowers doing fewer projects, as they’re required to put more capital into each. With less competition for them in the market, they will hopefully make that up with improved returns.
• New Construction // Unfortunately, new construction may be the one area that takes a much longer time to come back to pre-COVID-19 activity. To Noah Martin’s point, investors do not see an attractive risk/return trade-off yet, so new construction may significantly lag light and even heavy rehab in 2020.
• Alignment // We’re seeing a cultural shift back to alignment of interests. A focus on volume replaced credit in many firms. In the lending world, the easiest way to grow has always been to drop underwriting standards, but it’s also the fastest way to destroy value and lose trust with investors. Bringing credit back to the forefront, often through financial alignment, will be key.
• Secondary Trades // The industry was flooded over the last few months with bargain hunters looking to buy stranded loan tapes for 70 cents on the dollar. For the most part, these groups left empty-handed, and we’re now seeing tapes trade at par or just below.

Looking forward, the private lending industry’s future is as promising as ever. Banks have almost always behaved more conservatively coming out of economic shocks. At the same time, COVID did nothing to help the nation’s shortage in new home builds or its glut of aging housing stock that requires rehab, so there will be plenty of borrowers in the market. Couple that with perhaps a reversal in the migration from suburbs to cities, and the private lending industry will be more important than ever. It’s time to get to work.