More consolidation is coming—which coalition of federated solutions is going to lead the way?

Is private lending following in the footsteps of the owner-occupied lending market and becoming a commodity? Is the pace accelerating in the market?

By late 2019, we witnessed the perfect combination of four key factors that drove the private lending lineup, creating the perfect commodity:

• Large demand in the market for private funding, driven by an increase in demand and shortage of housing units, whether for purchase or rental, multiunit or mixed-use urban trend demands
• Abundance of liquidity in the market, driven by a booming economy and the substantial entry of institutional funds into the private lending space
• The flock of brokers struggling to compete in the owner-occupied space, generating a flux of applications and, more importantly, creating what amounts to an abundance of well-trained sales professionals hungry for new opportunities
• The prevalence of technology in the industry, presenting solutions that are rapidly adapting to new market needs

Those market forces are so dominant they are repeating themselves for slightly different reasons at the end of 2020 as we wobble toward a rebound.

Although the market product offering contracted slightly during the early stages of COVID, several lenders (let’s use that term loosely for now) offered lower rates, competitive underwriting terms, and quick closes. In essence, those lenders introduced what appear to be higher risk products to the market, driving others to retreat, find alternative products, or exit the market altogether. One lender, for example, is offering a quick online application, no appraisal, a low rate, and high LTV/ARV minimal due diligence.

Driving Market Forces

What are the forces driving the private lending market? There are several.

The first is, of course, capital. Thankfully for the private lending industry, the capital supply is in abundance from two primary sources: institutional capital and money from private individuals. Both are looking for a return on their investment and see real estate-backed private loans as a potential safe haven for their money.

The second force driving the market has been the increasingly commoditized nature of owner-occupied loans. Lenders making these loans have seen their products become a commodity due to:

• Technology that allows lenders to work directly with borrowers rather than going through brokers.
• Quality Mortgage (QM) APOR rate limits.
• Ever-increasing costs to lenders to stay compliant with consumer mortgage regulations.
• Industry consolidation, primarily due to the above points.

The third force driving the market is the entry of smaller lenders and brokers into the private lending market. Many of these lenders arrived at private lending after being driven out of the owner-occupied (consumer) mortgage market because they were unable to keep up with the advancements made by larger lenders and the commoditization of the consumer mortgage industry. The private lending industry faces fewer of the above issues and is not nearly as advanced technologically or as saturated.

The fourth force driving the private lending industry, much like one of the drivers of the owner-occupied loan industry above, is technology. Although adaptation of technology is still lagging behind the traditional consumer lending market, private lenders are making clear advancements and are beginning to leave slow adapters behind (much as the conventional loan market has done).

As industry advancements continue to be made, the private lending industry will expand much as conventional lending did, even as it consolidates under the umbrella of some of the larger lenders in the space.

The Transformation Begins

The flux of new “lenders” became a target for the intermediate lenders (in some circles called “aggregators”). The aggregators had two problems to solve: (1) fulfill their obligations to the institutional money they borrowed to lend (or, in some cases, placed in their custody to lend and generate revenue) and (2) solve their inability to be a lender that could generate the necessary volume. The result? The aggregators started seeking smaller local lenders and, very shortly after, brokers who needed money to table fund their loans.

Although they publicly deny it, the aggregators clearly drove rates down, lowered underwriting quality, and drove higher-risk loans. The aggregators started eroding and squeezing traditional local and regional private funds and lenders. Those lenders have higher yield requirements than the institutional money flowing through the aggregators. One notable exception proved to be crucial: The regional and local private lenders who have their own money to lend continued to lend though the middle of 2020. Just as during the Great Recession, those lenders appear to be the saving grace for traditional private lending. They continued to lend and ultimately drove the market back to its feet.

An Historical Parallel Path

For a long time, owner-occupied lending was a niche. It was spread across 7,400 lending institutions, until the prevalence of technology, ever-declining interest rates, and shrinking margins finally caught up. Then we saw consolidations and the mass exit of the broker. The remaining players had to adopt technology solutions for efficiency and survival.

Even some smaller lenders looking for survival turned to “non-QM” loans—higher interest loans that are considered uninsurable and high risk. But, given the competitive nature of the market and insatiable appetite of Wall Street, that market started flourishing even as securitization of those loans were sold to institutional investors.

House of Cards Is Falling

However, as the pandemic spread and took its toll on the economy, similar to the Great Recession, the first in the market to be impacted were non-QM lenders. This happened nearly at the same time that lenders who used institutional money sources saw their capital flow and, therefore, their ability to extend loans come to a sudden halt. None of the aggregators or the institutional lenders proved to be reliable.

As the quick money from institutional channels dried and the aggregators froze, the brokers found themselves with no one to turn to, so the traditional regional and local private funds lending thrived. In fact, there is evidence those lenders increased their margins and rates, enjoying a 1.2% rate increase and an additional average 1.5 origination points.

The return of institutional money to the aggregators in a limited capacity, starting with modified longer-term rental products, is ushering the return to the inevitable. Volume demand, the return of institutional funds, the abundance of brokers/sales force, and technology is culminating to once again create a volume of products and lenders competing for market share, turning private lending into a commodity.

The Impact of Technology (or Lack of)

Technology is attempting to provide the means for direct-to-borrower private lending. It threatens to cut the middleman, namely the brokers, correspondent lenders, and aggregators. If successful, it will certainly accelerate the commoditization of private lending.

That doesn’t mean that technology, especially fintech, can’t be a solution. But, the sheer volume of lending demand and supply of money cries for a technology solution that powers sound lending practices.

If you analyze the tools that made the home lending side thrive, you can easily see the next wave of innovation that will propel lenders to take a leading role in the industry. The growth, survival and consolidation is coming. The question is who is (or which coalition of federated solutions) is going to lead the way.