Working with community banks may help you grow deal flow and returns.

Since the banking crisis of 2007, the landscape for traditional lenders has changed dramatically. The most obvious, and ironic, change is that big banks have become much bigger. For example, JPMorgan Chase, with $2.7 trillion assets under management, is so huge that if it were a country, it would be the eighth largest economy on the planet.

It is not just bigger banks that have been undergoing significant change; smaller banks have too. Many have sounded the death drum as global banks and fintech have taken up much of the ink. Although smaller lenders certainly face adaptation challenges, more than 5,000 community banks are still in operation today, representing 95% of all bank charters. Following the shakeout after 2008, where we saw small lenders with under $100 million assets being acquired or shuttered, the community banks that remain are generally thriving, some with assets of up to $100 billion.

These local and regional players are increasing market share in smaller commercial real estate (CRE) deals that no longer interest the “too big to fail” global banks. For private lenders, community banks can play an important role in helping grow your CRE business too. There is no time like the present to update your contacts and attend more networking events to get to know them better.

Here are four reasons why it’s important to build a solid working relationship with community banks in your market.

1. Community banks can be a terrific source of deal flow for private lenders
   Since the Dodd-Frank legislation and Basel II requirements came into force, like all publicly-
   chartered banks, community lenders are highly regulated. As a result, underwriters are cautious with new loans; they are now required to hold more capital against them than in the past. Underwriting is tough for smaller commercial real estate projects, where loan-to-value ratios require applicants to bring more equity than ever to get a deal done. Community banks will close CRE deals with well-known operators who have strong balance sheets, the “A-quality” applicants, but a lot of “B-quality” deals simply cannot get done at a bank.It is not as if the loan officer at a community bank takes pleasure in turning down an applicant. Community bankers usually have strong roots in the community and want to see worthy “B” projects get done. This is when the private lender comes in. A private lender that has a strong relationship with the loan officer of a community bank is going to get referrals, in many cases as often as once a month, of applicants who don’t pass muster with the bank.
2. Community banks can be your exit
   The toughest time to get a CRE deal underwritten by a bank is before ground has broken, or before a remodel project is underway. The risks are much higher at these beginning stages because labor is scarcer and more expensive today, and project delays will quickly eat into a developer’s cash flow and ability to service a loan. This is the case whether an applicant wants to develop a mixed-use project, construct multifamily housing or flip houses. Naturally, this is the sweet spot for private lending.A private lender does not need to stay in the deal until the project is finished and sold. For example, once construction is substantially complete, encourage your borrower to refinance with a community bank to significantly lower their interest burden, and then introduce them to your contact.

   Why do that if you’re earning a good rate of return? First, because it’s better for your borrower, so you’ll build loyalty and repeat business. Second, because it keeps you top of mind with the loan officer at the bank, encouraging more quid pro quo referrals back to you. And third, because you can redeploy your capital into a new project.

3. You’ll gain deeper insights into default characteristics for your market
   As a hard money lender, your collateral is the sell-off value of the real asset for each project. But how do you keep track of the prevailing market value for such land or structures? Are you 100% confident you can always sell off a foreclosed asset and recoup your principal in the case of a default? Here you can learn from traditional lenders who have adopted best practices with collateral management, because regulatory compliance has forced that discipline. A study by McKinsey consulting shows that under the new regulations from 2010 to 2015 bank impairment costs—lender losses from bad debts—dropped by more than 60%.Today mortgage default rates are at their lowest point in 11 years, due to tighter underwriting criteria combined with low interest and unemployment rates. But, when interest rates inevitably rise and/or the economy downshifts, default rates may start creeping up again. And, if particular classes of CRE fall out of favor, having a good relationship with a community lender will provide you additional insight into your local market.

   Banks have access to more tools than most private lenders, like syndicated third-party research, bulletins from the Federal Deposit Insurance Corp. and OCC, and large risk-management staff, so they’re a great source of market information. Even community banks are being forced to adopt new accounting standards where they must amortize expected loan losses at the point of origination, so you can count on them being very knowledgeable about measuring the risks in your market.

   Understanding your community bank’s perspective gives you valuable insight into whether a certain borrower or type of project represents a great opportunity to make margin or a big default risk.

Community banks can be a source of capital for some private lenders
Hard money loans are typically funded by individual accredited investors or by funds that aggregate capital from multiple limited partners. Of course, such investors are incredibly important, but hard money lenders can increase their return on equity by also adding a layer of bank debt capital to the mix. Depending on the size and history of your operation, bank debt can be in the form of a warehouse loan or a commercial line of credit. The interest rates on these are very low, but you’ll need an excellent credit score and stable history of revenues and completed exits to obtain them.

Additionally, you can structure deals where a community bank participates in one portion of a deal while you underwrite another. For example, you extend a hard money loan for land acquisition while the bank provides the borrower a line of credit for construction. In structures like this, you’ll probably have to agree to a standstill clause allowing the bank to recoup its collateral first in the event of a default. However, where you can get those deals done, it’s a great way to reduce your risks while increasing the size of deals.

It’s natural to think of community banks as your competition for borrowers. But remember, the economy is very, very large. There’s room for lenders of all stripes to work together for common objectives. While big banks are getting bigger, and fintech firms are getting more pervasive and nimbler, working with community banks may be just the ticket to help grow private lenders’ deal flow and returns.