Many factors are driving the trend, but private lenders must also understand the risks.

Before we get into the latest loan craze in private lending—long-term rentals (LTRs)—let’s review how we got here. For years the focus in lending was around single-family fix-and-flip loans. The focus on this product hasn’t been a few years in the making; it’s straddled decades. The fix-and-flip concept has matured so rapidly it has become a part of pop culture. With dozens of television shows ranging from competitive flipping to finding the perfect home for newlyweds, it is safe to say that America knows about house flipping.

Behind the television shows, private lenders can tell you what’s really happening. Lending, of course! Most single-family residential flipping is being done with private money. It’s how many private lenders got their start. It’s also how so many conventional loan brokers were able to make a quick transition into the space after the Great Recession of 2008.

In the Beginning

How these loans are funded has changed over time. Perhaps “in the beginning” is too strong of a phrase, but if you met with private lenders for a loan shortly after 2008, it sure felt like the beginning. Many lenders were doing syndications and acting as go-between brokers. It would take time for lenders to grow to a level where they could quickly and easily fund loans on their own. Getting there required substantial capital and, generally, the direct or indirect control of that capital. Naturally, this led to the rise of more efficient small balance sheet real estate funds. With the advent of loan buyers in the space around 2015, lending became supercharged. The same capital could not be used to fund loans monthly as opposed to yearly.

But the hunger for more lending always creates more supply. Yield demand remained strong, and fix-and-flip loans were increasingly difficult to find and fund at higher rates. Enter new construction loans. It was the same asset class—single-family residential—but now the demand for housing coupled with the lack of traditional construction lending created a new subcategory for private lenders in new construction. That construction has been largely focused on infill development of new homes.

The private lending industry has been slow to evolve in a single direction since the spread of residential new construction lending. There has been significant interest in projects in which the end borrower is building multiple homes at once, in either small communities or with condos or townhomes. And, as the affordability crisis for homeowners spreads from city to city, there’s been interest in tiny homes. Naturally, there is always some interest in moving into commercial real estate development. But there is little industry alignment when it comes to what’s next. Until now.

What’s Next?

For the longest time we have seen borrowers complete renovations on single-family homes only to bemoan selling the asset. Clearly there are situations when the economics demonstrate the prudent path would be to keep the property and turn it into rental property. But, several barriers conspire to keep borrowers from that scenario: trapped equity borrowers need to fund their next deals, high interest rates from their fix-and flip-loan that prevent cash flow, and, finally, a lack or limited amount of traditional bank lending. Once again, until now.

The golden age of long-term rentals in the private lending industry is upon us. Macroeconomics in the U.S. are creating more favorable conditions for landlords to expand their portfolios. Savvy investors are learning how to generate cash flow, create long-term appreciation, and often tax incentives.

This new subcategory of the single-family residential loan is spreading like wildfire through the private lending industry. There has always been a demand, but only recently—with the advent of loan buyers and a lower cost of capital—has there been a possibility for the supply to manifest.

What’s Driving the Trend?

To understand whether this product has staying power, it’s important to dissect what’s behind the demand for long-term residential real estate investment loans. There is another asset class that Wall Street investors are incredibly familiar with that looks a lot like the “landlord loans” you see private lenders pushing into the markets: mortgage-backed securities (MBS). If that doesn’t ring any bells, how about collateralized debt obligations (CDOs)?

Yes, we are talking about the debt-investment instruments in the subprime mortgage business that contributed largely to the collapse of the global marketplace in 2008.

If you didn’t read that last sentence twice, or at least lean forward in your chair, then you weren’t working in the financial sector in 2008. The similarities between traditional 30-year MBS and the new long-term rental landlord loans (LTRs) in the private lending industry are striking. Further, when you follow the money and learn exactly who it is that is aggregating, selling, and ultimately carrying the LTR landlord loans, the similarities are uncanny.

The major differences, of course, are the loan-to-value ratios and underlying credit criteria backing these loans. That may provide a sigh of relief, except that both of those are eroding rapidly.

LTRs are likely here to stay for the time being. But it’s important to know that the capital supply could shift away quickly. Investment funds that are either aggregating and/or holding the paper for yield are often opportunistic and responsive to the market. Meaning: Should another asset class with higher returns, or even the same returns with lower risk present itself, capital could exit the space quickly.

More than ever it’s important to consider partnerships. If not in the official legal capacity, at least strategically. Consider pairing your fix-and-flip loan buyer with your long-term rental product. The same buyer may be able to offer a single closing product creating efficiencies not just for the lender but also for the borrower. Consider a closer alignment with your loan buyer. There are numerous examples of actual partnerships in the private lending space now between lenders and loan buyers. And, finally, consider keeping your own capital on hand. You just never know when you will need to fund that loan yourself.

There are potential risks associated with an LTR product that we haven’t seen before. This is the first large-scale product that involves, in some capacity, a consumer for the long term. Although the consumer is a tenant of the borrower, they are still involved in the process. And in an increasingly regulated field, all lenders must consider what that may mean to their clients. We saw this firsthand with the eviction moratorium as a health and safety response to COVID-19.

In addition to regulatory risks, there is always market risk. Demand for single-family homes may be at an all-time high in America, but that’s not always the case.

Does LTR as a loan product have staying power in the private lending industry? The verdict will remain out for some time. But it does look promising for a variety of reasons. We must pay attention to regulatory and market risk, but we should also be watching exactly who the ultimate purchaser of this paper is. What are they doing with that investment, and how could that potential impact us all?