Today, as Wall Street is looking for measured risk and maximum yield, private money for business-purpose residential loans is reemerging as an ideal market for their investments.

COVID delivered a major blow to the private lending space for a brief period. However, it is unlikely to have any significant, permanent impact on the market. In fact, volumes are already heading back to pre-pandemic levels. Still, there have been eminent changes.

Repo facilities, for example, have generally lowered advance rates, and LIBOR spreads have widened, which has made the cost of warehouse financing more expensive. That being said, spreads and advance rates are typically benchmarked to securitization execution, and they should improve over time as the securitization market gains momentum.

 What Investors Want

Perhaps a bigger change,  is how the capital markets and institutional investors perceive the private money space. More than ever, investors want to make sure the lenders they do business with have the expertise and resources to make good loans. They want high-quality paper, which boils down to a question of liquidity. In other words, how difficult will it be to sell the loan—and for what price?

The basic rules apply here—higher rate, lower loan-to-value (LTV) products that are well underwritten have greater liquidity. Beyond loan characteristics, however, institutional investors want originators with proven track records. It’s not uncommon to see elevated levels of delinquency for business-purpose loans, so the real puzzle is how to manage non-performance.

For private lenders, this requires having the internal infrastructure to manage risk and understand value to prevent borrowers from getting in over their heads. Many capital partners spend a significant amount of time analyzing how lenders look at the world and how deeply they work to validate the borrower’s strategy. Investors want to know, for example, how much information lenders collect from borrowers seeking rehab financing and how the construction process is managed. They’re also interested in the cash reserves they have to work with and whether loan requirements change depending on a borrower’s real estate investment experience level or FICO score.

These days, private lenders can expect to spend quite a bit of time with their counterparty’s credit team, walking them through the origination process and underwriting criteria. Another focal point is the procedures that are in place with the servicer around loss mitigation and REO management.

Most leading private lenders already recognize their fiduciary responsibility to act in the best interest of borrowers and have already put into place methods to reduce risk. For example, having valuation and construction experts on staff who can look closely at each transaction to ensure the deal makes financial sense. Such experts can help identify construction risks the borrower might not be considering, as well as assess reserves and cash flow to ensure the borrower isn’t getting too far ahead of themselves on their rehab exposure. In addition to protecting borrowers, these methods can also give capital partners extra confidence in loan quality.

One lesson COVID taught is this: Over the past few years there’s been a gradual deterioration in the quality of private money loans, to the point where the capital markets began taking a hard look at the risk associated with the paper that was being written. The private lenders best prepared for the disruption were those that weren’t overleveraged, had liquidity, and had developed multiple sources of capital. These lenders quickly adjusted, managed LTVs closely, and did not overcorrect on interest rates or fee compression. By acting prudently, smart private money lenders were able to recapture their markets relatively quickly.

Opportunities for Growth

Today, as Wall Street is looking for measured risk and maximum yield, private money for business-purpose residential loans is reemerging as an ideal market for their investments. Competition is returning to the market as more large lenders and new capital partners reenter the space, and pricing has become more reasonable.

Still, private lenders have quite a bit of wood to chop when it comes to educating our investor base and continuing to press the limits on pricing. Most in our space believe private money is the best relative value in all of mortgage lending, yet it still prices worse than other mortgage products. For this reason, there are tremendous opportunities for any lender that can offer consistent volume and quality while continuing to introduce the asset to more investors searching for yield.

Obviously, diversifying your capital sources can offer protection against having to shut down during a crisis. However, it’s important to understand the intent of your purchaser and limit your exposure to mark-to-market (MTM) financing, if possible. If you are dependent on purchases that rely on mark -to-market financing, subsequent whole loan transactions or securitizations to recycle cash, you need to be prepared for the scenario we experienced earlier this year, when a rapidly shifting repo environment and securitization market caused secondary markets to virtually disappear.

Private lenders can hedge these risks by having sufficient capacity on a committed non-MTM repo facility to wait out any future storm or focus on issuing revolving securitizations with 24-month investment periods and a one-year wind down. Of course, smaller lenders that do not have these options are at a disadvantage, but they can partner with larger players that have access to institutional capital. In doing so, it is critical to learn their partner’s secondary market execution strategies and the risks that go along with them. Having such a partner to bridge the gap with capital markets can open avenues for growth.

The private lending market is still not back to 2019 levels, but for lenders that provide quality financing and have access to a variety of capital sources, the future for private lending is brighter than ever. With conventional mortgage lending rates at record lows, it is clear that Wall Street is looking for quality, quantity, and consistency in their investment opportunities. With private money lenders, the ability to take advantage of growing demand for financing alternatives to conventional lending at reasonably low interest rates has never been greater.

While all lenders are susceptible to setbacks, they are also capable of learning from them. The lenders that prevail in a post-COVID market will have diversified their capital partners and have proven, experienced leadership capable of making smart decisions when uncertainty and chaos arrive—as they eventually will.