The term “capital markets” is broad—so is its reach and impact.

In private lending circles, “capital markets” are often defined, at least implicitly, as the sources of institutional capital. Although often associated with fixed-income markets such as debt security or bonds, capital could also be derived from other institutional sources, including insurance companies, larger REITs, or even banks.

If one were to look at private lending through a rudimentary lens, it could be broken down into two primary asset classes: Debt Service Coverage Rental Loans (DSCR Loans) and Residential Transitional Loan (RTLs). Of course, there are many variations of both.

Debt Service Coverage Ratio Loans

The capital markets’ impact on DSCR loans is fairly straightforward and direct. As a function of price, there is usually some correlation to the 5-year Treasury rate. This is based on historical data and current assumptions that the weighted life of DSCR loans is close to five years.

The spread between the 5-year Treasury rate and offered DSCR rates depends on several factors, including the specific capital source, investors’ risk assumptions, market supply and demand, overall liquidity, and even sentiment. For most of 2022, rising interest rates have not only put pressure on DCSR pricing directly, but also adversely impacted the liquidity landscape and investor sentiment—it is all interrelated.

Investors and aggregators do not want to own DSCR loans at 7.5% rates if they assume the market price is going to be 8% next month, because the value of the loan will go down. Further, although there is ample performance data in the DSCR space, there is uncertainty around how a borrower’s valuation calculus could change and its potential impact on loan performance. Consider the following three factors:

1. Single-family rents have increased approximately 10%-15% year over year.
2. Real wages (increase in wages less inflation) have decreased 2.3% year over year (10/2021 to 10/2022).
3. Payments on DSCR loans have increased more than 125%.

Given the relativity of markets, the lack of precedent data or information related to the third factor has increased the risk premium over the 5-year Treasury Rate required by many investors of DSCR loans. Combined with higher carrying costs of aggregation facilities, it is not difficult to rationalize the sharp upward trajectory of DSCR rates.

Whether you are a large or small originator, broker of DSCR loans, or a borrower, your correlation to these forces is direct and fairly obvious. Higher rates have a macro-level impact on borrower demand. They also put pressure on eligibility, because higher payments cause a smaller percentage of properties to cash flow, which is a primary qualifying factor in a DSCR Loan. A general tightening of credit in the asset class will also impact overall eligibility criteria.

At the very least, if you have built any infrastructure to facilitate the origination of these loans or have taken on a recurring cost load to originate them, capital markets forces will require you to adjust. If you actually fund DSCR Loans with your balance sheet, your risk is heightened.

As we have witnessed historical volatility in DSCR prices, even intraday, pipeline movement, and secondary market delivery have not been able to keep up. This has forced industry participants that fund DSCR loans to reprice before closing, which causes reputational damage, or to take a secondary market loss. If a company chooses the latter, there is only so much you can take before economics do not justify this kind of risk.

The best plan is to diversify your sources of capital or find partners that are diversified. Although this will not eradicate the impact of capital market forces, it can mitigate some of the volatility.

Residential Transitional Loans (RTLs)

In the last 10 years, the progressive integration of institutional capital into the RTL market has been a primary contributor to the market’s exponential growth. Equally (or even more) impressive, have been those companies, funds, and individuals who have capitalized their businesses with non-institutional sources. Their resilience, savvy, and ability to endure even the most difficult market conditions is admirable (March 2020 notwithstanding, when most participants reliant on institutional capital experienced a disruption).

Although non-institutional funds may not be particularly appropriate for funding a 30-year single-digit coupon loan in today’s market environment, they have been proven extremely effective for RTLs. The non-institutional capital is diverse in its own right, and many of the platforms that deploy it are well managed, often by exceptional principals. These platforms thrive on flexibility, speed, and targeted market knowledge to provide reliability and quality service to their borrower bases. It is no wonder they have maintained impressive market share, even at times when institutionally sourced lenders offered very low price levels to the RTL market.

Overall, the cost of institutional RTL capital has increased dramatically during the last 120 days (as of this writing). RTL capital is correlated to the shorter end of the treasury curve. The rise in the 2- and 3-year Treasury rates has contributed to the upward move in RTL interest rates. When you add to that several RTL securitizations from strong sponsors hitting the market at unattractive levels of execution and aggregators of RTL adjusting their risk assumptions related to the direction of the real estate market in general, you can see why institutional rates have been under pressure. Beyond that, RTL credit conditions have tightened, and maximum loan-to-cost and loan-to-value levels have come in in many cases.

When a company’s source of capital is insulated (even somewhat) from the aforementioned market dynamics, the long arm of the capital markets may create opportunity. Privately funded platforms generally win with the RTL borrower based on flexibility, speed, and other knowledge—local or otherwise—that institutional-based providers have difficulty folding into the origination process. The great equalizer has historically been price, but that advantage could be diluted or negated altogether in the current market conditions.

There is a flip side though. Unless you are one of the few who lends to own, a successful RTL requires the borrower to effectuate a liquidity event to satisfy their obligation in full. When that does not happen, we all know what does—legal fees, loss of interest income, potential losses, and other risk factors associated with an unsuccessful transaction.

When it comes to many of today’s RTL portfolios, approximately 30%-40% of loan liquidations are the result of a refinance into some variation of longer-term credit, such as a DSCR loan. In the last 12 months, DSCR rates have more than doubled. As discussed, the impact on eligibility, feasibility, or desirability of a refinance could be demonstrably different from when an RTL loan was originated. Although your mileage may vary relative to how your book exits, the capital markets still have an influence.

To reiterate, the capital markets are broad. They also encapsulate the conventional owner-occupied mortgage rate, which has more than doubled since the beginning of 2022. It comes back to the impact on the valuation calculus. In this case, it would be the property’s end user. Whether that end user is a prospective homeowner or landlord, the current cost of financing changes the lens a purchaser looks through, in general and from the time the RTL was originated.

The risk profiles have changed, and that impacts non-institutional capital directly and indirectly, even if the impact is not the cost of funds. You should anticipate the effect on performance, default costs, and the durations (how does it impact when money cycles back in compared to before) of RTL loans as the demand curve has shifted in concert with the rate landscape.

These simple dynamics just scratch the surface of how capital markets impact the wide range and variety of capital sources in private lending markets. The arm is long, and its influence can be both positive and negative. Either way, recognize, understand, and appreciate its reach.