Why Is Alternative Lending Growing So Rapidly?
10 . 13 . 2019
A couple of years ago, Deloitte questioned whether or not commercial real estate companies could continue to find funding alternatives.1
Fast forward two years to today. Thanks to the rapid growth of alternative lending, the answer to Deloitte’s question is a resounding yes.
The financial advisory firm asked this question for a good reason. Expanding regulations that traditional bank lenders face effectively cap the amount of money banks can loan. In turn, this forces a traditional lender such as a bank to be more selective.
Borrowers looking for capital have to fit the bank’s desired profile or have a project in the preferred property asset class. Those that don’t are frequently frustrated by the lack of creative financing options offered by a traditional lender. In many cases, borrowers are turned down for conventional bank loans simply because the property doesn’t fit into the lender’s cookie cutter mold.
Types of alternative loans
Traditional loans are still the most common options for financing the development, purchase, or repositioning of commercial real estate. However, a growing number of investors are beginning to use alternative loan types to enhance or completely replace bank-sourced loans.
Examples of alternative loan types include:
Installment sales contracts
Also known as “land sales contract”, installment sales can be used for any type of real property.
In this type of transaction, the buyer pays the purchase price in installments over a fixed period of time. Once the contract is satisfied and the purchase is paid for in full, the title passes from the seller to the buyer.
Sale leaseback agreements
Under a sale leaseback arrangement, the seller agrees to leaseback the property sold to the buyer. Normally, the lease agreement is incorporated into the sales agreement, so that when the property closes escrow the lease immediately begins.
Both buyer and seller can benefit from a sales leaseback agreement. The seller frees up equity in the property by turning it into capital to use for other purposes, while the buyer has a qualified tenant, usually under a net lease arrangement.
While they can be designed in a variety of ways, the most common form of a mezzanine loan is a type of subordinated debt. Rather than being secured directly by the property, a borrower pledges equity in the entity that owns the real property and not the property itself.
Borrowers obtain mezzanine financing for several reasons:
- Reduce the purchaser’s own equity
- Finance a specific project that costs more than a traditional mortgage loan will provide
- As a workaround to a lender’s prohibition of subordinate mortgage financing
In many cases, mezzanine loan investors take on more risk. The trade off is the receipt of required monthly or quarterly interest payments at a rate (or fixed amount) that is greater than what a traditional lender receives.
Preferred equity investments
A preferred equity investment is another way a borrower can increase total leverage on a property above and beyond what the senior mortgage lender is willing to offer. In contrast to mezzanine loans on the debt portion of the capital stack, preferred equity normally takes the form of a direct equity investment in the real property.
Similar to mezzanine financing, a preferred equity investment can be negotiated in a variety of different ways. In general, a preferred equity investor receives a preferential return paid before common equity investors receive distributions in exchange for the increased risk of being subordinate to both the senior and mezzanine lenders.
Alternative lender options
Insurance companies and pension funds, conduit lenders, and well-capitalized and experienced real estate developers are some of the common options for alternative loans.
Institutional alternative lenders
Life insurance companies and pension funds are two types of institutional lenders the provide investors with long-term, fixed mortgage rates and the flexibility to modify or amend the loan if needed.
Because insurance companies require loans to maintain a targeted yield, they typically prefer property with credit tenant net leases or income-oriented commercial real estate such as multifamily or industrial investments.
Conduit lendersuse pools of mortgage funds to create commercial mortgage backed securities (CMBS). CMBS are divided into tranches and rated by the amount of risk and cash flows produced by the underlying loans, then securitized and resold as commercial mortgage backed securities.
CMBS can be “sliced and diced” in a countless number of ways. This type of mortgage security specifies a minimum interest rate, with a spread set between the Treasury yield and the benchmark loan rate.
While conduit financing generates longer-term amortizations, a main drawback is that there is very little flexibility to modify individual loan agreements once they are packaged and resold.
Developers and private equity
Real estate developers and private equity firms are also grabbing a growing share of the alternative lending market. A recent article in Bisnow notes how over the last 24 months equity investors and well-heeled real estate developers have begun capitalizing on the demand for alternative lending:2
RXR Realtymanages 71 commercial real estate properties in the New York Metropolitan area. The firm’s portfolio consists of about 31.4 million square feet and a gross asset value of approximately $20.5 billion. RXR Realty recently partnered with a Canadian pension fund to offer $300 million of equity investment along all CRE asset classes.
Silverstein Properties has formed a joint venture with a sovereign wealth fund and a pension fund to create Silverstein Capital Partners, as reported byBloomberg.3 The new company provides senior loans, bridge loans, subordinate loans, and rescue capital to borrowers with shovel-ready ground-up construction, heavy value-add repositioning projects, and land and inventory loans.
Moinian Capital Partners is a relatively new player in the alternative lending field, according to a recent article in Forbes, “Alternative Lenders Becoming Increasingly Mainstream In Commercial Real Estate”.4 The firm is a unit of The Moinian Group, with a portfolio of over 20 million square feet of office, retail, and multifamily and hotel property in major markets such as New York, Chicago, Dallas, and Los Angeles.
To be fair, some executives in the traditional lending arena question whether projects funded with alternative financing are better off not being done in the first place. In response, alternative lenders such as Silverstein believe they are filling a needed gap for financing large complicated projects that banks simply are not equipped to handle.
Growth in alternative lending
While commercial real estate experts may debate the reasons why alternative lending is growing, the fact is that alternative lenders are significantly increasing their market share.
Alternative lending grows by 57% in 12 months
In “U.S. Commercial Real Estate Lenders Expect A Strong 2019”, the Urban Land Institute (ULI) described how rapidly the alternative lending landscape is changing.5
Drawing on data from Real Capital Analytics, ULI noted that debt funds and nonbank alternative lenders made up about 11% of the debt market for commercial multifamily properties, up from 7% over the previous year for increase of over 57%. In fact, today there are over 100 debt funds operating in the U.S. alone and they’re expected to capture an increasingly large share of the capital market over the next several years.
For the time being, traditional lenders still control a majority of the commercial real estate debt market. Banks hold a 40% share, followed by government-sponsored enterprises with 22%, CMBS conduit lenders with 16%, and life insurance companies with a 10% share.
Life insurance lending remains flat
Interestingly, the amount of business done by life insurance companies has remained essentially flat over the past three years.
According to Kevin Westra, the director of real estate at Northwestern Mutual, “It seems like all life companies have done about the same amount of business the last three years.”
Westra does believe that life companies may be looking to increase yields going forward, noting that Northwestern recently did its first mezzanine loan and other life insurance companies have begun exploring debt funds.
CBRE Lending Momentum Index Q3 2019
Although commercial lending activity was tepid at the beginning of the year, lending activity has gained momentum over the last couple of quarters. In the firm’s U.S. Lending Figures Q3 2019, CBRE notes that:6
- Recent Federal Reserve interest rate policy shift has spurred the capital markets
- Lending activity in September 2019 was up 8.2% compared to June 2019
- Alternative lenders and life insurance companies led origination activity in Q3 2019
- Each group accounted for about 30% of origination activity
- Market share from traditional bank lending declined slightly while CMBS lender share rose
In Q3 2019 the average commercial LTV was 62.8%, an increase from the same quarter in the previous year. Multifamily LTV declined slightly to 67.9% compared to the same quarter a year ago, while the average debt yield increased to 8.90% for the same period one year ago.
CBRE also notes that loan underwriting has become more aggressive, as competition from alternative lenders and declining interest rates help motivate lenders to generate increased yield.
Here’s a look at how key underwriting measures changed over the last few years:
|Metric||Q3 2019||Q3 2018||Q3 2016|
|Debt service coverage ratio||1.38||1.41||1.72|
|Loan to value %||67.2||66.5||64|
|Cap rate %||5.82||5.62||6.35|
|Interest rate %||4.05||4.69||3.86|
|Debt yield %||8.9||8.66||10.37|
The percentage of loans carrying a partial or full interest-only term have also increased, from 52.1% in Q3 2016 to 67.9% in Q3 2019. The share of interest-only loans rose from 12.3% in Q3 2016 to 14.8% in Q3 2019.
Alternative financing: a win-win for borrower and lender
Alternative lending can benefit all stakeholders in a commercial real estate transaction:
- Borrowers and lenders have the flexibility of creating loan terms and conditions that traditional lenders can’t or won’t do
- Private developers are generating new income streams while partnering with pension and sovereign wealth funds
- Investors now have a new and potentially better way to put their capital to work
It’s important to note that because alternative loans aren’t burdened by the same laws and regulations the traditional bank loans are, they may be riskier if not structured properly.