Rising interest rates, soaring inflation and lingering fears of a recession triggered a recent banking crisis that involved collapses and government takeovers. The commercial mortgage industry was also under pressure. Capital markets pulled back, reassessed and — in some cases — almost dried up.

“The currently constrained capital market is an opportunity for sponsors to take advantage of fundraising tailwinds. Contraction among traditional lenders is also presenting debt funds with an opportunity to deploy capital.”

Borrowers had already started to seek capital for their real estate projects from a variety of new sources as more traditional sources contracted. This shift opened the door for private capital in the bridge lending space, and investors began turning to bridge lenders last year when they discovered that debt funding was unavailable elsewhere as the ultra-low interest rate environment disappeared.

As the Federal Reserve raised interest rates in 2022 to combat inflation, it pushed many borrowers into scenarios with higher mortgage costs that required larger equity commitments. On the floating-rate side, the Secured Overnight Financing Rate, which is the rate that large financial institutions pay each other for overnight loans, stood at 0.05% at the start of 2022. One year later, it stood at 4.3%, causing mortgage rates to rise dramatically while the costs of interest rate caps are up to 10 times higher. And the 10-year Treasury yield increased from 2.74% in mid-April 2022 to 3.42% a year later.

Conditions across the financial markets shifted dramatically during first-quarter 2023. This included a shift in private lending. Lines of credit were reduced or halted altogether. In fact, some well-known lenders closed shop while many others were barely functioning. General contraction occurred across the financial markets, which worked to the benefit of well-capitalized balance-sheet lenders. More time is needed for the capital markets to adjust and determine a comfortable level of activity. For now, this pause is creating opportunities for bridge lenders to fill gaps in the capital stack.

Gaining traction

Private debt, which is a loan made by a private company rather than a bank, is an investment tool that has been growing in popularity of late. This is because it provides an opportunity to invest in tangible, income-producing assets at a discount to valuation, which gives a margin of safety for pricing compression.

As loan-to-value (LTV) ratios continue to compress, capital sources with dry powder are being overwhelmed with lending requests on high-quality assets in strong growth markets. This provides a tremendous opportunity for the lenders that have adopted a creative approach with their operations. There is a large amount of private debt capital waiting for opportunities, and stronger sponsors with experience in this niche will stand out in the market.

Commercial real estate investors continue to be attracted to private debt because they can find relative certainty within a favored alternative asset class, according to a recent survey from real estate services firm CBRE. Despite economic uncertainty, debt tied to real estate (especially multifamily and industrial assets) delivered higher returns compared to other investment types. Private debt is attractive because it provides short-term, opportunistic capital amid a higher interest rate environment.

CBRE’s survey found that more investors are expected to implement opportunistic debt strategies this year compared to last year, due to the attractive returns amid higher interest rates and tighter financial market conditions. Many investors expect to see pricing discounts of 30% or more across multiple sectors, with shopping malls and value-add office assets expected to offer the greatest opportunities.

In other instances, bridge lenders come to the rescue when borrowers find the traditional loan approval process is taking too long. Rather than waiting, borrowers move to solidify their positions with a bridge loan — short-term financing that is designed for transitionary periods and helps to ensure a project moves forward in alignment with a business plan. As banks and other traditional lenders pause to reassess the market, bridge lenders are often a viable solution because they provide certainty that the sponsor’s business plan can be executed. Bridge loans also have proven useful in cases where a borrower no longer qualifies for a bank loan due to the rapidly shifting market.

Lower expectations

Market turmoil at the beginning of 2023 was cited as a factor in liquidity reductions across the commercial real estate capital markets. Caution and conservative underwriting tend to be a comfort zone for lenders. The volatility and subsequent pullback caused spreads to widen across a range of lending groups, from debt funds to banks and commercial mortgage-backed securities (CMBS). In fact, CMBS issuance was down nearly 80% year over year in Q1 2023, according to Trepp data.

An unintended consequence is that as risk increases, investors seek safer investments such as Treasury bonds. This works to drive down yields and increase prices, which can reduce losses on bond sales. For commercial mortgage borrowers, they could eventually find themselves in a more favorable interest rate situation.

This should not be a surprise. Loan activity was already decreasing at the end of 2022, and projections for this year called for commercial and multifamily mortgage lending volumes to fall by about 15%, according to the Mortgage Bankers Association. The trade group’s forecast assumed “economic weakness at the start of 2023 with a moderation in interest rates and an overall improvement in the economy as the year goes on.”

Banks experienced a record year of commercial mortgage originations in 2022, making $479 billion in loans or nearly 60% of the total origination volume among all capital sources. But these sources are pulling back and even disappearing as they assess portfolio risk and address depository requirements.

Rocky road

Borrowers who face looming loan maturities in 2023 aren’t likely to find many allies either. Trepp estimated this past March that some $448 billion in commercial mortgage debt will mature this year. Interest rate hedges must be extended at much higher costs, delinquencies are expected to rise and market participants will naturally be a bit nervous.

The year ahead will likely include a period when traditional lenders retrench. New capital looks to find a home in the market. The coming year generally looks to be a growth opportunity phase for private lenders that reserved cash and have been operating without leverage. It is expected to be a lender’s market as large banks retreat while small and midsized banks work to stabilize themselves. The recent collapses of Silicon Valley Bank and Signature Bank have stoked caution.

This environment is creating more opportunities for bridge lenders to complete deals that involve higher-quality borrowers and less risk to achieve improved returns. Yields in the high single digits to mid-teens are being realized, depending on the strategy.

Quality loan submissions are increasing while LTVs have decreased due to debt-service-coverage constraints. That said, the market is shifting, with select property types falling out of favor. That alone is a reason to move ahead with caution. Lenders that focus on senior positions and less leverage will be able to withstand a major economic event. This structure has worked well in the past and will continue to give lenders an edge while the market corrects.

Returns for debt funds are expected to exceed those achieved from 2019 to 2022. The wider margins that debt investors are experiencing across risk profiles are being realized because of capital market headwinds and the Fed’s intention to drive down inflation through higher baseline rates. Lenders have an opportunity to seize outsized returns even when lending on collateral that’s been repriced due to factors such as the expansion of capitalization rates.

Market transformations

Leverage on new loans being made today is nowhere near historic averages. This places lenders in more advantageous positions in the capital stack now compared to where they may have been following the financial crisis of 2007 to 2009. Ultimately, the risk-reward trade-off found in the current market is likely better than what lenders experience in typical cycles.

The currently constrained capital market is an opportunity for sponsors to take advantage of fundraising tailwinds. Contraction among traditional lenders is also presenting debt funds with an opportunity to deploy capital. Some lenders have extended their pipelines as interest rates have increased, largely because floating-rate lenders, debt funds and non-debt capital sources have dramatically curtailed their lending activities.

The market also has experienced a transformation among bridge lenders that were reliant on demand for floating-rate products, as well as business models that required warehouse lines or securitization in the collateralized loan obligation (CLO) market. These sources of capital have been weakened by the current market conditions.

Some bridge lenders have responded by adding new products, putting them in a better position to satisfy demand from borrowers and investors who seek lower risk profiles. Even in a higher interest rate environment, there’s an opportunity for growth.

● ● ●

Those who’ve been in the commercial mortgage industry for more than a decade understand that markets change and adaptations to these changes are required for survival. They also know that, amid the darkness, hope remains and opportunity exists.

Time will tell if the stress being felt across the banking industry results in decreased commercial mortgage activity for the balance of the year. It is a legitimate concern, especially since regional and midsized banks hold crucial roles across the entire banking system and account for much of the capital for commercial real estate loans. To mitigate pain, borrowers will need to explore options they may not have previously considered. One of these avenues will likely lead them down the path to a bridge loan. ●

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Plentiful options

The dominant factors driving today’s commercial real estate market include optimism sparked by the post-pandemic recovery, readily available capital and pent-up consumer demand.

Market drivers

Uneven recovery

Watching for dangers

Broker tips

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Bridge loans from the best alternative lenders provide speed, flexibility and certainty of execution, but not every lender can provide all of these. Brokers and their borrowers need to be diligent and thorough in selecting an alternative lender. Your choice matters in terms of the quality of service, timeliness of funding and flexibility of terms. If a lender has questionable financial stability, it could lead to a string of broken promises and result in a failed deal.

An expanding field

Generally, bridge loans offer short-term financing from anywhere between a few months up to five years. The loans are typically backed by commercial real estate that the borrower already owns or is looking to purchase.

Borrowers often use short-term commercial real estate loans to “bridge” a funding gap until they can arrange long-term financing or sell the asset. They may use the loan proceeds to upgrade the property, attract a new tenant, convert the property to an alternative use or take advantage of potential transactions in which speed and reliability are critical.

The bridge loan space has evolved as it has grown. More borrowers are using longer-term bridge financing to restore or improve properties, thus increasing their value. Property owners may need to carry the loans for longer stretches to give them enough time to stabilize the properties. Previously, bridge loans were mainly used for property acquisitions.

Banks and regional hard money lenders have acted as traditional financing providers in the bridge loan space. Other financiers of bridge loans include life insurance companies and pension funds; government agencies; real estate investment trusts; and, more recently, lending platforms that use the collateralized loan obligation (CLO) market as their primary execution channel.

Large hedge funds and private equity companies such as Starwood Property Trust and the Blackstone Group, as well as a slew of alternative nonbank lenders, have joined the business in recent years. Collectively, they’ve enlarged the space today to at least 236 bridge lenders, according to an internal survey conducted by Money360.

Competitive terms and prices

Alternative bridge lenders have several advantages over traditional lenders, starting with speed. Banks can take up to three times as long as an alternative bridge lender to process and approve an application and extend credit. Approval processes through alternative lenders can take between two and six weeks. A speedy turnaround matters to a borrower closing on a sale or buying out a partner.

Alternative lenders also typically have more freedom to structure a loan in terms of pricing, leverage levels and flexibility. Strictly regulated banks and other traditional lenders often have inflexible internal policies that produce rigid guidelines. Additionally, bank loans are secured by the real estate in question and usually must be personally guaranteed by the borrower. With most bridge loans, however, alternative lenders typically only use the underlying real estate as security. Many borrowers don’t want to have the liability of a personal guarantee on their balance sheet. This can be the decisive factor in choosing a nonbank alternative lender over a bank or other traditional lender.

The entry of so many alternative lenders also has lowered prices for bridge loans. Recently, the money pouring into the bridge loan space has boosted market efficiency and competition, and has forced down pricing for all transaction types. The price is typically calculated by a spread over the 30-day London Interbank Offered Rate, or LIBOR.

Leverage levels for bridge loans have remained stable at around a 75 percent to 80 percent loan-to-value (LTV) ratio for core assets in primary markets backed by good sponsors, such as office buildings in Los Angeles. Borrowers and mortgage brokers, however, should expect wider spreads and more conservative LTVs for transactions in smaller markets, those with less-experienced sponsors or for assets that are considered unconventional.

As competition in the bridge loan space intensifies, some alternative lenders are trying to separate themselves from the competition by taking on more risk, such as providing bridge loans for construction financing or so the owner can lease up the building. Some alternative lenders are structuring loans in ways that others may not. Many also are very competitive from a rate standpoint, offering prices closer to those of banks.

Gauge lending partners

More competition, however, brings more risks. In some cases, a new alternative lender could be little more than a platform focused entirely on a CLO execution — the vehicle used to securitize bridge loans — and may not have full discretion in the decisionmaking process or the funding of a transaction.

Lenders that are new to the bridge loan space may not know the market well. Many of these lenders may have been involved in the commercial real estate market in other capacities, such as placing equity, mezzanine financing or commercial mortgage-backed securities debt.

Given the risks, you will need to perform the necessary due diligence on bridge lenders. Talk to other borrowers or intermediaries who have done business with a prospective lender. This can help you assess the lender’s dependability, and determine whether they have the experience and funding capacity in the bridge loan space, as well as whether they have worked through several lending cycles.

You can take steps to gauge a lender’s overall viability and funding model by understanding their approval process and sources of funding. The lender may not be able to close on the loan if its source of funds dries up. You also should take a close look at a lender’s track record to ensure the lender can make its own credit decisions and isn’t required to consult a warehouse loan provider or potential B-piece conduit buyers to get approval to fund the loan.

Ultimately, a lender should offer the pricing that meets the need; the structure that meets the request; the authority to render a credit decision; and experienced staff to process and close the loan. An expanded bridge loan market means ample choices and capital for borrowers. There also is risk. With so many available options, you should take the necessary steps to ensure you’re partnering with the right lender.

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The lending industry is no stranger to change. For centuries, lending was dominated by banks, life-insurance companies, credit unions, pension funds and other so-called “traditional” lenders. But over the past decade, two seismic shifts have forever changed how we think about borrowing and lending. That has allowed a new player to emerge in the industry — the alternative lender.

Change is groundbreaking for some industries. For instance, who in the music business could have predicted that a platform as seemingly innocuous as Napster would forever change the way people consume and experience music? Who in the news media could have predicted that a social networking site like Facebook would one day become a primary source of information for millions of people?

Whether it’s a young, innovative upstart that offers a better product at a better price, or an unforeseen macroeconomic event that disrupts entire business models, change is the one constant in the business world.

Tracing direct lending’s roots

There’s a simple reason that traditional lenders control so much lending activity: They sit in the middle of the flow of capital.

Imagine how people went about getting a loan in the days before banks. You could ask your family members or neighbors and try to scrounge up enough capital to meet your needs. You could ask a wealthy local businessman, who would likely ask something of you in return.

What if your family and friends didn’t have any money to spare, however? What if the businessman asked for something you couldn’t deliver? You might walk around the entire village asking everyone you know until someone said “yes.”

The problem with this early form of direct lending is a conflict of desire: A borrower who needs to borrow a certain amount of money for a certain period of time must find a lender willing to lend that amount of money for that period of time. This process, human beings realized fairly early on, is incredibly inefficient. So, they created a better way — the fractional-reserve banking system.

Instead of forcing everyone to find their own capital, early financiers created a system that could match the needs of savers and borrowers, absorbing any mismatches of time and amount. The bank played the role of middleman, aggregating the supply and demand of capital to make sure that businesses have access to funds and savers are able to earn a return on investment.

Technology opens doors

Thanks to the internet and the rise of alternative lenders — which include technology-enabled direct lenders, nonbank lenders and marketplace lenders — the process of matching savers and borrowers has become faster, easier and more transparent.

Instead of waiting weeks or even months for a bank to make a decision on a loan application, for example, borrowers using tech-enabled alternative lenders can often apply in just 10 minutes and receive a decision in as little as 24 to 48 hours. Many of these lenders also offer online deal trackers or managers, allowing mortgage brokers and borrowers to see the real-time status of their loan applications or payments. This resulted in an improved customer experience and, ultimately, more deal flow.

Today, practically every lender uses technology in some aspect of its business, whether to evaluate potential borrowers or track customer behavior. But increasingly, it’s the alternative and nonbank lenders who are setting the standard for what the lending experience should look like, and it’s why they are beginning to capture a significant percentage of the commercial real estate market.

Recession sparks retrenchment

Every good story needs a climax, and in the story of alternative lending, that moment is the global financial crisis. As markets crashed worldwide, traditional lenders tightened their balance sheets and all but eliminated their various forms of lending out of fear that the whole system was about to coming crashing down.

According to Federal Reserve data, commercial and industrial loans issued by all commercial banks peaked at almost $1.58 trillion in November 2008. Lending volumes plummeted over the next two years, however, dropping by one quarter to about $1.19 trillion in November 2010.

To make matters worse for banks, financial regulations such as the Dodd-Frank Act and Basel III imposed strict capital requirements on banks in an attempt to prevent another crisis. These requirements had the added effect of making it less profitable for banks to engage in lending, since they had to hold a certain percentage of assets on their balance sheets to cover liabilities. Naturally, banks responded by severely scaling back their lending activities and focusing only on the largest and most credit- worthy borrowers.

The rise of alternatives

So, how did smaller and less creditworthy borrowers obtain capital? The answer was alternative and nonbank lenders, which stepped in to help fill the void left by banks. As the economy recovered and interest rates remained low, alternative and nonbank lenders further solidified their positions.

Alternative small-business lenders had a 4.3 percent share of the U.S. small-business lending market in 2015, a share that is expected to rise to 20.7 percent by 2020, according to Business Insider. The Mortgage Bankers Association reported alternative lenders had a 68 percent year-over-year increase in commercial and multifamily loans in 2015. That was nearly double the 35 percent increase for commercial banks.

While banks still represent the majority of lending volumes, it’s clear that alternative lenders are increasingly becoming a go-to source of capital for small and medium-sized businesses, as well as individual consumers. The lenders that are best positioned to continue accumulating market share are likely to be the ones that can best combine the benefits of technology with a dedicated customer experience.

• • •

The next chapter in the story of commercial real estate lending is unclear, but alternative and nonbank lenders are likely to continue to play a major role. Recent lending volumes point to a future where both borrowers and mortgage brokers will have a wide range of options for their capital needs. Commercial mortgage brokers should take the time to learn about the different types of alternative lenders and educate their clients about why an alternative lender may make sense for them.

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This growth in the use of nonbank lenders is supported by two larger trends — the overall health of the commercial real estate market and the advantages of using nonbank lenders relative to traditional lenders like big banks.

Some 52 percent of the 148 mortgage professionals responding to the survey at the MBA event expect multifamily properties to be the hottest commercial asset class in 2018, followed by industrial (30 percent), hospitality (8 percent), office (6 percent) and retail (2 percent). The industrial-space sector, in particular, should receive a boost from recent federal tax reforms, with a significant increase in supply expected over the next 18 to 24 months.

A rising tide

Data from the Money360 survey reveals that a number of economic drivers are fueling growth in the commercial real estate market, with strong economic growth (38 percent), rising interest rates (27 percent) and continued suburban development (20 percent) highlighted as the top three factors. The effects of these factors will likely be the most dramatic in Tier II cities such as Charlotte, North Carolina; Phoenix; Salt Lake City; and Portland, Oregon — all of which still have ample room for growth.

“ The most successful alternative lenders combine technology, particularly for an initial screen, with a dedicated team that has years of experience. ” 

Nonbank lenders will continue to benefit from this surge in commercial activity as mortgage brokers look for additional sources of financing. In fact, on average, 42 percent of the brokers polled said they approach more than six lenders when looking for commercial financing, which can encompass a broad range of business models and financial institutions. This suggests that the vast majority of borrowers and brokers in the commercial real estate space are now looking at nonbank lenders as potential sources of financing.

More than 40 percent of the mortgage brokers surveyed at the MBA event said they use nonbank lenders to finance 25 percent to 50 percent of their commercial deals, and 29 percent said they opted for nonbank lenders for 50 percent to 75 percent of their deals. These numbers are a testament to how much the alternative-lending industry has grown and matured since the financial crisis.

It’s easy to see why alternative lenders today are so popular. Of the survey respondents who said they will seek more financing from nonbank lenders in 2018, nearly half (49 percent) said it was because of the financing flexibility offered by nonbank lenders. Transparency (18 percent) and speed (18 percent) also were cited as primary reasons by survey respondents for choosing nonbank lenders.

Regulations imposed on banks to prevent them from becoming over-leveraged, such as the Dodd-Frank Act and the Basel III capital requirements, have caused these large financial institutions to focus on only the most lucrative commercial real estate projects. Increased reserve requirements made it less profitable for many banks to pursue small and midsized loans or borrowers.

As a result, many borrowers were squeezed out of the market and needed alternative sources of capital. With traditional lenders largely constrained within the commercial real estate space, a multitude of alternative lenders have popped up in the market.

The tech edge

Just as regulations were tightening, technology was improving. Enhanced internet capabilities and access allowed alternative lenders to fill the gap left by the banks. These alternative-lending companies were willing to take on smaller loans that traditional lenders ignored and were able to greatly accelerate the lending process for borrowers through the use of tech-enabled platforms.

Instead of waiting weeks or even months for a bank or other lender to decide on a loan application, borrowers using tech-enabled alternative lenders can often apply in minutes and receive a loan decision in as little as 24 to 48 hours. On top of improved speed, technology-based platforms generally include online deal trackers or managers. These tools allow mortgage brokers and borrowers to keep track in real time of the status of a loan, thereby delivering an improved customer experience.

While technology plays a big role in the success of online lenders, they are not solely reliant on it. Alternative lenders understand that each loan decision is unique and requires human expertise. An algorithm will never be able to account for all the nuances that go into underwriting a commercial property.

For this reason, the most successful alternative lenders combine technology, particularly for an initial screen, with a dedicated team that has years of experience underwriting and structuring commercial real estate loans. This dual approach ensures that each borrower receives a loan that fits their particular needs, increasing the chances that it is repaid and the lender recovers its capital.

Direct-lender advantage

As more borrowers and brokers enter the commercial real estate market, it is important to select the right lender. First, all mortgage brokers need to understand the difference between a direct lender and a crowdfunding platform. In the simplest terms, a direct lender makes loans directly from its balance sheet while a crowdfunding platform aggregates capital from a combination of institutional and retail investors before it can fund a loan.

Nonbank direct lenders are becoming an increasingly attractive option for mortgage brokers and borrowers who want to eliminate the middle man. Instead of potentially waiting days or weeks for funding from outside investors, direct lenders provide an added level of certainty that a transaction will be completed — a vital characteristic in an industry where timeliness is critical.

On top of their expertise within the alternative-lending space, direct lenders also offer other advantages over traditional banks. Direct lenders, for instance, typically enjoy more flexibility to provide brokers with an opportunity to customize each deal to their clients’ specifications. This advantage is particularly important given the growing demand for projects involving the rehabilitation or revitalization of older buildings. Those tend to require the kind of short-term loans or tailored financing that many direct lenders specialize in arranging.

• • •

The speed and flexibility of nonbank lenders have enabled them to become a go-to source for capital for borrowers and mortgage brokers specializing in the commercial real estate field. As the industry continues to grow, it is important that commercial mortgage brokers and borrowers understand the different types of alternative lenders that are out there as well as the advantages of choosing a nonbank lender.

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