Lending to smaller real estate investors and developers, with loan sizes typically under $5 million, has been a large market for decades. This market became professionalised and grew rapidly after the global financial crisis. New regulations during the GFC caused many banks to retreat from investor loans, leaving a new breed of direct lenders to fill the void, including dozens of debt investment funds. The old guard of “hard money lenders”, which were mostly wealthy individuals and their mortgage brokers, became uncompetitive for many loans.
Today, as some of the newer entrants encounter defaults and problems with their Wall Street financing sources, the playing field is shifting once again. The result is that lending to this market in 2020 is much like it was in 2015, with strong yields and much less competition than in the late 2010s, resulting in 7-10 percent net returns to investors.
Wall Street discovers a niche it likes
In recent years, Wall Street identified this niche as an attractive market. First, the opportunity is vast, including about one-third of the entire US housing stock that is owned by small investors and operated as rental properties, as well as the millions of apartments and commercial properties that are too small to get attention from institutional investors and investment managers. To get an idea of the market size, think about flying into Los Angeles. The lion’s share of all the real estate you see consists of small buildings, not large ones.
Second, the interest rates that small investors pay remain significantly higher than for large bridge loans, typically 200-500 basis points higher. Wall Street investment banks identified these high-yielding loans and loan originators as a market to be served with repo lines as well as securitisations. These products frequently go hand in hand, with repo lines used to aggregate a portfolio of bridge and renovation loans, to be taken out by a securitisation once there is enough critical mass of loans to cover the fixed costs of issuing and selling a bond. The market developed much as the subprime mortgage market did 10 years earlier, though on a much smaller scale.
Big investors move in
Three transactions typified the evolution of this niche into a more mainstream investment. First, Goldman Sachs purchased Genesis Capital. Next, the Kuwaiti sovereign wealth manager Wafra took a majority stake in Anchor Loans. Finally, KKR helped start a business called Toorak, which purchased loans from dozens of small lenders, rather than originating loans. All three firms focus on single-family renovation loans, with some making construction loans and small apartment loans as well.
The flood of money into this market drove down pricing and in some cases led to firms offering higher leverage than the 75 percent loan-to-cost which had previously been standard in the market. In 2018 and 2019, some firms originated “90-100” loans featuring 90 percent financing for the purchase and 100 percent of renovation costs. Other lenders – particularly those with direct relationships with borrowers, like the author’s firm Arixa Capital – kept leverage around 75 percent and saw yields drop over time.
For 12-month maturity bridge and renovation loans, all-in rates (including origination fees) were in the 10-11 percent range in the early 2010s and settled around 8-9 percent by 2019. During this time the number of lenders multiplied, because any mortgage originator with a little capital could become a direct lender, by selling loans and recycling their limited capital.
Bankers get creative to securitise these loans
Loan maturities in this market tend to be around 12-18 months, because borrowers only need the capital while a property is in transition. After renovation, they typically sell or in some cases refinance the underlying property. The short maturity feature of bridge and renovation loans is mainly a positive for investors because it limits interest rate and market risk. Securitisations sidestepped the challenge of short maturities by creating structures that allowed for substitution of new loans for old loans that paid off. As long as the loan criteria fitted the same guidelines, the security could continue paying bondholders even as the underlying loans rotated in and out of the portfolio.
But why did securitisation coincide with loosening of lending standards? Why were many borrowers offered 85 percent or 90 percent financing on their projects? The answer likely relates to incentives. For the bankers who generate fees from securitisation, more product (loans) is better. The looser the standards, the easier it is to gather new loans to feed the securitisation machine. Going one level further, investors and wealth managers feel safe with the liquidity of publicly-traded bonds, and they pay a big premium for that liquidity, by demanding very little yield from their bond investments, even if those investments consist of high-leverage real estate loans.
Covid reshuffles the deck
When covid-19 hit the US in March, the first casualty was lenders and funds relying on Wall Street repo lines and securitisations. With repo lines, these credit funds could borrow 80 percent or more of the money to build a portfolio of loans, at attractive rates. However, the provider of these credit lines – typically bulge-bracket investment banks with a focus on mortgage trading – can require a margin call if the bank believes the value of the underlying loans has dropped. Credit funds were forced to come up with cash very quickly and the market briefly saw sales of performing loans at a discount to par, while funds that had been buying loans stopped doing so.
Soon after that, defaults began to crop up, particularly for those lenders and credit funds that had focused on providing high loan-to-cost loans. The number of lenders, which had ballooned into dozens of competitors in every market, returned to the same three to five active lenders in each region that had pioneered each respective market years earlier. The securitisation market is on hold as all parties wait to see how the defaulted loans play out and how hard it is to get partially renovated foreclosure in disparate locations completed and sold off. Only the real balance sheet direct lenders remain active today. To paraphrase the economist Joseph Schumpeter, the cycle of creative destruction ended, and a new cycle is now beginning.
Today’s market is not as starved for capital as in the years right after the GFC, but it is much more disciplined than the market of six months ago. Yields are back up, leverage is prudent, and those who survived are making money and building infrastructure for the next phase of growth. Investors can expect net returns of 7-8 percent with no structural leverage and about 10 percent with leverage. Expect to see even more scale and professionalism in this niche of direct lending in the years to come.
Jan Brzeski is managing director and chief investment officer of Arixa Capital, a real estate investment advisor based in Los Angeles.