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It’s pretty safe to say we’re amidst a market correction. While some may challenge whether or not we’re in a true recession yet, the fact remains that the real estate investing game has changed drastically since the beginning of the year. War in Ukraine, multiple interest rate hikes, housing inventory rising again with increasing days on market; the list of alarmist headlines continues to grow with each passing day. The impact of these market changes has also affected real estate lending significantly. Just as with the early days of Covid, we’re starting to see lender “fragility” affecting investors’ ability to close deals.
What Does This Mean For Investors?
Unstable interest rates impacting deal analysis, additional underwriting conditions with tightened lending guidelines, lower loan-to-value (LTV) requiring more money out of pocket, and potentially lower after-repair values reducing anticipated profit margins. Why you may not be able to change what is happening in the market, what you do have control over is understanding and being selective with your chosen sources of capital for investments.
Similarly, this happened back in March 2020 and the months to follow. Many large national and regional hard money lenders significantly changed their lending criteria amidst market uncertainty. These immediate changes in underwriting conditions left real estate investors at risk of losing earnest money unless they brought additional capital required to close. Quite a few lenders stopped funding altogether or froze untapped rehab and construction funds being held back by the lender. Borrowers couldn’t pay invoices past due, couldn’t initiate any new work, and some were still paying interest on funds not yet released.
But do you know why? Most borrowers may not know where their lender gets their capital, and quite frankly, they likely do not care as long as their deal gets funded. But when something like the pandemic happens or even a small market fluctuation—when your deals are precariously in the hands of “flakey” lenders, you need to start paying attention. Often lender performance has to do with the lender’s source of capital. After all, these institutions make their revenue off your loan origination, so, in theory, they need and want your loans to close.
A Lender’s Control Over Capital Makes a Huge Difference
You might say this is inconsequential, and before 2020, it was to a certain extent. However, whether a lender controls their own capital or not makes a difference. Just ask some of your fellow real estate investors. If a hard money lender taps out their pooled fund and no one is buying loans on the secondary market, which is what happened last year, the lender is benched from funding new deals until they can free up more capital. If a lender with a private debt fund chooses to get a warehouse line of credit secured by the assets held in the fund (loans/notes), they could succumb to abrupt capital constraints hampering their ability to originate new loans. If your lender relied on capital partners to “table fund” loans and these partnerships suddenly stop all loan originations as they did in 2020, the lender is also sidelined, leaving borrowers in the lurch.
In contrast, most true private lenders do not have these market constraints in capital deployment. Our private money matchmaking business grew nearly 25% year-over-year post-Covid, largely due to our own control of capital (and a lack of active competition). This was a great opportunity to showcase our agility, flexibility, and execution as a smaller lender with no ties to Wall Street. My capital partners still needed a safe place to invest for interest income, and we could call the shots as a local lender, making their deals even more secure given the uncertain market conditions at the time. Those lenders with dependency on capital markets do not have this luxury. In fact, lenders and capital partners across the nation shuttered their doors for nearly the entire year, and many only returned to pre-Covid capacity in the second quarter of 2022. With recent rate hikes, these large lenders are feeling the squeeze financially again.
The Fed has raised rates several times with a Federal funds rate now set at 3.75%-4% and a possible target rate of 4.75% – 5% by early 2023. As a result of higher interest rates and their trailing effects on the real estate market, once again, we find lenders pausing their loan originations—either temporarily for a few months or indefinitely. Some lenders are shuttering altogether. However, unlike the pandemic-induced shutdown of 2020, this modification to the lending world is likely to stick around much longer. Even if you are bullish about the market, understanding the capital constraints of your lenders is critical moving forward so you do not get stuck with deals that can’t be funded, losing you earnest money, being able to take down a good deal, or worse.
Know Where Your Lender Gets Their Capital
More than ever, investors need to be aware of the sources of capital that back their projects. Long gone are the days of shopping around for the lowest rates and points. Rather, you need to ensure a high likelihood of performance so that your deal isn’t jeopardized. Most investors are familiar with traditional hard money lenders and their terms, but private lenders are a different type of lender entirely, and realizing what those differences are can help an active investor pick the best tool for the job.
Here are just a few questions that you could use to interview your lending options on a potential project in order to find the right lender for your individual circumstance:
Are you a direct lender?
How will my loan be funded, and is this capital controlled by your company, or will an outside partner fund it?
Please explain how your underwriting approval process works and who the decision makers are, who sets loan rates and terms, and who provides loan approval.
If teams outside your local office complete loan approvals and underwriting, could you tell me who and where these decision-makers are located?
Do you have some borrower references that I could speak with regarding their experience with you?
There are definitely advantages to having institutional hard money lenders in the market. In the past, emerging national hard money lenders backed by institutional partners were the catalyst driving down the cost of capital for real estate investors. Institutionally-backed lenders could offer lower rates, larger loan amounts, and in some circumstances, tolerate higher risk due to sheer loan volume and velocity. But when there is uncertainty in the market, as there has been this year, depending on who you talk to, lender performance will become a necessary means of evaluating your loan options, not just the cheapest rate.
As you have seen, the difference in where your capital is coming from has real-world effects on your business as an active investor. Possibly the most crucial aspect of your business is being able to obtain leverage quickly, consistently, and easily. Knowing where that source of capital is coming from will be crucial to the success of active investors moving forward in these uncertain times. So while looking for a lender, don’t discount the little independent lenders that can get the job done!
Learn how to create financial freedom and passive income in real estate as a private money lender. Lend to Live makes passive income through private lending achievable for anyone.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.