Once relegated to risky, extremely unconventional or emergency borrowing situations, hard-money lending has recently surged in everyday popularity as balance-sheet-minded banks continue to pull back and general credit availability remains tight.
Moreover, even as the hard-money field becomes increasingly crowded, many of these lenders expect that the capable and well-capitalized hard-money players will enjoy a prolonged day in the sun – even after the return of mass liquidity.
‘Private capital has a long runway here, because we have a material reset in the way commercial real estate is financed,’ explains Jay Rollins, president and founder of JCR Capital LLC. ‘When you look back on the history of commercial real estate finance, you're going to see 2005, 2006 and the first half of 2007 as an anomaly of the business.’
He notes that in that era, typical securitization reach extended far beyond the traditional and safer bets – stabilized commercial assets – and encompassed land, condos and lots as well. Under the rules of this system, transitional assets (and nearly everything else) were cheap, and paying LIBOR +300 in a land deal, for example, was not unusual.
‘We'd been lulled into this false sense of pricing on what transitional assets should cost and how they are financed,’ Rollins says. ‘We're going through a wake-up period now that the securitization model has shown that it is not appropriate for those types of assets.’
Although the specific definitions of hard money, bridge funding and asset-based finance – the other typical forms of finance for these specialized situations – vary among both providers and borrowers, the common purpose and strong need for all variants these days justify a common grouping, according to Rollins.
‘You can call it hard money; you can call it bridge loans; you can call it asset-based funding,’ he says. ‘But at the end of the day, it's really about speed and short-term duration.’ Regardless of the term, he believes the market has now begun to give these forms of funding their due respect and predicts that when securitization returns, it will not cover assets traditionally financed by hard money.
Chasing quality deals
In addition to the continued absence of a viable commercial mortgage securitization market, institutional lenders' growing reticence – particularly in real estate lending – has created a new segment of potential transactions that many hard-money lenders have been quick to embrace.
‘The banks have basically shut the faucet off,’ remarks Thomas OBryon, CEO and fund manager at Wilshire Finance Partners. ‘They are afraid to make loans, and let's face it – if they can run to the Fed window and borrow at two percent, and then go out and put it in a Treasury bill at three percent, then that is a much safer bet than wondering if real estate is going to go up.’
Liquidity shortages and collections of bothersome bad loans on the books continue to impede activity at banks, which likely would not be able to make key deals, even if they were willing to participate, adds Kevin DeMeritt, fund manager at Wilshire. Though many institutions are currently trying to raise capital in hopes of re-entering soon, he expects most to remain quiet for at least a while longer.
In addition, even some strong banks have seen their transaction velocity stunted by growing regulatory limitations and inhibited access to certain asset classes. ‘A lot of the rules and regulations that the government has put forth in this market have helped the private-money lenders – not so much in increasing rates, but in helping us get a lot more deal flow,’ DeMeritt says.
Of course, despite the struggles of some institutions, numerous other banks, life companies and other lenders remain active in the commercial mortgage market alongside hard-money providers, and the two groups intersect and compete regularly on certain deals.
At the same time, traditional lenders' usual transaction preferences of late – top-tier assets with ample cashflow and high-quality sponsors in top-tier markets – eliminate a significant number of what they now consider marginal opportunities.
These situations, which would have been considered acceptable by the average traditional lender under the old lending regime, might feature a borrower with a thin portfolio of comparable experience or a good asset in a potentially waning market, for instance. Adam Glick, director of loan originations at Paradigm Capital Group, reports seeing ‘better’ borrowers these days because of conventional lenders' raising the bar.
Anything below top-grade in every respect may fall into the welcoming arms in hard-money territory these days, agrees Chris Kelly, managing director at CapitalSource. ‘Hard money is looking to expand its market share, so providers are going to go a little upstream in terms of the quality of the sponsor and the real estate asset,’ he remarks.
Accordingly, the very definition of a top-tier opportunity has shifted in the minds of financiers from both the conventional-financing side and the hard-money side.
‘A top-tier sponsor a year ago might have been a group that has done six to eight real estate assets – with a market cap of $100 million,’ Kelly says. ‘Today, maybe it's a group that's done 20 to 30 real estate deals, and their asset space is $200 million and $300 million.’
Required values
For most hard-money lenders, brisk deal flow and increased borrower quality still accompany a trend toward conservative underwriting and deal structuring – even for these traditionally more risk-welcoming players.
In general, ‘You have to make sure that you are going into a new deal today with an abundance of caution,’ warns Kelly. ‘Make sure that you have alignment with the underlying sponsor by seeing that they have equity in the deal and that they have a business plan that is viable and can be delivered in the face of a tougher market.’
Of course, with the increased menu of transactions on the table these days, hard-money lenders can afford to be more selective in their chosen deals.
Tenant diversity, steady appreciation in the given asset's market, property fungibility and depth of surrounding economy rank among the top considerations for today's hard-money players, but any of the major commercial property types is generally eligible. Rollins anticipates an increase in hard money for the for-sale asset classes, such as land, lots and condos.
On the other hand, Glick reports a tendency to avoid environmentally charged properties, while OBryon considers incomplete projects the most difficult and dangerous – though funding requests for this type of deal are currently arriving in record numbers.
With closing speed a crucial consideration for the typical hard-money deal, the lender is likely to focus only on certain key values to arrive at its decision. For Wilshire Finance Partners, square feet and comparable sales values are not likely to figure into the value equation, says OBryon.
‘Those numbers mean absolutely nothing to us,’ he says. ‘We're looking at it from an economic perspective, so when we value it, we're valuing it based upon the income that it can generate to support the debt we've placed on it.’ The firm always includes a sizeable cashflow cushion for adequately servicing the debt as well.
Some hard-money lenders have historically built these types of guards and escape latches into their deals, but certain protective mechanisms appear to be more common across the board. For instance, according to Kelly, sponsors are increasingly likely to be subject to business-plan covenants.
With these measures in place, unfavorable events during the course of the loan may trigger an additional equity requirement, more required recourse or collateral to offset the risk, or perhaps a certain level of loan amortization. Lenders that forego these options and wait until loan maturity to attack any problems, on the other hand, do so at their own peril.
‘If you're lending on a transitional real estate asset, you want to have a very high level of oversight over the property and the borrower's performance over your loan term,’ Kelly stresses. ‘You don't want to wake up at loan maturity and find out that the borrower was asleep at the wheel during your finance term. It might be too late.’
Prevailing opinion varies regarding the relative importance of borrower/sponsor profiles during the underwriting process. ‘We're generally not underwriting the sponsor's credit,’ says Rollins. ‘There's no relationship. It is purely asset-based, collateral-based underwriting.’
Others, like Kelly, cite a need to ensure the sponsors themselves will be able to operate under challenging conditions – particularly in the face of popular opinion that commercial property markets are in for a bit of a rough ride in the coming months. He suggests also examining property management personnel, leasing staff, construction staff and other peripheral parties.
Glick also recommends always considering both the property profile and the borrower profile, but he points out that analyzing the latter may be difficult if the borrower's existing net wealth heavily depends on real estate and its now-uncertain values.
Looking ahead
In addition the usual shrunken loan-to-values and inclusion of recourse, which will almost inevitably be found in a hard-money deal today, exit strategies have become a point of focus for creating reassurance and stability. Kelly reports a particular trend toward ensuring a certain level of cashflow on the property rather than simply looking at the takeout by the next lender.
During a dealmaking era that has highlighted the importance of strong relationships, putting together an acceptable exit strategy may include making a point to directly contact the parties involved with that exit strategy – before making the hard-money loan.
‘I think where private-money lenders are really going to take it in the shorts is when they don't try to figure out what their exit strategy is in the next 12 to 24 months by going to the banks and seeing which banks can lend – and will lend – on that particular piece of property,’ DeMeritt warns.
He reports that some banks have been receptive to such conversations, but their generally conservative parameters have informed Wilshire Finance Partners' own decisions on the hard-money loan. The company will not lend more than their takeout bank will subsequently lend and often max out slightly below that figure to guard against future property-value decline.
The conversation strategy may be appealing in theory, but practicality is a concern, according to Kelly. ‘I don't think you can really go to a traditional lender and see where they'll be in a year or two,’ he states. ‘Most of them, quite frankly, don't even know if they're going to have a job in the next week, and the market is still in a state of flux.’
Certain hard-money lenders may be keeping an eye on job security these days, too. The same set of conditions that has set the stage for the finance form's popularity also threatens many hard-money lenders themselves.
After all, just like any other lender, these firms require a steady, reliable flow of capital to continue operation, and ‘credit crunch’ is not a foreign term in hard-money land – regardless of the wide array of deals available.
Consequently, for hard money today, ‘It's really a tale of two cities,’ states Kelly. ‘You have well-funded hard-money lenders that are now seeing opportunities to do better assets at lower leverage and higher spreads. The well-funded hard-money lenders are in a position, like portfolio lenders, to carve out a bigger market share.
‘The other side of the story is that certain hard-money lenders no longer have access to capital to fund their businesses day-to-day,’ he continues. ‘While they're seeing an abundance of opportunities, a lot of their sources of capital have dried up.’ These firms have been forced to slow their businesses or close up shop altogether. Others have been sidelined by needing to spend too much time managing existing portfolios.
‘There are a lot of hard-money lenders that are now out of the market or are quietly going out of business, and that puts pressure on the business as well,’ agrees Rollins.
As boutique shops continue to pop up and seek to join the hard-money party – in spite of the closures – experience will likely dictate the ultimate winners and losers. The executives at the major hard-money firms agree that the majority of the latest batch of entrants will not survive.
Kelly predicts that in some cases, the hedge funds that initially backed the new crop of start-up hard-money lenders are now likely to view real estate as more challenging than anticipated – and thus move on to a more appealing sector of the market, leaving the lender in the lurch.Â
Additionally – and possibly less predictably – access to a quality attorney is invaluable for hard-money success, adds DeMeritt. ‘There are so many new rules and regulations coming out that it is almost impossible to wrap your arms around them,’ he warns.
