Authored by Raymond Hu, Senior Investment Director – Head of Real Estate Credit
June 7, 2023
At one time, debt financing options for real estate projects were limited to traditional lenders—most commonly banks, credit unions, and life insurance companies. But during the late 1980s and early 1990s, the lending field expanded to include alternative lenders. These days, qualified private lenders can be a viable alternative to traditional lending sources, depending on the commercial real estate project and funding needs.
Both alternative and traditional lenders are in the business of issuing debt. That said, they differ in other ways. It’s important to understand these differences so that sponsors can determine the best financing strategies for their business plans and what loan options are available to them, especially in a challenging capital markets environment like the one we’re facing in 2023.
Traditional Lending—Stricter Requirements
Traditional lending institutions offer savings, checking, and investment accounts to individuals and businesses. Life insurance companies sell products and services and receive premium payments in return. These institutions lend money based on the amount of capital on their balance sheets and strict lending requirements.
Traditional lenders might also sell their loans to third parties, like Fannie Mae or Freddie Mac. While traditional lenders do offer recourse and non-recourse loans, more often than not, the debt is secured by a first lien position on the property that’s being financed.
One main benefit of borrowing from traditional lenders is that they can be stable, based on capital requirements. They can also offer lower interest rates, as they use property as collateral. Traditional lenders can also offer longer repayment terms than other types of debt.
The downside of borrowing from these institutions is that they must follow strict state and federal regulations, as well in-stone loan-to-capital ratio requirements. This means lending standards can be tight, which might make financing difficult for certain real estate projects. Another disadvantage is that such institutions offer low leverage loans which might not meet borrower’s capital needs.
As such, traditional lending sources can often be preferrable when purchasing or refinancing a core or core-plus profile real estate investment property. That said, given the Fed’s aggressive interest rate hikes this past year, many banks and other traditional lenders have pulled back and this is expected to continue for the foreseeable future.
Private Lending—More Flexibility
Not all properties fall under the category of core and core-plus. Because of this, they might not meet the criteria for traditional loans. This is where private lending companies can come in handy. Further, the commercial real estate market is currently experiencing a continued and growing disconnect in asset values versus the cost of capital. Because of this, we will see more investors moving away from traditional financing and looking to alternatives like debt funds in order to meet their capital needs.
Unlike traditional lenders, alternative private lenders obtain their capital from individuals or businesses looking for a higher return on investment. They typically invest in specific dedicated funds, which then offer creative financing options on real estate projects that are likely to offer acceptable yield.
Alternative lenders can offer more creative and flexible terms than their traditional lender counterparts. That said, these lenders can charge higher interest rates. Additionally, these products provide short-term financing solutions, rather than supporting long-term strategies. Private loans work best for projects that need a business plan (e.g., a value-add renovation plan, mark-to-market rollover, etc.) to achieve stabilized value. This lending might also be used on properties requiring a quick close. It’s not unusual for private loans to be refinanced into more conventional loans once they reach maturity.
In the current market, sponsors often seek bridge loans from alternative lenders for the acquisition or repositioning of properties on a timeline and within terms that work with their business plans.
Analyzing the Present Situation
Traditional and private lenders both offer loan options, which is the one thing they have in common. Otherwise, their capital sources, underwriting methods and sponsor requirements differ.
Traditional loans and private loans aren’t inherently better or worse than each other. Both financing methods have their benefits and downsides. Due to this, it’s essential to understand the property’s situation and needs before applying for financing.
Additionally, as traditional lenders are pulling back on their loan originations, alternative private lenders can bridge the “leverage gap” by providing B-Note, mezzanine, and preferred equity loans to borrowers. Another desirable characteristic of private lending capital is that it can offer non-recourse loans with discretionary capital. A balance sheet lender may not securitize loans—unlike many of the traditional lenders—which minimizes the interest rate risk to investors.
For questions or comments, contact our general information department at info@kimc.com.
