Times are exciting for hard money lenders and if you’re one of them you’re in for a surprise.
The commercial real estate market has all the signs of becoming overheated. There is a surging demand for commercial property which reminds financial analysts of the delirious boom in the mid-2000s. Analysts observe that banks are selling commercial mortgage backed securities (CMBS) at the fastest clip since 2008, thanks in part to a seventh year of near-zero interest rates that have investors lining up for higher-yielding securities
Even the Federal Reserve is warning about this frothy market that it helped to inflate.
Shaky borrowers are snagging commercial property and defaulting on loans.
The situation seems to be out of control and escalating. Bloomberg (August 10, 2015) told the sorry tale of a Wall Street developer in Ohio who snagged a $25 million loan amongst five dozen others, and like his predecessors, quickly defaulted – this time in six months. His loans had been bundled and sold to pension funds and money managers as bonds with ratings as high as AAA. His default caused the loans to be auctioned and bondholders experienced massive losses.
Stories, such as this, make analysts such as Richard Hill, a Morgan Stanley expert warn that Wall Street is financing increasingly risky property deals. Loosening standards, in turn, result in “faster defaults than what was observed prior to the financial crisis and potentially higher cumulative losses over time than the market may expect,” he said. Analysts and investors worry that this borrowing and defaulting pattern could be a harbinger of more widespread pain.
Banks that finance risky commercial deals
One such bank that has shown the trend of accepting riskier deals is Deutsche Bank AG. It has been among the most aggressive CMBS underwriters, posting the highest percentage of underperforming loans in the securities, 21 percent, among all U.S. CMBS deals sold in 2013 and 2014, according to Trepp data gathered by Nomura analysts. In fact, one can call its deals “pro forma,” which is defined by Moody’s Investors Service as an underwriting method that is based on “unproven, optimistic projections for future property performance.” GE underwrites about 5 percent of its commercial mortgages in this pro forma manner resulting, almost certainly, in loan liquidations.
One of the steps of this bank has been to load more bond deals with properties in regions that are not only less economically diverse but also slower to recover in a downturn. Investors who are saddled with such properties may find it difficult to retain them later.
Other commercial deals that insurance companies and banks such as the Deutsche Bank AG finance include risky transactions with retail malls in well-populated areas and with hotels in crowded urban markets. Shaky borrowers sign on and tremulously shrug off their loans as quickly as they’ve accepted them. Banks, learning from their errors, are starting to tighten their purse strings and more closely scrutinize potential buyers.
So where are buyers who have been shunned by banks to go? Hard money lending seems to be one of the few solutions.
Here’s the situation at the moment
The Urban Land Institute (ULI) Center for Capital Markets and Real Estate predicts that banks and insurance companies are expected to increase commercial mortgage-backed loans to $150 billion in 2017 (rising from $115 billion in 2015 and $133 billion in 2016). At the same time, Moody’s/RCA Index projects that commercial real estate prices will rise by an average of 7.6 percent per year, compared to a long term average increase of 5.3 percent, making it more expensive for investors to buy.
Simultaneously, the Federal Reserve has been talking about raising interest rates.
With many of these borrowers in the lurch, analysts are concerned that struggling lenders will be unable to refinance once the Fed starts raising their rates.
Once again, borrowers may want to consider hard money lenders. Hard money lending sounds the most feasible option…
Rising interest rates
Here’s the situation: In July 15, 2015, Federal Reserve Chair Janet Yellen stated that she saw improvements in unemployment and affirmed her satisfaction with companies such as Wal-Mart and Target that were offering wage increases to their employees. At the same time, she warned Congress of the threat of an overheated CMBS market in a still-recovering U.S. economy:
“Valuation pressures in commercial real estate are raising as commercial property prices continue to increase rapidly and underwriting standards at banks and in commercial mortgage-backed securities have been loosening,”
This may be one of the reasons why the Reserve intends to raise interest rates by December if not by September.
Higher interest rates mean lower borrowing power. So analysts predict that many investors will jump on the wagon and swallow up real-estate property before the Federal Reserve goes ahead with its step. Which leaves us again with risky deals, defaulted loans, and increasingly more banks tightening their strings.
The result is a tantalizing future for hard money lenders. Investors will want to jump into an attractive commercial market before interest rates escalate. Buyers will strain to maintain their grip on their commercial purchases but they will find their doing so increasingly shaky once the Reserve starts hiking its rates. Both types of borrowers may go to banks, but banks and similar agencies are likely to become more selective.
So tight lending creates opportunities for new lenders to get into the commercial hard money game and to profit from the situation.
In conclusion, here’s what Mr. Kohn chief financial officer at National Equity Funding Inc. has to say:
“We’re thrilled when the banks don’t lend. There is tremendous opportunity.”
Fees and interest rates may be higher than those of a bank, but prospective borrowers have no choice. Hard money lending is the future!