Are Risky Lending Practices Giving Alternative Lenders A Bad Name?
When Acres Capital founder and CEO Mark Fogel left Arbor Realty Trust, a publicly traded debt capital and mortgage REIT, following the Great Financial Crisis of 2008, he did so to fill a void left vacant by banks in the market.
The housing crisis had hit banks particularly hard, eliminating key players in the bridge lending space that would traditionally issue loans for commercial projects and ground-up developments.
“I realized, ‘Nobody is lending any money right now — banks are sitting on the sidelines and all of those bridge lenders that existed went out of business.’ I knew banks would never be the same,” Fogel said.
An expert in real estate finance, Fogel got the ball rolling in 2010 to start a firm that would raise funds to lend to markets sorely in need of debt capital. Westbury, New York-based Acres Capital was founded two years later to issue bridge and mezzanine loans for commercial real estate construction, adaptive reuse and renovation projects — all of which banks had taken a huge step back from post-recession due to stringent regulations.
Acres Capital is one of more than 100 alternative lenders and private debt funds active in the real estate market this year, according to Preqin data. The firm targets middle-market developers and sponsors in particular, and operates a portfolio of more than $750M through a series of closed-end funds and joint ventures.
“Ground-up construction is something banks are not necessarily doing these days. Because of the fact that the CMBS market is a bit slow and not as active as it has been in years past, you’re not seeing assets like retail or hotels getting financed so easily,” Fogel said. “You’re seeing a lot of groups that in the past ... bought real estate, cycle into the debt side of the equation and they’re seeing good yield from it because there’s not a lot of competition in certain asset classes.”
Higher loan-to-value ratios compared to traditional lenders have been flagged as a potential concern, but sources tell Bisnow this flexibility is what gives alternative lenders their edge.
“All the bank folks I talk to tell me they are having a hard time competing with debt funds these days because they may come in with fewer covenants — [meaning] fewer restrictions on a loan or what they can do,” Real Capital Analytics Senior Vice President Jim Costello said.
A recent Real Capital Analytics report revealed that roughly 20% of debt fund loans are originated at an 80% loan-to-value ratio or higher, which translates to higher risk profiles because those loans are only insulated from a 20% drop in asset values before lenders will experience a loss.
For more traditional lenders, average LTV ratios tend to hover around 60%, meaning the value of a property would have to drop more than 40% before lenders would see a negative return.
“I think what we're seeing is a return to leverage levels that were available pre-crisis, and I think that’s making some people concerned about the impact that a downturn in the real estate market would have on the overall global financial system,” said Adam Troso, managing director and head of Real Estate Corporate Advisory at Greenhill & Co., an investment bank in New York City.
However, Troso said leverage levels via debt funds this cycle are vastly different from pre-crisis leverage levels because alternative lenders operate in a closed system and do not impact the overall credit rating of other securities or affect banks’ balance sheets.
“What’s different this time is that these debt funds are making the higher LTV loans, but because those debt funds are private institutions and in a closed system, if an individual loan in a debt fund goes bad, too bad for the investors in that fund — but that loan is not part of a securitized pool that’s going to infect the credit rating of other securities,” Troso said.
Low Risk, High Returns Fueling Real Estate Debt Market
The commercial real estate debt market has become an increasingly attractive option for institutional investors on the hunt for low-risk, high-return investments to diversify their portfolios.
With property valuations at record highs, interest rates on the rise and uncertainty as to when this unusually long cycle will enter a downturn, being on the debt side of the capital stack presents less downside risk.
“Where we’re at, where prices have gone up quite a bit, the debt portion of the capital stack is actually very attractive for several reasons — one, returns are still good at this point, and two is it actually provides a little more protection [and] a little lower risk, because they are lower on the capital stack,” Altus Group Senior Executive Vice President of Advisory Rick Kalvoda said. “Any drop in [property] value first comes away from the equity, then goes down to mezzanine financing, bridge loans, then goes down to senior loans — which is where a lot of these debt funds operate in the lending space."
Pension funds, private equity firms, sovereign wealth funds and other institutional players are giving rise to the competitive real estate debt landscape through the launch of, and investment in, new funds. Even real estate developers like Moinian Group, Madison Realty Capital and RXR Realty are jumping into the commercial lending fray, picking up loans to help fill the void left by banks.
As of early 2018, there were roughly 112 active real estate debt funds on the market worldwide, according to Preqin data. Fundraising efforts in the space have been on the rise since 2012, with a record 56 real estate funds raising a collective $29B in 2017 alone compared to the $6.2B raised in 2012. Capital commitments have been largely focused on North American opportunities, according to Preqin, with European funds raising about $1.5B compared to the $5.4B raised by North American funds in May. Year-to-date, roughly 39 real estate debt funds have raised $19.8B.
A recent study conducted by Altus Group found that more than 82% of the 400 development executives surveyed are using at least one alternative lending vehicle to fill their capital stack. These debt funds have created intense competition for traditional banks, as debt funds are not subject to the same strict restrictions as banks — making them more appealing to borrowers in need of quick and more creative financing options.
“The banks are forced to make loans that fit into certain boxes that auditors can understand and underwrite, and that really limits the amount of creativity a lender or a banker can have,” Greenhill & Co.'s Troso said.
In terms of creativity, Troso said debt funds have banks beat because they have more underwriting flexibility when it comes to interest rates, leverage levels and collateral.
“Bankers pride themselves on being creative in their ability to structure a loan that works for the bank and the borrower. But when you have to explain hundreds of loans to your auditors in what seems like an ongoing process, it becomes harder and harder to be creative.
“And so, you do see debt funds that are not regulated able to be creative in the way they structure their loans. In many cases that doesn’t make it a riskier loan, it just matches the needs of the borrower … you’re seeing this flexibility and creativity become very attractive to developers and real estate entrepreneurs because they’re a better fit for their individual circumstances,” Troso said.