How Institutional Money has Changed Private Money
The private lending sector for real estate investing has exploded over the past decade. Also referred to as First Trust Deed investing, these loans are secured against non owner occupied properties with a first priority lien. These are short term loans with relatively high interest rates - currently around 10% annually. Due to the security of real estate and possible double digit returns, it’s no surprise institutional money wanted their piece. In just a few years, interest rates have decreased almost 50%. What’s this mean for the future of private money lending?
First, let’s review the interest rates and fees. Private money or Hard money is quite expensive compared to conventional banking rates. Our national average mortgage interest rate is about 4% currently, making private money 2.5X more expensive. Not too mention the origination fees, adding another 2% + upfront. This amounts to 3x more expensive to the borrowers or about 3x better returns on the lenders’ capital.
Next most important to note is the very short loan term, typically 12 months. Often times referred to as a Bridge Loan, these short cycles offer increased liquidity and flexibility for the investors. Having your capital tied up for less time is favorable to most investors, as you never know what future opportunities may come your way. Once again, given the high demand for private money, hedge funds have found a very desirable alternative to more publicly discussed options like the stock market and bonds.
Institutional money hit the market in a big way through the early years after the Recession. Influx of capital drove prices down, personally seeing average note rates drop from 12-14% to 8-9% within 3 years. This isn’t a bad thing, the real estate investors borrowing the money now have the ability to continue profiting on their projects, even as prices and competition continue to rise.
The issues start to happen when too many inexperienced capital sources get involved. Just like an amateur fix n flipper paying way too much for a potential flip property, inexperienced underwriting can cause the same issues. Since institutional money isn’t solely focused on real estate investments, they often fail at the ability to truly understand all the variables involved with each project. There’s so many nuances to be aware of in real estate and some could alter the investment greatly.
It’s not the institutions fault, with billions in assets under management, across various industries, it’s physically impossible to give the time and focus necessary to achieve success in each allocation area. Investment real estate is an industry that can’t be completely systematized, there will always need to be an experienced human component throughout the process. Being COO and a complete systems nerd, that pains me to say. A growing amount of experienced investors are seeing these institutional systems backfire, losing deals, time and money due to inefficiencies.
In real estate investing, these projects need more of a capital partner than just a capital source. This is most noticeable during the closing process, which typically is limited to about 5-10 days, sometimes less. Transferring all the paperwork,completing necessary reports, then reviewing and analyzing in such a short due diligence period means dedicated teams are an absolute necessity. The balancing of internal operations must be airtight. Institutions try to hedge the risk by incorporating loads more of unnecessary paperwork and over complicate the process. This is simply because they have too much capital deployment focus and not enough borrower and project focus.
There are many good things that come from big players getting in the game. Competition drives everyone to be their best and get creative with their approaches. However, when lender’s lose sight of what’s important - protecting the investment through rigorous underwriting - they may try to increase loans (sales) by opening up their underwriting criteria. In other words, lenders will finance worse deals just to deploy capital. This was a big reason behind our crash in 08-09’ and I wouldn’t be surprised if the private industry experiences a lesser version of this soon. The private lending industry fills a big void in our financial markets and isn’t going anywhere, but I do expect the amount of lenders to naturally filter out soon, leading to a more sustainable and steady investment real estate market.