Borrowers looking to increase their assets and diversify their portfolios have more financing options today than ever before. Yet securing the proper financing for a real estate project can prove to be challenging, especially considering investment strategy is not a one-size-fits-all approach. Investors can choose to borrow from a traditional bank or a private lender and it’s important to note the complexities of each to see how they fit into your overall plan. Let’s take a closer look at these two popular financing methods.
Borrowing from a bank
Bank lending is the most traditional and commonly sought-after financing strategy for commercial real estate professionals. According to a recently published report by the Mortgage Bankers Association (MBA), 2018 was another stellar year for commercial and multifamily mortgage originations with a 14 percent rise in borrowing reported at the close of the year. Additionally, a preliminary measure from the 2018 fourth quarter mortgage originations survey pointed to volume that was 3 percent higher than the record-breaking $530 million reported at the close of 2017. Multifamily, industrial, offices, hotels, and retail spaces ranked as the most in-demand properties contributing to this increase.
Research has shown that bank lending remains a popular financing strategy for most commercial real estate owners. Why? Many owners—especially those new to the business—believe the bank is the only place to get a business loan. Some have the notion that banks are more trustworthy than alternative lender options and that their standardized process is more efficient, but these misconceptions most often stem from a lack of experience with private lenders. However, working with an established bank is not without its merits. For instance, bank loans typically offer lower interest rates. This is due to their depositors keeping a steady cash flow across their checking and savings accounts—granting banks easy access to these funds for lending purposes. Banks pay minimal interest for these balances; in fact, most pay under half a percent today, making it even cheaper to use these funds. Additionally, all banks have access to federal funds with current rates at 2.5 percent. Today’s rate is much lower than in the past, when rates ranged on average anywhere from 4.0 to 6.0 percent, and even as high as 19.0 percent.
Banks have the ability to lend at a lower rate, but many rarely do. Why? Because at the end of the day, they are large bottom-line businesses, typically with a lot of overhead. Banks compare net interest rate spreads to set their rates. A net interest rate spread is the difference between the average yield various financial institutions receive from loans, interest-accruing activities, and average rates paid on deposits and borrowings. Banks will often set their interest rates just below the thresholds of their competitors to secure borrowers. This strategy proves successful because businesses are looking for the best possible deal for their own bottom line, even if it is only half a percent difference.
Choosing a bank loan may offer cheaper interest rates, but the process of securing this type of financing is much more difficult than alternative options. For one, banks have stricter loan regulations and often don’t lend to new business owners. They also have strict requirements regarding credit history, overall cash/liquidity flow, and debt-to-income ratios, sometimes turning down experienced developers and owners with solid business plans. In addition, banks push an overwhelming amount of paperwork because they require multiple levels of approval throughout processing, resulting in a more drawn-out loan process. If approved for the loan, banks will typically limit non-recourse financing to 55 percent of the property’s value. Borrowers may also be responsible for paying secondary fees, such as the costs of covenants and reporting requirements. Banks can play hardball with the terms of a loan due to the sheer volume of transactions done, meaning the process and the loan itself are less likely to be tailored to the needs of the customer.
Borrowing from a private lender
Private loans have recently become a popular alternative to traditional bank loans, especially for borrowers looking for bridge or construction financing.
As previously mentioned, private loans tend to have higher interest rates. This is because private lenders must set their net interest rate spreads at an inflated percentage in order to repay the bank or investors for the funds loaned. Though interest rates are higher, private lenders often offer flexible payment plans, and require less capital upfront, in comparison to bank loans, which can help mitigate some of the cost.
Additionally, securing a private loan can be a more efficient and streamlined process than a bank loan. For example, there aren’t strict parameters for lending, which enables both the lender and the borrower to work together to establish their own terms for repayment. This increases the borrower’s chances of approval, as private lenders are more willing to work on a case-by-case basis and rely on their intuition, putting less emphasis on blemishes in credit history, net worth, and liquidity.
Additionally, with private lending, borrowers are usually in direct contact with the decision makers that are responsible for making funding decisions—ultimately speeding up the application and approval process, as opposed to bank loan contracts, which must go through multiple tiers of extensive review before receiving approval. This time-intensive process often leaves borrowers scrambling to gather the proper authorization that will allow them to move forward with their projects. This also makes for a more personalized experience in private lending, as the borrower is involved in much of the process along the way. Furthermore, private lenders are more open to non-recourse loans, which allows borrowers to use the underlying property as collateral in a deal instead of personal assets.
Private loans can offer great benefits, but it’s important to note that a majority of them are designed for short-term purposes only. This means borrowers must show their project’s potential income and create a realistic exit strategy upfront. Also, in order to obtain the full amount of requested financing, borrowers may need to cross-collateralize, depending upon their loan-to-value ratios.
In the end, the loan type you choose is going to be dependent upon your overall business strategy. Bank loans make sense for plenty of established commercial real estate professionals. But if you are new to the industry or struggling to get approvals through traditional financial paths, you may be better suited to seek out a private lender. Whichever path you choose, it’s important to know your options and do your homework to achieve long-term success.
Ethan O. Schelin is president at Virtua Credit Corp., a subsidiary of Virtua Partners. He is responsible for managing the loan origination process when closing new investments and refinancing debt.