Investment Analysis

Shadow Banking

With capital tougher to obtain, alternatives are cropping up.

After the 2008 financial crisis and the ensuing Great Recession, traditional lending sources were no longer able to make loans that had once easily passed through credit committee approval. As a result, the floodgates opened for nontraditional lending sources, stepping into the void left by the banks.

In 2012, commercial mortgage-backed securities issuance volume hit $48 billion, a fraction of 2007 issuance of $228 billion and tiny compared to 2013 commercial real estate debt maturity of $374 billion. While CMBS issuance has crept up since then, it is nowhere near pre-2007 levels, according to the Commercial Mortgage Report. The supply and demand imbalance has created an incredible opportunity for nontraditional debt capital providers. 

As private lenders and nimble debt funds began to form what is known as the shadow banking space, new challenges have emerged pertaining to risk management, as this was uncharted territory for regulators. Many lenders began making unsecured loans, and these loans represented a larger percentage of nontraditional debt as lenders pursued creative structures to meet the demand for capital. Enough time has passed to observe the risk of unsecured debt versus the relative safety of secured loans.

Securing Debt

While a personal guarantee from the borrower provides some safety for a lender, there is no doubt that it is easier to underwrite the value of real assets, such as real estate, equipment, or inventory, as opposed to gamble on a borrower's net worth.

Unsecured debt is exemplified by a credit card. A borrower can effectively delay repayment obligations for years until the lender files a notice of default. The lender, however, is not compensated at this point. The dispute is taken to the courts, where the judge could potentially decide that the lender is not owed the principal balance in full.

In contrast, foreclosing upon a real estate asset involves a notice of default, a cure period in which the length of time depends on state law, and the transfer of ownership through the lender's trust deed.

Unfortunately, some lenders may use this mechanism as a way to take title to a property by aggressive leverage and high pricing, often leaving the borrower with unlikely prospects of repaying the loan. However, most lenders simply want the principal returned, and the lender's ability to foreclose through a streamlined process gives incentives for the borrower to repay the loan.

Forecasting Outcomes

While all underwriting involves some combination of art and science, it is recognized as more objective to underwrite property than to underwrite a borrower. Anomalous situations aside, a lender can forecast a host of outcomes and structure the loan accordingly, while knowing the value of the underlying collateral.

On the other hand, it is very difficult to determine a borrower's net worth. Even if a lender can reach a well-supported net worth figure, it can be difficult to gauge liquidity and the borrower's ability to quickly repay the loan.

Since many loan requests require quick funding, sometimes in less than two weeks, a lender must underwrite the deal quickly. Digging through a borrower's tax returns, brokerage accounts, and other assets only delays the process.

Collateralizing real property by relying on an appraised value of property is a more efficient business practice when a lender is working with a borrower who must act quickly to capitalize on an opportunistic transaction. In this way, secured debt allows the lender to move quickly, a benefit that is passed on to the borrower. 

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Will McCabe

Will McCabe is investment associate/originator with iBorrow,  a direct lender specializing in private money loans for commercial real estate nationwide. Contact him at will@iborrow.com.

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