Keeping the Lending Cake Upright: How the Lending Industry’s Liquidity Crisis is Affecting Investors

Recently, when the Fed raised interest rates again, my company, an institutional real estate investment lender in the private lending community, was bombarded with calls from investors saying, “My lender suspended me for 45 days. They are waiting to see if Wall Street starts buying again!”

How can that happen? 

Rising interest rates are forcing everyone across the real estate investment lending spectrum to make quick adjustments. 

In this case, Wall Street banks, which purchase loans from lenders like us (who loan to investors like you), suddenly stopped buying those loans. 

This caused interruptions for some retail lenders who did not have enough of their own liquidity to continue funding (some discontinued funding temporarily, and others did so permanently.)

This, in turn, created a liquidity crisis for some real estate investors.

This is just one example of a lending industry in flux and its impact on borrowers. 

If you are an investor looking to ensure continuity in your project’s financing, it’s to your benefit to understand how money flows in the lending industry and what is taking place behind the scenes right now.

The Lending Industry Can Be Described Like a Cake

I’m a lender, not a baker, but I will use the analogy of a three-layer cake to explain how money flows in our industry.

The whole cake represents the institutional private lending industry. 

The cake’s three layers provide liquidity amongst themselves while minimizing the risk within the cake.

• Layer #1 (Top): Sovereign wealth, insurance money, large pension funds, endowments, overseas investors, and REITs (real estate investment trusts, such as MFA Financial, Inc. and Two Harbors Investment Corp.)
• Layer #2 (Middle): Private equity, Wall Street banks, and hedge fund companies (such as Blackstone, Nomura, and KKR). 
• Layer #3 (Bottom): Loan originators (like us) for retail investors (like many of you). 

When these layers function fluidly, everyone benefits. However, a disruption in one layer affects them all. When that happens, you—the investor—may not get your piece of funding to complete your project. If you do, it may not be at the interest rate you anticipated.

How the Layers Function

Layer #3

Loan originators (us) lend money to investors (you). 

We typically sell your loan to Layer #2, which provides us with cash flow to continue lending. For assorted reasons, some of us carry some loans on our books (smaller lenders cannot do this for long without running out of money.)

Layer #2

These companies are aggregators of all types of investments, including real estate whole loans. 

They buy high volumes of investments (with billions in buying capacity) from Layer #3, bundle them together into “securities,” and sell them to Layer #1 as “instruments.”  

Layer #1

Layer #1 companies’ primary job is to put money to work by investing in various asset classes. They analyze the projected return of each class daily to determine where to put their next dollar. Layer #1 tends to have lower return hurdles and longer time horizons on these investments, so they can buy the securities from Layer #2 at lower interest rates or price points. 

Co-Dependency: Interest Rates

As the cost of money (interest rates) rises, it affects all three layers, and each must adjust its return parameters. 

With inflation hovering around 9% and interest rates rising across all asset classes, asset managers in layer #1 continually review each class to find the best risk-adjusted returns available. (The risk-adjusted return is the return on capital one gets for the perceived risk in the investment.) They review factors such as treasury rates to determine how much premium they will receive for that investment over those treasury rates.

Layer #2, which also manages risk across many assets classes, can no longer buy whole loans from layer #3 at lower rates due to increased financing costs from their lending partners (typically big banks), and lower demand from layer #1 for their securitizations at current coupon rates.

So, layer #2 raises their pass-through rate, or “buy rate,” to layer #3, which must then increase the rate to their investor borrowers to make their spread.

The Layers Have a Liquidity Crisis

Since layer #1 drives a lot of the demand (liquidity), there is a traffic jam of loans on layers #2 and #3 as demand has waned. 

Layer #2’s balance sheets are overflowing with previously purchased lower interest rate loans. Because layer #1 now expects a higher interest rate, layer #2 is slowing down the securitization process.

Layer #3 lenders also have loans they cannot sell. If their balance sheet is large enough, they can carry those loans until liquidity returns. If not, they may need to halt investor draws, stop lending temporarily, or even close their doors. 

This overall situation is also causing delays in closings, lenders to disappear, reputable lenders to tighten their borrower pools, and loan brokers to fall behind, as lenders fund their preferred clients. 

As you may have already experienced first-hand, all of this is trickling down to you, the investor, in the form of higher rates, less loan security, and fewer loan options.

The Cake Flops (or Does It)?

Will this cake flop?

We don’t think so. 

At some point, layer #2’s ability to start securitizing loans will turn back on. But no one knows when that will happen, and in the meantime, a lot of lenders could be in limbo. 

How to Have Your Cake and Eat It Too

Here are some things you can do to make sure your next project gets funded and stays funded:

1. Build strong relationships with reputable lenders. 

2. Talk with your lender. (Be aware that not all lenders go through the layer #2 securitization process, including hard money lenders, private money lenders funding from 401(k)s and IRAs), and some lenders with finite funding capacities of $10 to $100 million that keep all their loans on their balance sheets.)

3. Underwrite your deal numbers accounting for interest rate volatility.

We do not know what impact the upcoming market and interest rate changes will have on lending. 

As an investor, the best thing you can do to mitigate the uncertainty is to work with a lender who knows their stuff and has the resources to have your back if and when things hit the fan.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.