Alternative Lenders Spy an Opportunity in Banking Crisis
They'll still have trouble competing on scale with even regional banks
Take a moment and think about this: Imagine an alternate timeline where Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell chose not to coordinate a federal response to seize Silicon Valley Bank and Signature Bank amid their sudden collapse during the second weekend in March.
It’s a scary thought, but the likelihood is that, absent that federal backstop, more regional banks with heavily leveraged long-term debt securities portfolios — such as First Republic Bank, Zions Bancorporation and Pacific Western Bank — would also have failed. The threat of contagion would probably have spread through the banking system and caused some short-term economic chaos, if not long-term pain.
But, believe it or not, even in a hypothetical world without banks, there would still be a universe of institutional capital to keep the financial system moving along, at least as far as commercial real estate is concerned. Enter alternative lenders — or private lenders, or non-banks — the private debt funds that provide senior loans, mezzanine financing and even preferred equity stakes for commercial real estate projects all across the country.
“The deposit base is different,” Seth Weissman, Managing Partner of Urban Standard Capital, a real estate private equity firm, said of non-bank lenders. “For us, our capital [source] is sticky: pension funds, insurance companies, foundations, family offices. It’s not transitory deposit capital that can get pulled.”
The alternative lending space has been around for decades, but both the 2008 Global Financial Crisis and the ongoing regional banking crisis of 2023 — which saw Silicon Valley Bank, Signature Bank and Credit Suisse (CS) disappear within days of each other — have hastened the standing of alternative lenders in the eyes of a commercial real estate community seeking flexible capital for projects across various asset classes.
“The base of banks providing capital will shrink, and we believe there’s a big void for us to provide in leveraging other lenders,” said Josh Zegen, managing principal and co-founder of Madison Realty Capital, an alternative lender. He noted his firm and others like it specialize in whole loans, value-add loans, and buying performing and nonperforming loans.
“I think the shock to the system and the change in psychology and psyche [from this recent financial crisis] is not something that’s quick to reverse,” Zegen added. “We’re very much open for business.”
Weissman said alternative lenders like his firm are increasingly seen as more reliable partners than a regional banking system that has experienced multiple failures, mergers, runs and federally coordinated consolidations in three short weeks — and a near fatal collapse 15 years ago.
“If you’re a borrower that’s focused on counterparty risk, the perception of banks as necessarily reliable programmatic capital partners has thinned out over the last 10 years and really accelerated in the last week,” Weissman said on March 15. “People who need certainty of execution and speed of execution are looking toward the private market.”
To get a proper handle on the scope of the alternative lending industry — and where it could be going — one must go back to the fearful days of the 2008 Global Financial Crisis (GFC). In the aftermath of the financial collapse, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which, among other things, restricted commercial banks from proprietary trading, established new minimum capital requirements at banks, and imposed periodic capital-level stress testing at banks with more than $250 billion in assets.
This lockup of previously free-flowing liquidity had immediate ramifications.
Prior to the GFC, private capital markets had emerged on a small scale through the tentacles of North America’s largest private equity firms: Fortress Investment Group, Starwood Capital, KKR, Brookfield and Apollo Global Management.
Toby Cobb, co-founder and managing partner of 3650 REIT, an alternative lender, estimated that this handful of pre-GFC alternative lenders didn’t provide more than $5 billion in annual origination volumes across private capital markets.
But the post-Dodd-Frank landscape necessitated the creation of a new class of non-bank lenders that would feed the demand for commercial real estate loans in a world where interest rates spent nearly a decade below 1 percent. And so a more mature transitional lending business was born out of both the reluctance of commercial banks to make loans that would attract the attention of regulators and the need for that same capital to find a home in a resurgent financial system.
“Today there’s probably 40 alternative lenders of consequence, so it’s quadrupled in size,” Cobb said. “But it’s still relatively small, and I don’t think if you added up everyone in the top 40 alternative lenders that, cumulatively, there’d be $100 billion of equity invested [in 2022].”
Despite that small equity sum relative to the capital deployed annually by regional banks like First Republic (or even too-big-to-fail institutions like JPMorgan Chase), that $100 billion of collective alternative lender capital is able to do things that traditional banks either won’t or can’t do.
Alternative lenders are not regulated as banks, and this freedom has left many of them well positioned from a capital perspective now that traditional commercial real estate lenders have broadly pulled back, said one industry executive, who did not want to be identified.
This positioning has come in handy in a world of 5 percent interest rates, where sponsors have found it hard to secure the high-leverage loans that generate big returns. To account for this credit shortfall, the executive noted, sponsors have offered more equity in deals as loan-to-value and loan-to-cost ratios have fallen across the board for alternative lenders on real estate deals.
“It’s a good thing,” the executive said. “We’re putting out less money on each deal by underwriting more conservatively, but our returns are going up significantly because we’re charging higher rates.”
Ran Eliasaf, founder and managing partner at Northwind Group, emphasized these higher interest rates are offset by the certainty of execution and faster draw process that alternative lenders can guarantee.
“Typically private lenders are usually faster and sometimes more flexible on some terms and that allows for a more seamless execution,” Eliasaf said.
Cobb concurred on this point and said one of the reasons commercial real estate sponsors have become drawn to alternative lenders, despite the higher interest rates, is because of the stability these debt funds provide.
“The business model for the bank, at large, is ‘borrow short, lend long,’ and be wildly mismatched in your assets and liabilities for the life of your entity,” Cobb said. “The vast majority of liabilities for banks are deposits and the vast majority of deposits are demand deposits due back in a day. If everybody wants their money back at the same time, the banks fail.
“Our model is infinitely better, more stable,” he continued, using his firm, 3650 REIT, as an example. “A lot of our capital has 14-year liabilities to it. All of our capital has more than seven years [of] liabilities. We don’t borrow short and lend long — we borrow long and lend long.”
Perhaps the most effective fuel for the expansion of private capital markets is the allure from new borrowers across asset classes who are looking for fresh sources of capital and long-term partners.
“The opportunity [available] for alternative credit providers is that we’ll have the ability to work with stronger borrowers with higher-quality collateral at more attractive rates because of the pullback from small and midsize regional banks,” explained Nitin Chexal, co-founder and managing partner at real estate investing firm Palladius Capital. “Short term, we’re already seeing those opportunities.”
But not everything is shiny or stable in the world of private capital. Take Blackstone Real Estate Income Trust (BREIT), a $71 billion investment fund that limited investor withdrawals for four straight months beginning November 2022. BREIT funded only 35 percent of redemption requests in February 2023, according to Reuters.
Carl Fornaris, co-chair of the financial services practice at law firm Winston & Strawn, emphasized that banks will never be superseded by alternative lenders because of the attraction — and stability — banks carry of being a regulated depository institution whose deposits have a federal backstop hardwired into their business model.
“Companies need depositories, especially when you’re dealing with millions of dollars, and they need those banks to have those depositor relationships, and cash management,” Fornaris explained. “So alternative lenders without a bank license can’t do that, and that’s what separates them from depository institutions.”
What also gives the regional banking system an outsize importance compared to alternative lenders is another word commonly used within business circles: scale.
The $20 trillion commercial real estate and multifamily market is financed with $5.5 trillion of debt, of which 50.3 percent is provided by commercial banks, according to The Real Estate Roundtable, an industry trade group. The other half of that debt pie includes insurance companies, CMBS trusts and securitized vehicles, government sponsored entities (GSEs), the U.S. government, pension plans, and, yes, alternative lenders from private capital markets.
Urban Standard Capital’s Weissman admitted that regional banks and local banks will remain a critical part of both capital markets infrastructure and the small business economy.
“There’s a lot of loans that Chase, HSBC or Wells Fargo just won’t do, so you have really important banking institutions like a First Republic Bank or a Signature Bank that have an important role, especially for small and midsize businesses,” he said. “So a broader failure and pullback in that space is not good in the overall economy, frankly.”
But a pullback seems inevitable, especially after the events of the last month.
Justin Kennedy, co-founder and managing partner of 3650 REIT along with Cobb, said the recent regional banking crisis has “proven out the absolute necessity of the private lending industry” being part of the capital markets mix far into the future.
He said the ability of private credit markets to offer the full suite of asset management and underwriting capabilities, rather than just providing broker or syndicated credit originated by third parties, will place the industry on firm footing going forward, especially in middle markets.
“While I’m sure there will be voices out there that say private credit is providing a risk to the economy, there’s lots of risk out there, and having a more diversified set of funding, different types of capital sources, is a good thing for the markets,” Kennedy said. “If we were solely reliant on banks … the world would be in a much more difficult place than it is.”
Brian Pascus can be reached at firstname.lastname@example.org.