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WHITEPAPER JUNE 2020
How Debt Funds Use Warehouse and Other Credit Lines
Background
Real estate investors and developers have come to rely increasingly on non-bank lenders since the Great Financial Crisis (GFC). Bank regulation has made banks much slower and less reliable as providers of senior loans, particularly for shorter-term loans, including bridge, renovation and construction loans.
Definitions: In this white paper, we will refer to such loans as “business purpose loans” (BPLs), to distinguish them from real estate loans secured by single family homes made to owner occupants, which are consumer loans. This white paper also applies to commercial real estate (CRE) loans, namely, loans secured by real estate other than 1-4 unit residential properties. Collectively, BPLs and CRE loans will be referred to as “investor loans.”
Meanwhile, real estate investors and developers value speed and certainty of execution. Because they intend to use such loans for relatively short periods of time, many borrowers are willing to pay relatively high interest rates on such loans– frequently 50+% higher interest rates versus what a bank would charge.
This demand for dependable loans, even if the pricing is higher, has made such loans a popular asset class for investors seeking attractive yields together with a margin of safety, and relatively low interest rate risk. Together, these factors have led to a thriving non-bank lending industry in real estate. In the BPL market, there are many lenders with more than $1 billion/yr of origination volume. In the CRE bridge lending space, there are lenders at or above $10 billion/ yr of origination volume.
Across the many hundreds of lenders in these two related markets, annual origination by non-bank lenders may be $100 billion or more, though there is little definitive research on the market. Oaktree Capital estimates the share of real estate loans held by debt funds and mortgage REITs at 10% of the larger $3.7 trillion mortgage market, or more than $370 billion.1
1 Source: https://www.oaktreecapital.com/docs/default-source/default-document-library/the-case-for-private-debt-in-real-estate-investing.pdf?sfvrsn=ae6b9265_7.
How non-bank lenders are capitalized
To fund these loans, and free up capital to make new loans, non-bank lenders use a variety of capital sources. We’ll discuss each of the following sources individually:
High net worth individual investors
Institutional investors
Warehouse lines of credit
Repurchase, or “repo” lines of credit
Securitization
High net worth investors
Many non-bank lenders started during or soon after the GFC, as banks retreated from making investor loans. The most common way that non-bank lending entrepreneurs raised money initially was from high net worth (HNW) investors. Frequently, such lenders established a fund and raised capital from Accredited Investors (as defined by the SEC) and used the capital raised to originate investor loans. The interest income from these loans was then distributed to the HNW investors, typically monthly or quarterly. This model remains viable and the author started one such fund in 2010.
In some cases, ultra HNW individuals–typically with a net worth of $1 billion or more– established or co-founded companies dedicated to making investor loans, using their own money to fund the loans. Examples of such companies in Los Angeles that were founded or co-founded by ultra HNW persons include Karlin Asset Management, which established Calmwater Capital; Hankey Investment Company; and Parkview Financial.
Institutional Investors
Many institutional investors realized soon after the GFC that investing in real estate debt could be an attractive supplement to their CRE equity investing programs. Investment managers who accessed pension fund and endowment capital early for their lending programs include Mesa West Capital (since purchased by Morgan Stanley); PCCP; and Canyon Capital Real Estate. These are just three examples of Los Angeles companies, among dozens around the U.S. pursuing similar programs.
All of these companies focus on CRE loans, not BPLs. BPL loans are too small to be worthwhile for these lenders, given their need to deploy billions of dollars of capital per year, and their aversion to building the large headcounts that would be needed to do so with small loans. These three companies specifically would probably not pursue a loan smaller than $30 million today, and their minimums might be closer to $50 million.
Along with their larger average loan size, these companies usually lend at lower rates, compared to the companies financed by HNW capital. Also, institutional investors have almost always viewed their investments in vehicles managed by these lenders as part of their CRE investment allocation. CRE investments are expected to generate annual returns in the high single digits or low double digits, because they are illiquid investments. Because these lenders charge rates in the mid-single digits, the only way to generate net returns (after fees) in the high single digits is to use structural leverage. We’ll discuss this topic in much more detail later.
Definitions
Structural leverage – for purposes of this white paper–refers to non-bank lenders using borrowed funds to finance some of their loan portfolios. For example, an investment manager that holds $1 billion of short term real estate loans to investors might borrow $600 million and fund the remaining $400 million with investor capital, in order to deliver a net return to investors in the high single digits. The $600 million of borrowed funds is the structural leverage in this case. We will also sometimes refer to structural leverage as “super-senior financing.” It is “super senior” in that the underlying loans are already senior loans (first liens on real property) and the provider of structural leverage is getting a first priority lien on these senior loans.
Warehouse lines of credit
Warehouse lines of credit (or simply, “warehouse lines”) are revolving lines of credit typically offered by banks to non-bank lenders. They are a form of structural leverage, as defined above. In the example used in the definition, a lender had a $1 billion book of loans and borrowed $600 million of the total. This could have been borrowed from a bank in the form of a warehouse line. Such lines typically use a borrowing base, whereby the non-bank lender pledges specific real estate loans (which we will call the “underlying loans”) and can then borrow a prescribed amount secured by each loan.
Warehouse lines provide several benefits to non-bank lenders. First, they help such lenders to avoid “cash drag” which reduces returns when there is too much cash in a lender’s portfolio, given that cash has a near- zero return. Second, it enhances returns by mixing investor capital, which is frequently seeking a higher return, with bank financing on which the interest rate is typically lower. Third, for those lenders who make renovation and construction loans, it provides a source of liquidity to fund construction draws, as the borrowers on the underlying loans improve their properties.
The same features that make warehouse lines so useful for non-bank lenders also make them operationally intensive for the banks that provide warehouse lines. Such banks need to have teams that understand these lines and may have many transactions every week involving such lines, as new underlying loans are pledged into the borrowing base; as other underlying loans pay off; and in some cases, as the dollars outstanding on underlying loans may increase as underlying properties are improved by their owners. Because of this operational intensity, only certain banks provide warehouse lines of credit. Two banks that have provided warehouse lines for non-bank lenders who specialize in BPLs are Western Alliance Bank and Wells Fargo.
Definitions
A borrowing base is a portfolio of real estate loans pledged to a bank or other provider of structural leverage. The non-bank lender can typically borrow a specific percentage of the value of the loans. For example, a borrowing base consisting of $100 million of loans may allow the owner of those loans to borrow $70 million from their bank lender. This would be referred to as an “attachment point” of 70%. Note that in this case the $100 million of underlying loans would be secured by real estate whose value is typically significantly higher, for example, $135 million. In this example, the warehouse lender’s loan would represent $70/$135 = approx. 52% of the value of the underlying collateral. Because the warehouse lender’s position is so secure, they can price their loans at a relatively low rate, making them more useful to non-bank lenders.