Since the onset of the pandemic, non-conventional lenders have faced two primary hurdles to making new loans.
The First Challenge
The first challenge has been a decrease in originations due to restrictions aimed at curbing the spread of COVID-19 and a reluctance of borrowers to move forward with purchase transactions. Their reluctance is due to uncertainty surrounding tenants’ ability to pay rent combined with eviction moratoriums. Commercial originations have slowed due to fear that rents will not be consistent nor sufficient to service a loan, especially in the retail, restaurant, and hospitality sectors. It should be noted that Geraci has witnessed a slow increase in the number of originations in the form of loan transactions that we handle each month.
The Second Challenge
The second challenge has been a reduction in available funds to make loans. Specifically, capital has been scarce for many lenders that rely on one or more of the following:
- Lines of credit from banks;
- Sales of loan portfolios to institutional investors; and
- Collateralized loan obligations.
With the trend appearing to be a gradual uptick in loan originations, limited access to capital becomes that much more of an issue. In order to free up funds to fund new originations, many lenders are turning back the clock to a time when non-conventional lenders often relied on raising their own capital through private investors, rather than looking to institutions. Despite the limited availability of capital markets, lenders can still leverage their existing pool of loans to create liquidity. The three most common leverage strategies are the sale of fractional interests, the sale of participation interests, and hypothecations. Which method is chosen will depend on the preferences and tolerances of the lender and its investors.
Selling Fractional Interests
Selling fractional interests in a loan is the most common approach utilized, as this structure is the easiest for both lender and investor to understand. This method is quite like brokering a multi-beneficiary loan; however, rather than the investor being named in the loan documents from the outset, the investor’s interest is documented post-closing. In a fractional sale, an investor is purchasing a direct ownership interest in the loan and loan documents, and therefore has a direct connection to the borrower and real property collateral. A fractional sale is memorialized at a minimum by an assignment of the mortgage/deed of trust and allonge to the promissory note.
While there is no prohibition against selling all of the ownership interest in a loan to multiple investors in the aggregate, many originating lenders opt to reserve an interest for themselves (please note that, as used throughout this article, “originating lender” means the lender that currently owns the loan(s), regardless of whether or not it was originated by them). The originating lender can sell the loan interests but retain the servicing rights so it can collect a spread between the note rate and the return being realized by the fractionalized lenders. This arrangement works well for originating lenders that have experience servicing loans, or at least working with servicers, since the originating lender can sell 100% of the loan, but still retain origination fees and collect a residual income from the monthly debt service.
This arrangement is not appealing to originating lenders that want to maintain complete control of a loan and realize any and all upside from a foreclosure. In addition, some investors may prefer to passively invest and remain anonymous, which is not consistent with purchasing a fractional loan interest.
Selling Participation Interests
On the opposite side of the spectrum from the sale of fractional loan interests, selling participation interests is a great vehicle for (a) originating lenders that do not want to cede any interest or control in the loans in its loan pool and (b) investors that wish to passively invest and remain anonymous. By selling a participation interest, the originating lender is only transferring a right to the income stream created by the debt service from the borrower.
The sale of a participation interest is usually accomplished through a participation agreement and certificate of participation. Since the subject interest is only in an income stream, participants have no connection to the underlying borrower(s) and the loans in the loan pool. The sale of participation interests is quite favorable to the originating lender in that performance is tied to the income stream from the underlying loan, but there is no actual or collateral interest given to the participant to ensure performance. As a result of the increased risk faced by the participants, they often receive superior terms in the form of priority of payment of their participation and/or a return that actually exceeds the underlying note rate.
Hypothecations
Simply put, a hypothecation is a loan secured by another loan. In a hypothecation, the originating lender obtains a loan from an investor, whose loan is secured by some or all the originating lender’s interest in a loan or multiple loans. Typically, the transaction is documented by a note, collateral security agreement, and collateral assignment(s) of mortgage given by originating lender in favor of the investor. The interest rate of the hypothecation note should be low enough that debt service from the loan(s) securing the hypothecation is sufficient to cover debt service required under the hypothecation.
Many investors prefer hypothecation to participation because it allows them to realize a return in the form of interest payments that the originating lender must pay unless the terms of the hypothecation make the originating lender’s performance contingent on receipt of payment from the underlying borrower. Hypothecations also provide the investor with collateral to ensure that the hypothecation is repaid. In order to mitigate potential liability, an originating lender will often limit the investor’s recourse to the collateral loan(s).
Additional Considerations
- The discussion of each strategy above only addresses their respective basic concepts. Since the transactions are highly customizable and often negotiated, there is really no “standard” transaction. There are only common threads that are present for each.
- All three vehicles for raising capital outlined in this article are subject to the applicable state’s licensing and securities laws and regulations. Since each method involves a security, the originating lender must either comply with registration requirements or be exempt therefrom. In addition, some states may require that the originating lender and/or investor be licensed in order to be a party to the transaction.
Conclusion
Although the pandemic has made it difficult for many lenders to access capital from institutional lenders and capital markets, there are options. The sale of fractional and participation interests in loans, along with hypothecations, offer an opportunity to capital strapped lenders to obtain funds by leveraging their loan pool. The desired strategy will vary depending on the proclivities of each lender and their respective investors. Even if the descriptions of each method do not seem to fit a lender’s needs, each one can be tailored to address them.
