Debunking Private Banking Misconceptions

LOS ANGELES—Private lending has experienced wild growth over the past few years, thanks in part to increased banking regulations. According to Brian Good, president of Eagle Group Finance, banks aren't lending as much as people believe and private lenders are benefitting. While some investors are flocking to private lenders, the industry, as a whole, still has a bad reputation. To find out about this dichotomy, including why private lending is on an upswing and about the private lending due diligence process as well as how private lenders can revamp their reputation, we sat down with Good for an exclusive interview.

GlobeSt.com: You have been quoted as saying that there is a big "misconception" that banks are lending." Can you explain?

Brian Good: As the real estate market rebounded after 2008, people assumed the banks would fulfill their traditional roles as providers of debt capital. The banks often said, 'Debt capital markets are no longer frozen, we're flush with deposits and ready to lend!' But because of regulations like Dodd Frank and Basel III, the banks' real estate lending box actually shrunk, and traditionally safe loans couldn't get through a bank's credit committee even if the real estate itself was of high quality, those loans were still deemed 'riskier.' Even if a loan was approved, they are often forced to hold capital reserves (i.e. for every dollar lent out to earn interest, a dollar must be held in a reserve account by the bank against the loan) that made these types of loans less attractive for banks because they couldn't achieve an attractive return on that type of loan.

As traditional bank credit boxes have gotten smaller, many other players have stepped in to meet demand for debt. Just as firms like Eagle have filled the gap in real estate lending, vehicles known as business development companies (BDC's) have grown to fulfill the needs of middle market companies. People often confuse these firms with banks, but they are really private debt funds. They aren't restricted by the same covenants as traditional banks, and they don't slice up the loan into many pieces and sell it off. So if you need to renegotiate terms, you don't have to chase down a hundred people holding a piece of the loan. Debt capital is widely available, although the difference now is that it comes from a variety of sources. Historically, a bank was really the only place to get a loan. That's just not the case anymore. These "shadow bank" which Eagle falls into are now mainstream, and sometimes a first call for a needy borrower.

GlobeSt.com: What property types are the most sought-after by banks?

Good: Multifamily in A locations. These assets are perceived as the safest, which is hard to argue with based on increasing rent and occupancy. A bank lender knows that an apartment building in Santa Monica will have very little vacancy and strong cash flow. Additionally, Freddie and Fannie offer government backed loans on these type of assets which illustrates the confidence they have in this asset class. Banks are chasing these types of minimal-risk loans because they are the only types of loans that banks would want to keep on their balance sheets. It's not uncommon for a borrower to get a sub 4% loan on these types of assets. Of course we're in a very low interest rate environment, but there is also so much competition among banks for these types of minimal risk loans, putting downward pressure on pricing. Banks will still lend against office, retail and industrial property, but there is no doubt that multi-family is the strongest sector and perceived as the safest.

GlobeSt.com: Private lenders have grown tremendously in the past few years. Why are investors flocking to private lenders? What is the draw?

Good: It's really about execution and flexibility. A bank underwriting process is generally 60 days, sometimes more, and you can be inches from the finish line only to have someone with little understanding of the deal deny the loan because the bank has reached their quota for that property type or market area. Even if the borrower checks all the boxes, extraneous circumstances can easily jeopardize the loan, and this is incredibly frustrating for borrowers. A private lender can underwrite a deal in two weeks, have the loan approved by a small loan committee with an intimate knowledge of the transaction, and the deal is done with no headache. Moreover, private lenders can get creative with regard to structure. For example, let's say a developer/investor comes across an old vacant industrial building in an urban area seeing a high demand for creative office space. A conversion to creative office would eliminate cash flow, which is a major obstacle for a traditional bank. But after diving into the business plan, a private lender could understand the end goal and include an interest reserve in the loan, mitigating the cash flow issue. After a tenant is in place, the borrower would refinance the private loan with traditional long-term bank debt. B

Another advantage is that many private lenders, including Eagle, provide non-recourse loans, whereas most banks will require a full guaranty by the borrower. Naturally, this makes potential borrowers either uncomfortable or unqualified. We simply are not going to ask a borrower for 5 years of tax returns because it is irrelevant to our underwriting and due diligence – we are really lending against the value of the asset.

GlobeSt.com: Have increased banking regulations helped to bolster the private lending business?

Good: Yes. It is common knowledge now to borrowers that bank loans are harder to get. We don't see much in the way of traditional banks loosening their standards to attract new borrowers. They may be simply loosening their standards for the existing clientele only. So banks are not broadening their base, even though they have more money to lend. I really do not think there is such a thing as a "relationship bank" any more. All of this helps bolster the private lending business. We don't see banks softening their criteria to increase their borrower pool any time soon, and private lenders are picking up the slack in a permanent way.

GlobeSt.com: At Eagle Group, what kind of  due diligence and scrutiny does an investment and borrower undergo before approval?

Like most lenders, we have a very detailed closing check list which we distribute early in the loan process. The difference is we work the list very quickly, and have the ability to waive certain items should the need arise.

We focus primarily on the real estate securing the loan. We are an asset-based lender, so we are really underwriting the value of the real estate. We want to make sure there is an adequate equity cushion between our loan amount and the property value (generally between 40% and 60%). Our simple goal is to lend the money and get it back - we aren't interested in loan to own deals. When the loan-to-value ratios begin climbing up, the borrower is more inclined to turn over the keys at the first bump in the road. You need to make sure the borrower has some skin in the game. Aside from an appraisal, we'll have an environmental consultant perform a Phase I on the property to ensure there are no environmental issues, and the title report will show any liens encumbering the property. While we aren't interested in owning the property, we do need to make sure there will not be any issues in the event of foreclosure.

Although our primary concern is the collateral, we do look at the professionalism of the borrower. We pay special interest to the borrower business plan, and their previous success in executing on those plans. So we look at track record. We will run a credit report and litigation searches looking for glaring red flags. If a borrower has ever sued a lender, we will most likely not move forward with the deal.

GlobeSt.com: Private lenders don't always have the best reputation in the commercial industry. Why is that, and how can private lenders change the narrative?

Good: Traditionally, banks were able to accommodate most types of loans. If a deal was riskier, the rate increased, but the loan was done through traditional channels. A private loan was the last resort, when the borrower had no other place to go and was faced with a pretty dire situation. So you would see some colorful characters  engaging in immoral practices, charging exorbitantly high interest rates, taking advantage of a borrower's compromised situation. The bad reputation carries over from bad people engaging in these type of practices, unfortunately.

A lot of times a lender would make a loan with the intention of foreclosing on the property. The loan documents may include nebulous language that in effect make it incredibly hard for a borrower to satisfy the terms of the loan and therefore trigger foreclosure. Private lenders can change the narrative simply by engaging in ethical business practices. We observe the lender-borrower relationship as a partnership. The entire point of the loan is to help the borrower achieve a business goal, and it's in our interest that the borrower achieves that goal. If something comes up, a lender can  work with our borrower to resolve issue (extension, loan modification, etc.) as we service our loans.