Capital Markets

2023 Midyear Update

• by Eric Abramovich
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Squid Games and Green Shoots for Private Lending By Eric Abramovich The private lending industry emerged from 2022 battered but hopeful. At the halfway mark of 2023, we are really starting to feel the repercussions of Fed policy slamming the brakes on the economy. Just like the anti-lock braking mechanism of modern cars, where pressure is released and reapplied in a pumping fashion in order to stabilize the stop, the Fed is doing its best to slow the economy down without grinding activity to a halt. That said, the Fed has caused Wall Street to sneeze, and the private lending industry has definitely caught a cold. While there are signs of thawing with green shoots sprouting if we just look, it feels like we keep reemerging from the last round of squid games only to find that there’s another round left before we reach safety. As we look back at the carnage and the challenges ahead, we also wonder how long the malaise might last. Unlike the consumer mortgage space, which is having its own severe challenges in this environment, our nascent private lending industry has an even worse liquidity profile because it isn’t backed by the government agencies Fannie and Freddie. The institutional capital that came in gradually from 2013 and then quickly during the pandemic has rapidly retreated, creating a world of winners and losers — those with capital to lend and those without. Encouragingly, securitization markets seem to function at the right price, but a public RTL (aka fix/flip) deal hasn’t closed since January, mainly because the pricing offered is too high for private lender and borrower tastes. In stark contrast to the times when every lender had more capital than deals, the liquidity has now congregated around a few national lenders backed by well-capitalized insurance companies and less-leverage-reliant asset managers hungry to own the space. This has created a multi-polar world of sorts, where those not aligned to a strong pole are facing existential crises. The survivors are getting stronger even in the face of declining borrower transaction volume, buoyed by less intense competition from the fallout of their misaligned competitor lenders. But even for those aligned to the seemingly strong poles today, safety in the next round of private lender squid games is far from guaranteed. The Next Domino to Fall The banking crisis was the next domino to fall, and so far, the fallout and readthrough to our industry have been muted, with both risks and opportunities emerging. A year ago, some in the private lending industry all but dreamed of being acquired by a bank — with cheap permanent capital coming from stable deposits. The regional banks have also been providing much-needed liquidity in the form of warehouse lines to local and national lenders. The previously unthinkable bank runs are causing severe pain for those exposed, but for those aligned to the right poles, the retreat of banks is bringing back bankable real estate investors as borrowers. Further scarcity of capital has brought pricing rationality back to markets like California, where there was an almost perpetual bid on below-market-rate borrower loans. Table funders are reveling in providing liquidity to smaller lenders whose warehouse lines are constrained. It has been a mixed bag so far, but as if the banking crisis and the potential contagion aren’t bad enough, there is potentially an even more sinister evil spirit lurking in the background, which could be the next round — the ‘commercial real estate (CRE) bomb.’ While our discussion here is focused on private lenders that lend to residential real estate investors, with the impending maturity wall of loans against CRE quickly approaching, rates up dramatically, liquidity already scarce, and subsectors such as office and retail obliterated by pandemic trends — we need to stay cautious. Residential housing is showing very strong signs of resilience and holding its ground as an attractive investment, and while the negative perception seems contained to CRE, the fallout can lead to a vacuum where the relative value effect causes institutional capital to gravitate toward the most attractive opportunities. That is, an institutional investor might favor allocating capital toward deeply discounted distressed CRE assets versus residential assets that have barely budged from their valuation high-water marks. Are We Approaching the Last Round? It’s always difficult to call a market bottom or an end to a cycle. Surely the banking crisis has put us closer to the end, and usually, government intervention, this time via the FDIC stepping in and guaranteeing deposits, is a strong sign we’re approaching the last round. There are positive signals everywhere. Residential real estate transactions show surges in activity in reaction to slight downticks in mortgage rates, indicating a market buoyed by pent-up demand and lack of supply that is simply weighed down by affordability challenges, not crushed by them. Inflation is retreating, however begrudgingly, and there seems to be more chatter around rates coming down than going up. After a brief dark period for home builders, optimism abounds once again, and sales of new homes have been very strong. Fix/flip profitability signals, calculated as the difference between the buy and sale price on a 12-month hold, are as bad as they’ve been during the Great Financial Crisis — which is interesting as a sensationalist headline, but in reading between the lines, this looks like a bottoming out indicator. Coming into the Spring selling season, there have been sharp rebounds in HPA (Home Price Appreciation) in a lot of markets, and counterintuitively, some markets are now at their all-time highs. The green shoots are definitely sprouting, but only time will tell if this is a dead cat bounce or a trend with real legs. The mixed signals and crosscurrents are strong, but here at Roc360, we take the long view. We have focused on diversity of capital for our lending businesses and have built up an ecosystem for real estate investors. We’ve made sure to broaden our loan products while enhancing our ancillary products and services