California Real Estate Squeezing - Private Lending to the Rescue

Since 1968, Southern California’s population has grown from under 10 million to more than 22 million. California’s robust economy, diverse culture, and advantageous weather attract and retain many of the most talented people in the world. Many firms choose to base operations in such a rich employment pool, and the workers who fill this job base are not lacking in this region of the US.

However, California’s housing stock does not currently match up with what is needed by its population. Close to the best jobs in places like Los Angeles and the San Francisco Bay Area, housing was largely developed in the decades after World War II, and lack the function and space planning that today’s market demands. Many neighborhoods in prime locations were designed with very low density, resulting in too little housing near the best jobs, and too many commuters on the heavily taxed freeways.

A housing squeeze is definitely in play in these regional markets. While hundreds of small developers are busy renovating and repositioning this functionally obsolete housing stock into modern housing and higher density, something both buyers and elected officials desire, there are real challenges impacting this effort. One of the most serious obstacles these developers face is lending options.

In the wake of the financial crisis of 2008, and amid increasing regulatory reforms and burdens, many banks have all but ceased lending to smaller players. Typical residential development loans in this segment require between $400K -$2M to renovate and resell these urban properties at attractive returns. Bank lending to developers who specialize in this segment has receded, or requires too long a processing time, too much liquidity, assets, or income to be feasible. These small developers need reliable financing and, given the attractive profitability of their projects, can afford to pay significant returns to their lender. This fact is compounded by the current situation in which banks are not well-positioned or inclined to service their needs.

THE REAL ESTATE RENAISSANCE

Enter the private lending solution. With such small scale urban development crying for support, firms with the infrastructure, knowledge, and network necessary to find and fund these projects are well-positioned to deliver attractive income and returns to investors with modest risk exposure. By creating a basket of loans on solid projects with talented developers, originated and managed by a team of experienced portfolio managers, investors can receive attractive monthly income with a significant margin of safety and low correlation with most other investments.

How does this work? Private funding can fill the bank void for small developers by structuring senior short-term loans while maintaining a significant cash equity cushion to provide investors with downside protection. In the past several years, firms with the experience and connections required to fulfill this lending void have begun thriving, and investors are starting to take notice.

The objective of an investment in a portfolio of loans to small urban developers is to create positive monthly income while protecting the investor from loss of principal in case of changes in the market or failure of one or more borrowers to execute. The manager must take actions to mitigate the main risks of the investment strategy, which might include:

• Failure in assessing fair market value of a property

• A large drop in the immediate market area where an investment is located

• Borrower not completing the project due to lack of capital or some other reason

• Losses due to fraud or some other defect in the documentation of the loan.

Firms with the ability to source, assess, and manage their lending portfolios can avoid many of these risks and provide their investors with returns in the high single digits/low double digits with attractive liquidity.

THIS GLASS IS DEFINITELY HALF FULL, NOT HALF EMPTY

Private lending is growing both in sophistication and application across the spectrum of middle market financing. In this niche of small-scale real estate development, we believe that overall, supply and demand trends are likely to continue. Simultaneously, banks are unlikely to encroach on this market, as they have clearly indicated their reluctance to participate in such projects.

On the other side, we see a strong and committed investor base as well as many repeat borrowers who continue to uncover development opportunities. With interest rates near zero, investors looking for income have few good options. We believe we have built a vertical organization that can successfully navigate these twin goals of providing loans that solve developers’ issues with investment vehicles that deliver attractive income, returns, and liquidity profiles to today’s investor.

LEARN MORE ABOUT HOW THIS MIGHT WORK FOR YOU

Please join us for the second installment of a free educational webinar series with experts discussing how to best evaluate the options available as well as details on specific strategies that are working today.