Private lending provides access to capital to real estate investors for their short-term goals. The perpetual question in the residential investment sector is: “Why does the raising of the federal short-term rate affect the rates offered by a private lender?”
The short and simple answer to this question is: “Because they are correlated.” Consequently, many private lenders have increased interest rates since mid-2022 when the Federal Reserve began to raise the federal funds rate (i.e. the interest rate that banks charge one another for lending excess cash overnight).
This article will speak to the effects of the fed funds rate on conventional (bank) and private (hard money) loans. The federal funds rate will directly affect investors in their private life.
On the side of business and the creation of wealth using private money, the effect may seem somewhat indirect but still reverberates through the private lending industry.
Key Takeaways
- Private lenders will continue to underwrite to their criteria, yet their interest rate could be affected by federal monetary policy through Q1, 2023
- Private lenders are not mandated to adhere to the requirements of Fannie Mae and Freddie Mac
- Conventional lenders do not advertise rates quoted to investors
- Conventional lenders advertise rates targeted to homeowners
- Private lenders are willing to be exposed to the risks that a conventional lender cannot
- The private lending market will remain steady during these uncertain economic times
The effects of federal monetary policies on conventional and private lenders are as diverging as the respective loan structures. Because of the institutional investors and the federal mandates placed on banks, traditional lenders are held to the standards of Fannie Mae and Freddie Mac.
Conventional loans must conform to these standards even if a loan remains on the balance sheet and is administered in-house.
A private lender does not have these restrictions. Some private lenders are funded solely by private investors and underwrite to its criteria. Their loan programs conform to the goals of their investors regardless of the prevailing federal policy.
However, there are other private lenders whose capital structure involves a bank credit line or the sale of loans in the secondary market (i.e. Wall Street) like conventional banks. These private lenders will realize an increase in the carry costs relative to these lines.
The offered interest rates may rise commensurate with this increase in the cost of capital. Also, the fed funds rate increase drove up the buy rate of Wall Street, putting pressure on private lenders to increase the interest rates charged to real estate investors.
The Interest Rates in Private Lending
The Federal Reserve raised the fed funds rate 7 times by an aggregate of 4.25% in 2022. With a rate increase of 25 bps in February and another probable quarter-point increase in March, the prevailing private lending interest rate range will most likely hover around 11% to 13% for Q1 2023.
Nevertheless, due to the relative liberation from stringent regulations, many private lenders will be able to continue controlling their approval process and the offered rates depending on their fund-raising channels.
Despite strong headwinds in private lending, numerous real estate investors still rely on private lending to get their real estate investments funded. An investor experienced in the residential asset class knows of the practical advantages of a private loan over the short term.
A private lender can maintain flexibility in working with borrowers to structure a loan program to fit the deal. The offered rate will be based on the perception of risk to a significant degree.
The loan program will be underwritten on the merits of the value creation and the experience of the borrower to create the projected value. A private lender adheres to its self-imposed restrictions with relative freedom from external influence compared to conventional bank lenders.
Interest Rate of a Conventional Lender
The interest rate offered by a conventional lender in the residential asset class is directly tied to the federal short-term rate. As of this writing, the short-term rate is 4.55%.
Generally, the spread between the short-term rate and offered rate is 1.5%-3%. Therefore, the offered rate will be between 6.05% -7.55% to homeowners with a high W-2 wage, perfect credit, and who will occupy the collateral as a primary residence.
The interest rate offered to investors is higher than that offered to homeowners.
Investors with a long-term hold objective will experience higher rates on the loans taken to refinance a private loan when the asset stabilizes. These long-term investments are refinanced with conventional loans because of the lower rate and carrying costs.
All conventional lenders must comply with the requirements for a loan program, structure, and approval process set at the federal level. Gone are the days when a traditional lender will loan on an investment property that depends upon a renovation scope to achieve the highest market value. It is not that a conventional lender will not; it cannot.
The value-add opportunity and the time to achieve stabilization are risks a conventional lender cannot take.
Comparing Interest Rates: Private vs. Conventional
Regardless of the investor base, all lenders calculate the interest rate from its measurement of risk. Unlike a conventional lender, a private lender will lend on the value-add opportunity. The after-repair value is a consideration of the deal’s merits, along with the experience and liquidity of the borrower. The borrower’s income and credit score are secondary.
These elements of risk are accepted by a private lender and will affect the interest rate. The investment objective of a private lender is the same as an investor with the fix-and-flip objective: to get in and out of a deal over the short term at the highest value the market will support.
Because of the above factors, the interest rates offered by a private lender will be higher for the important reasons given below.
- The investors funding a private lender expect, and are entitled to, a higher return rate due to the exposed risks
- Generally, residential real estate is considered one of the riskiest due to the uncertainty of the value-add component and the illiquid nature of the investment
- Private lenders offer a faster approval-to-closing process than conventional lenders, and investors should understand the value of this competitive position
Lowering the Private Loan Rate
Establishing a relationship with a private money lender is the best way to reduce the offered rate. Over time, the risks lessen as the credibility and experience of the borrower rise.
An investor new to real estate investing with liquidity and a deal with merit will not be cause for denial by a private lender. The chances are good that a loan will close, but the rate will be higher than if the investor had an established relationship with the lender.
In the environment of rising rates, time and building the trust of a private lender will compress the spread between the rates offered by banks and private lenders.
Recognizing the Lending Niches
The niche for a conventional lender is long-term, where the homeowner or investor is not looking to sell or refinance in the near future. The time factor is less important on a long-term hold.
The niche for a private lender (or a hard money lender, in industry speak) is the investor’s access to capital on a value-add opportunity over the short term. The acquisition of the property and the costs of renovation scope are a part of the deal’s capital stack and will close simultaneously.
Time is of the essence on a short-term hold to lower the cost of capital.
Also Read; Essential Loan Ratios Used By Lenders And Investors
Conclusion
The rate of a conventional loan to refinance a private money loan will be higher than what is advertised by the lender. However, given the uncertainty of the economy and fiscal policy, there will remain plenty of value-add opportunities with the strong demand for housing at low inventory levels.
In these interesting times, an investor with a long-term hold for cash flow will need to understand the effects of rising rates on conventional loans, the market rent rates, and on the lives of their tenants.
The raising of the federal short-term rate will not immediately affect the interest rates offered by a private money lender for the acquisition and renovation of collateral in the residential asset class.
The private lending market will remain steady in these uncertain times.
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