Capital Structures Used by Private Mortgage Lenders

Almost all private and hard money lending companies use external capital to run their business. In this guide, we’ll cover 5 different capital structures used by private mortgage lending companies, and how loan originators can find new capital providers.

This topic may not be of interest to people who are not in the mortgage business. If you’re a real estate investor, you may not care how your lender gets their capital. Most private lending firms have multiple sources of capital which they can tap for various types of loan requests.

It can be a lot of effort to figure out a lender’s capital source per each deal, and perhaps it shouldn’t matter to you. As long as you’re getting good service, competitive pricing, and the lender can execute, it may not be worth thinking so much about where the money comes from or what happens to your interest payments.

Many real estate investors visit our website looking for a private money lender who lends out their own funds and doesn’t charge any points. These are typically individual investors who only lend in their local market and they are not easy to find. The money comes from their personal retirement account, and at some point they will run out of funds to lend.

When you deal with a private lending company, also known as a hard money lender, you’ll probably never hear them say that they’ve run out of money to lend. If the loan request meets their criteria, they will likely have the money to fund the loan.

That said, there was a 6-month period in 2020 when a lot of private lending companies did not have the money to lend. This was the result of one capital structure, relied upon by many lenders, which faced a lot of challenges when the pandemic hit the United States. However, there were many other lenders that were still lending during that period, and this was made possible because they used a different capital structure. So if there is another major economic event, that may be the time when a real estate investor would care to know about a lender’s capital structure, because it may determine the lender’s ability to perform, and it could affect the pricing as well.

The 5 Private Lending Capital Structures

Capital Structure #1 – Mortgage Investors

With this first capital structure, the lender doesn’t need to have any of their own money. They just originate the loan and find one or more mortgage investors to fund the loan at closing. This capital structure may also be called “Table Funding.”

The mortgage investor is typically a private individual, but it could be a family office or an investment firm that wants to hold the note and receive the interest payments directly. In most cases, it’s one investor to one loan, but some lenders will syndicate to multiple investors who will each have a fractional interest in the note or deed of trust.

Some people consider this loan brokering, but many lending companies using this structure would argue that they are not a broker in this case because the mortgage investor doesn’t participate in the origination or underwriting of the loan and doesn’t charge any origination fees.

Some states which require lenders to be licensed will define certain rules with this practice. For example, when arranging a loan under a California Department of Real Estate license, you are considered a mortgage loan broker, and the loan documents have to disclose the name of the trust deed investor prior to closing.

Capital Structure #2 – Fund and Portfolio

Many lenders will close the loan using their own funds and keep it on their books to collect the interest payments throughout the loan term. The key element to this structure is the lender will likely have a revolving line of credit from a bank which enables them to grow beyond the total of their own cash.

Each loan may be pledged as collateral on the credit line, and the line is paid down as the loans are paid off. The lender essentially borrows money from a bank at a low interest rate, and lends it out to real estate investors at a higher interest rate to make a spread, plus origination fees of course.

Getting a bank credit line secured by private mortgages is not easy. The banks that offer this are typically small community banks that only accept loans secured by properties in their own state or region. Texas is one state where this is popular.

Not all lenders that keep their loans are using a bank credit line, but many lenders that have a sizable portfolio of loans likely have access to a credit line in case they ever run out of funds to lend. There are many capital providers out there that offer note-on-note financing, so a lender can always pledge some of their notes as collateral to get more capital whenever needed.

Capital Structure #3 – Fund and Sell

This is one of the most popular capital structures used by lenders. The lender funds the loan off their own balance sheet and will sell them to the secondary market shortly after funding, with no intention of keeping any loans on their books. They can make a spread on the sale, plus points and other fees.

For some lenders, their secondary market may be individual investors. For others, it may be a fund backed by insurance companies. However, most private mortgages today are sold to an institutional investment firm that buys hundreds of loans and packages them up to be sold to the public markets.

These firms are also known as Aggregators, or Loan Traders. Many of these firms entered the private hard money space around 2015 to 2016, and their appetite for private mortgages has grown enormously.

The main benefit of selling loans to aggregators is efficiency. As long as the loan fits the box, the sale process is streamlined so lenders can quickly recapitalize and continue to lend.

One potential downside is the capital is tied to Wall Street. So if there is a major economic event like what happened in early 2020, the capital may not be available for a period of time.

Capital Structure #4 – Partnerships

Most lenders have strategic partnerships with other private lending firms that can fund loans which are outside of their area of expertise, or loans that require additional capital which they don’t have.

For example, a lender that mainly does residential fix & flip loans may come across a large bridge loan request for a commercial property which is not in their wheelhouse. Or a lender in California may get requests for loans in other states which they won’t fund themselves, but they can originate the loans and still earn a fee.

The key distinction here is that both lenders charge origination fees, so it’s essentially a brokered loan. It’s rare to find one of these partnerships where the actual lender doesn’t charge any points.

Capital partnerships have existed in private lending for many years. However, this concept was taken to another level starting in 2018 when there was an enormous amount of institutional capital in the private mortgage space.

Many of the large national lenders began offering a formal partnership program where any mortgage broker or lender could use their institutionally-backed capital to originate loans nationwide. Some of these programs offer an opportunity to earn origination fees and an interest yield spread.

There’s a few terms used to describe these capital partnerships:

  • Correspondent Program – Many people have a problem with this term because it has a different meaning in the consumer mortgage world.
  • Table Funding – Some people define table funding as the first capital structure we mentioned, when the actual lender is just an investor who is not involved in the underwriting or processing of the loan.
  • Wholesale Lending – Broad term that is widely accepted

Each of these capital partnerships have different fee structures. I’ll write a separate article to cover this topic in detail.

Capital Structure #5 – Mortgage Funds

A mortgage fund seems to be the most desirable capital structure among private and hard money lenders. It offers the greatest amount of control and scalability. But pooling funds from multiple accredited investors is extremely difficult, and it takes years to build up.

When a lender launches a fund, they have to spend a lot of their time on capital raising, or they’d have to hire someone for investor relations. We’ve seen a number of lenders that start off with the one-investor-one-loan model, and then convert to a fund. These lenders have a head start because they already have the investor relationships.

Until the fund is well-capitalized after a few years, the fund manager is likely using one or more of the other capital structures mentioned earlier. However, even lenders with an established mortgage fund will likely have partnerships with friendly competitors, and if they come across a loan that doesn’t fit their fund’s parameters, they may take it to one of their high net worth investors to fund.

Most loans funded using a mortgage fund will be kept in the fund until payoff. It’s very rare for a mortgage fund to sell a loan, but we’ve seen a new trend in the past year where a lender will form a mortgage fund for the purpose of closing loans which will be immediately sold to the secondary market.

For the fund investors, it offers liquidity within 30 days. And the benefit to the lender is it’s a great alternative to getting a bank credit line which bears the risk of being pulled when there’s a credit crunch.

How to Find Private Mortgage Capital Providers

Most lenders use a combination of capital structures with a variety of capital sources. With all the capital flooding the private lending space, it makes sense for lenders to explore all their options.

If you’re a loan originator seeking additional capital sources, use our website as a resource. Our Service Provider Directory has a Capital Section with several different categories:

The capital providers pay us a monthly advertising fee to be listed, so there is no cost to make contact through our website.

May 12, 2021