In recent years, a cycle of growth has been fueling supply and demand in the private credit sector. As more consumers turn to private lenders, more investors provide capital, increasing the infusion of resources into the industry and encouraging healthy competition whose benefits roll back to the borrowers.
Records were broken in 2017 when the capital pool of global private debt exceeded $100 billion (US). Of this, direct lending funds contributed over $50 billion—more than double the previous year’s $24 billion. According to the global private debt report released by Preqin (a resource provider for global private assets) in 2018, “North America is the largest and most developed private debt market from both an investor and borrower standpoint. In fact, the volume of private debt issued in the US and Canada is roughly 4-5x the volume of private debt issued in Europe.”
The Canadian alternative lending landscape attests the soundness of the global statistics. Since 2015, private lenders have doubled their share of the mortgage market; as of November 2018, 8% of all Canadian mortgages were attributed to the private debt sector.
Benjamin Tal, Deputy Chief Economist of CIBC World Markets, Inc., stated that private lenders’ market share has grown by as much as 25% every year since the 2008 recession. As a reaction to the economic downturn, traditional lending institutions tightened the reins on the available capital, squeezing the market and driving them to alternative sources of funding. The growth of private lending has been on a steep upward trajectory since then.
Several factors have contributed to the meteoric rise of alternative debt in the marketplace. One is that private investments, in general, have been exceeding expected returns; conversely, more traditional investments like stocks and bonds have underperformed in recent years. Another is the insufficient supply of more affordable housing options, driving the market to more expensive property purchases. Lastly, the stricter mortgage rules enacted by the OSFI has made borrowing from traditional lending institutions much more difficult.
The demand has not ceased, however, and while the more stringent borrowing environment was successful in cooling the housing market, recovery has already been observed. Growth is expected to normalize as the industry adjusts to the new parameters. In the meantime, borrowers have begun to turn to alternative financing, turning the period of adjustment into one of many opportunities and increased market awareness for private lenders.
On the consumers’ side, one demographic has recently been utilizing alternative financing more robustly. Self-employed borrowers have historically encountered more difficulty qualifying for conventional bank loans, and with ever-stricter government regulations, proving their ability to pay back loans has become even more challenging. These independent freelancers, consultants, and entrepreneurs have a different cash flow and accounting system from salary workers in that it is customary for the former to declare more expenses to reduce their taxable income. This affects their ability to meet the debt-to-income ratio most banks require. Adding to the challenge, the OSFI’s stress test now requires borrowers to have a 20% higher provable income.
More SMEs are also turning to private lenders to fund both daily operations and expansion efforts. Purely in numbers, this little-served market is huge. In December 2017, there were 1.15 million small businesses and 21,926 medium ones, making up 97.9% and 1.9%, respectively, of all Canadian businesses.
However, despite the economic dominance of SMEs, traditional lenders still tend to favour big businesses. The cost of disbursing a $100,000 loan is the same as lending out $1,000,000, and with the increasing difficulty of meeting the demand for financing, banks are less inclined to serve the needs of smaller businesses.
Startups face even more challenges. Without well-established track records or sophisticated portfolios, founders and entrepreneurs find difficulty convincing banks of their creditworthiness.
The affected enterprises have thus turned to alternative financing services to bridge the gap. This explains the rise of crowdfunding platforms and venture capital; neither, however, are perfect solutions. Some businesses are too big for crowdfunding, especially digital, and too small to entice venture capitalists and equity investors. Private lenders, however, have different metrics for fund allocation and are able to provide more flexible and customized terms in return for collateralized mortgages.
Because of the tangible securities involved, the private credit asset class is naturally designed to serve the real estate industry, and thanks to the current lending conditions, borrowers are quickly wising up to the fact.
The real estate market saw immediate consequences following the introduction of more stringent stress tests requiring borrowers to qualify for higher interest rates. It was only in the tail-end of 2019’s first quarter that the industry began to show signs of recovery, with sales picking up and prices normalizing. However, despite fewer homes sold thus far, the amount of debt has actually continued to increase, with year-on-year mortgage credit growth rates consistently going above 3%.
Conversely, Canada’s five biggest banks (Bank of Montreal, Scotiabank, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and Toronto–Dominion Bank) are losing their share of the mortgage market to other types of creditors, with private lenders picking up most of the slack. As the Big 5 lost 2.7 points from 2017 to 2018, private lenders gained 0.8 points.
Property owners, buyers, and investors alike are being driven to private lenders, and they have varied borrower profiles. Debunking the myth that only subprime borrowers utilize alternative financing, even those with good credit and steady employment are turning to private creditors for quicker turnarounds in emergencies like urgent repairs. Young families who need second mortgages for renovations are also having a hard time qualifying for bank loans and are finding relief in private debt, and yet another type of borrower being underserved by the traditional market is the homeowner who needs bridge financing (e.g. they have purchased a new property but have yet to sell the old one).
Real estate investors are also benefiting from private credit. In fact, a 2018 report co-published by Realoshopy and Teranet found that municipalities with the most robust presence of investors also had the highest growth rates in private financing.
With economies maturing and more consumers needing housing, even Stephen Poloz, governor of the Bank of Canada, is calling for more creativity and product variety in the mortgage market, and established institutions like Canadian Lending, Inc. are stepping up to the plate by providing underwriting services that ease the burdens of private lenders and making funding more accessible to a larger pool of borrowers. This strategy of serving both ends of the market should encourage the continued growth of the sector.