When it comes to private credit, short-term lending significantly changes a lender’s risk equation.

That’s because time exposure is one of the most important and least understood drivers of risk.

Short-term lending doesn’t just improve liquidity, it also:

• reduces macro exposure

• enables faster repricing of risk

• limits downside from market dislocations

• enhances compounding through capital recycling

Short-term lending is even more desirable in volatile economies.

But the key variable in any loan is its duration.

What ‘duration’ actually means in private credit

The duration of a loan is how long capital is exposed to a single-risk environment.

In public markets, that duration is tied inherently to bond maturity and interest rate sensitivity.

But with private credit, it means the loan term and the time needed for the lender to recover their capital.

The two are not always the same.

The loan term is simply the agreed length of the loan – it may be six, 12 or even 24 months.

The time taken to recover the capital is precisely how long it takes for a lender to get their money back, including delays, extensions and defaults.

Even in short-term lending, this can differ markedly from the stated loan term.

That’s important because a lender can’t loan their money to a new project until recovering it from the old one.

The longer the duration of a loan, the longer it will be before that money can be redeployed and the higher the probability that there will be some kind of delay.

Delays in capital recovery create a mismatch between assets (loans) and liabilities (investor expectations) which causes a lender’s internal rate of return (IRR) to fall and increases the opportunity cost.

Short-term lending reduces exposure to market cycles

Economic factors play a significant role in the health of any loan.

The longer the duration of a loan, the higher the likelihood that it will encounter adverse market conditions.

For instance, an interest rate rise can put a loan in jeopardy and increase the risk of default.

The average US real estate cycle length is understood to run for between 7-10 years.

But even within those cycles, price corrections of 10-20% can occur within as little as 12-24 months.

Hence a 5-year equity hold must survive:

• interest rate shifts

• changes in demand

• liquidity contractions

Conversely, a 9-12 month loan will likely enter and exit between volatility windows.

Interest rate risk: The silent portfolio killer

Long-duration assets are highly sensitive to interest rate changes.

Short-term lending is not.

Recent events illustrate the risks.

• Between 2022-23, the Federal Reserve increased interest rates by 525 basis points from a base of close to zero. It was one of the fastest rate-hike cycles in modern US history.

• In that period, long-duration bonds (eg 10+ year Treasuries) encountered double-digit losses. The iShares 20+ Year Treasury Bond ETF declined more than 40% peak to trough from 2021-23.

• Many commercial real estate valuations declined 15-30% due to cap rate expansion.

Short-term loans greatly reduce the risk of being impacted by market volatility.

That’s because they:

• reprice quickly

• can be originated at new, higher yields

• avoid being locked in at outdated pricing

Flexibility in uncertain markets

Short-term lending offers lenders many more options when markets fluctuate.

They may:

• tighten their underwriting

• increase pricing

• reduce risk exposure

• pivot geographically or by asset type 

Conversely, long-term lenders are locked into assumptions made years in advance and must hope for the best.

The COVID shock in 2020 and the interest rate spike in 2022 are two recent examples of this.

Capital recycling and the compounding effect

A short-term lender doesn’t just earn interest – they also recover their principal and lend it again at market rates.

This repeated cycle creates a compounding effect.

Short-term lending enables multiple deployment cycles, thus accelerating their return.

A lender would rather loan money to three different borrowers, each of 12 months duration over a 36-month period, than lend it to just one borrower for the entire three years.

Here’s why:

Repricing opportunities – if interest rates rise, the lender benefits by gaining a higher yield.

Multiple lending fees – the lender can charge origination fees, exit fees and potentially extension fees three times instead of just once.

Reduced duration drag – the lender’s capital is not locked for as long if better opportunities arise.

Capital recovery – shorter cycles improve time to recover capital

The compounding process is best captured by IRR via velocity of capital and relies on:

• minimal downtime between deals

• consistent deal flow

• disciplined underwriting

Even small improvements in annual yield, when compounded, lead to materially higher total returns over time.

Risks of short-term lending

While short-term lending is preferable to many private lenders, it doesn’t come completely risk-free.

For it to be successful, it relies on:

• Loan terms being realistic

• loaning to experienced borrowers

• extensions being managed carefully when needed

But there are a number of risks.

Refinance risk – short-term loans rely on a clear exit strategy. But if the borrower cannot sell the property or refinance into a longer-term loan, the exit fails and the lender doesn’t get paid on time.

Execution risk – construction delays, cost overruns or poor project management can delay the exit or even see the borrower run out of money.

Collateral value risk – a fall in housing prices, weak markets or overestimation of ARV can make refinancing more difficult or lead to default.

Concentration risk – lenders with concentrated exposure to a single borrower, project type or area increase their risk in the event something goes wrong. 

Extension risk – many short-term loans don’t run to plan and are extended, reducing IRR.

Reinvestment risk – the flip side of fast repayment is that lenders must continuously seek new borrowers.

Foreclosure risk – forced exits in weak markets create the need for resources to be deployed in costly and time-consuming areas. 

Interested in private credit?

We remain in a higher volatility, higher rate, late-cycle environment.

Interest rates are elevated compared to the previous decade.

Bank lending standards have tightened and there is growing uncertainty regarding inflation, commercial real estate and regional banking.

Hence, despite the noted risks, short-term lending remains a highly desirable option for lenders.

That’s because it protects them from much of the volatility and offers them valuable adaptability when there can be few if any confident predictions about the future.

Opportunities abound for ambitious individual investors, family offices and experienced property investors seeking capital for short-term projects.

Central (Central Mortgage Income Fund - CMIF) is a California-focused private credit fund that originates and acquires real estate-backed loans giving investors consistent, risk-adjusted returns from short-term, senior-secured loans.

We put your capital to work by aligning you with targeted borrowers utilising carefully underwritten short-duration loans with first-position liens and conservative loan-to-value ratios (average 65%).

To learn more, contact Central today.

This analysis is based on comprehensive market data and industry research. Past performance does not guarantee future results. Investors should conduct their own due diligence and consult with qualified advisors before making investment decisions.