Paper house and stacks of coins standing

Allowing a Lender to Cross Collateralize Against Additional Property

By Edward Brown

There are times when a lender is going to ask for additional [real estate] collateral in order to make a borrower a loan. The most likely scenario for this is when there is not enough equity in the target property. Other scenarios include a borrower with less than stellar credit, or the type or quality of the target property may not be enough to satisfy the lender to make the loan, as most lenders are more interested in making loans that will pay them back instead of facing foreclosures. For this reason, the lender may ask the borrower to put up additional collateral satisfactory to the lender so as to give the borrower an incentive to avoid defaulting on the loan.

In many cases, this cross collateralization may not be something the borrower worries about, as the borrower intends to pay the lender in full. The general plan is for the borrower to refinance the target property at a point where a new lender does not require cross collateralization, pay off the existing lender, and the existing lender releases both properties; however, what happens when the borrower sells the crossed property, or has the opportunity to refinance the target property, and there is not enough to pay off the current lender who crossed?

The danger here is that the lender may hold up the sale because it does not want to release their lien until they are paid in full. For example, let’s say the borrower owns a rental house that is worth $500,000 and there is a first mortgage in place for $200,000. The borrower wants to buy another rental for $800,000 and has $250,000 to put as a down payment. The borrower asks a lender to loan the remaining needed $550,000, but the lender is not comfortable with the LTV [68.75%], so the lender asks what other real estate the borrower owns, so it can cross collateralize its $550,000 loan. The borrower mentions the other rental, and the lender decides to ask for crossing on the first rental. Thus, the lender has lowered its risk because of the equity in the first rental.

Now, let’s say that the borrower receives an unsolicited offer for the first rental of $525,000, and he wishes to accept it. If there was no cross collateral against this property, the borrower could accept the offer, pay off the existing first of $200,000, and pocket the $325,000 remainder. However, because the rental has been crossed, the lender has $550,000 against the property in second position. That means that there is technically $750,000 of liens showing up against the property. The borrower cannot accept the $525,000 offer without having the second [the crossed loan] release its lien.

For this reason, it is imperative for there to be an agreed upon release price in which the lender agrees ahead of time to release its interest in either properties for a specific sum. It does not necessarily have to be just the remaining equity in the first sale [$325,000 in our example]. The release price could be a smaller amount. It could also be a larger amount [up to what the lender is owed]. If the lender desires more than the $325,000, the borrower would have to come up with additional cash in order to transact the sale. This may not be all bad, as the crossed lender’s loan has then been reduced.

For example, if the crossed rental was sold at a 5 CAP rate, and the crossed lender’s interest rate was 7%, the borrower may choose to sell the rental and come up with money to satisfy the lender should the lender want more than the $325,000 net proceeds from the sale. In other words, there are times when it makes economic sense to come up with money in order to sell property. Another similar scenario like this occurs when there is a blanket loan covering multiple properties, as is the case when an apartment building has been converted to condos and the owner of the building desires to sell off one condo at a time. A typical lender on the building will usually have release prices [agreed ahead of time] under which the lender will allow each unit to be sold and the lender takes a specific amount [or percentage of each sale] as a pay-down of its loan.

The release price can be negotiated between borrower and lender. Because the lender did not take the new property alone due to the high LTV, many times the lender will reduce its pay-down to where it feels comfortable with a specific amount of its loan on the remaining property. To make this point clear, let’s say that the lender usually makes loans for rental properties at an LTV of no more than 55%. Since the new rental was purchased for $800,000, the lender would be fine with a loan balance of $440,000. Thus, in order for the lender’s exposure to be reduced from its original loan of $550,000, it may be willing to accept $110,000 from the sale of the first rental in order for the lender to release its crossed lien. In this case, the borrower would sell the first rental for $525,000, pay off the first mortgage of $200,000, and pay the lender in second position $110,000 [to release its crossed lien of $550,000], and pocket the rest of the proceeds from the sale [$215,000]. The borrower would keep $215,000 from the sale, and the only debt on the second rental would be the lender [who crossed] of $440,000.

Borrowers who overlook release prices [a specific clause in the loan documents] risk having to ask the crossed lender after the fact under what circumstances the lender would be willing to release the first property. If there is no agreement ahead of time, the borrower runs the risk of being at the mercy of the lender, as the lender does not have an obligation to release its lien for less than what it is owed.

Many lenders may be willing to work out a reasonable amount for releasing either property, as it is in the lenders best interest to reduce the borrower’s default risk. Having more than one property as collateral sounds good in principle, but the added exposure of having a loan spread out amongst more than one property may not be worth the risk. Each situation will be different, but, as a general rule, it is more conservative from the lender’s viewpoint to have a low LTV on one property compared to having crossed on one or more additional properties that have a higher LTV. Additional costs of foreclosure, if needed on more than one property, as well as having to deal with an existing first mortgage [keeping them current, so that lender does not foreclose] may not be a desirable solution to protecting the lender’s interest.

This is the primary reason why typical banks do not usually cross collateralize their loans. Most banks do not like a lot of moving parts. They want to focus on one property and the risk associated with it.

Borrowers should make sure that the lender does not hold any of the borrower’s properties hostage and that release prices are set at a point where the borrower feel comfortable.


Edward Brown

Edward Brown currently hosts two radio shows, The Best of Investing and Sports Econ 101. He is also in the Investor Relations department for Pacific Private Money, a private real estate lending company. Edward has published many articles in various financial magazines as well as been an expert on CNN, in addition to appearing as an expert witness and consultant in cases involving investments and analysis of financial statements and tax returns.

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A New Era Of Zero Interest Rates?

By Fuquan Bilal

We could soon be in a new era of zero interest rates. What will it mean for investors, the markets and you?

Could We Have Negative Interest Rates?

The president has been pushing for lower interest rates. We could even potentially see zero rates and even negative interest rates. The fed already recently cut key rates, and more reductions could come in 2020. This may sound crazy at first, but it has been done around the globe at various times and has worked.

While everyone enjoyed pointing fingers at different parties in the wake of 2008, one of the biggest factors that actually caused the crash was rising interest rates. If they get it right this time, lowering rates could help the economy remain afloat and avoid falling into the abyss again.

The Impact

The most widespread outcome of this is it costing people to have money in the bank. It probably already does when you add up all the fees and charges. Yet, when banks start charging every interest for having money on deposit, there is going to be a massive need to find somewhere else to park money and invest it. Real estate is of course a nice solid alternative. Cutting out the banks as the middleman and directly investing in mortgage notes and funds can also be a smart way to turn those losses into net gains.

Negative interest rates also mean it will cost banks and lenders to make loans. The negative interest is applied to paying down your outstanding balance each month. There are other ways lenders can make up for this money, but clearly they will be pickier about who they loan to.

Perhaps most significantly for investors, a new period of mortgage originations with near zero or negative rates means soaring appeal and demand for older higher rate notes, including nonperforming and re-perfoming loan notes. 8% and even 4% notes will become far more valuable.

Those who acquire those assets early stand to win big as this unfolds.

Investment Opportunities

Find out more about investing in secured debt and real estate, go to NNG Capital Fund

 


Fuquan Bilal

Fuquan Bilal founded NNG in 2012 with the principal mission of capitalizing on the growing supply of mortgage notes in the interbank marketplace. Mr .Bilal utilizes his 17 years of residential and commercial real estate success to identify real estate opportunities and capitalize on them. To date, he has successfully managed three private mortgage note funds that primarily invest in singlefamily performing and non­performing mortgage notes. His financial acumen and proprietary set of investment criteria enable him to purchase underperforming real estate assets at a deep discount of face and market values, thereby increasing the value of the assets. This, coupled with his ability to maximize the use of leverage, enables him to build strong, secured portfolios with solid passive income flows.

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So Many Ways to Buy

By Bruce Kellogg

#1 – Cash Purchase

This is the simplest method: write a check, wire the funds, etc.  But more needs to be known etc.  a) The investor needs to calculate their percent cash return on their cash invested in order to compare with other investment opportunities in front of them.  b) When buying with cash, try for a price discount.  Don’t pay “retail” unless you have to.  c) After buying with cash, take out a credit line on the property for security if times get tough.  Credit unions are good for this.  In tough times, banks often reduce or cancel credit lines, which makes banks unreliable when you need them.

#2 – Assume an Existing Loan

This involves applying to the existing lender to replace the existing borrower.  You will have to qualify as a new borrower, and pay fees.  In this low interest rate environment, it can be preferable to simply assume the loan.  Some commercial and private loans are assumable as well as institutional loans on 1-4 residential units.

#3 – “Subject to” an Existing Loan

Unlike formally assuming an existing loan, this method involves taking title to the property without disturbing the loan, and just start paying on it.  Conceptually, it is simple, but in practice it is not.  Most loans nowadays are “due on sale”, so if the lender finds out the property was transferred, they can “accelerate” the loan and call it “due and payable”.  They have the right to foreclose if they are not paid, or a satisfactory arrangement made.

#4 – Create Financing

When a property is purchased, the numbers have to add up.  If the down payment and the existing or new loans do not equal the purchase price, then financing has to be created.  Often, the seller will agree to “carry back” a created loan for the buyer to complete the purchase.  This “note” can be sold, often at a discount, or borrowed against by the seller, so they are not stuck with it.  Or, they might like it and keep it in their pension fund, for example. The terms of the loan are whatever the parties agree, as long as the terms are legal.

#5 – Create a “Wraparound” Loan

One really useful created loan is called a “Wraparound” or “All-Inclusive” loan.  This is where a loan is created that “wraps” or “Includes,” the existing loan(s), which the buyer executes in favor of the seller.  Usually , the “wrap” includes the part of the purchase price that is unpaid by the down payment.  It’s basically the “carryback” amount due to the seller over time.

There are a couple of benefits to the “wrap”.  First, it is a useful way to work with a “subject to” transaction, described above as being somewhat complicated. 

Second, if the “wrap” is written at a higher interest rate than the loan(s) enclosed in it, the seller will receive excess interest above what he is paying out.  Yields can be high with a “wrap” this way.

#6 – “Creative” Financing

This is where real estate gets “creative”.  By legal definition, personal property is any property that is not real property.  Examples of personal property are cash, corporate stock, gemstones, art, vehicles, promissory notes, and so on.  How about, instead of cash, use other personal property for the down payment?  A 4 carat diamond was used to purchase the Mt. Diablo Hotel in Contra Costa County. A mid – 1930’s 40 foot wooden motor boat (gorgeous woods) was used to acquire a triplex in Redwood City.  How about a travel trailer for a down payment?  Anything goes, sometimes!

#7 – Funds From a Whole Life Policy

In most cases, it is possible to borrow from a “Whole Life”  insurance policy and use the funds to buy real estate.  This can be investigated by reading the terms of the policy, and then discussing this with the company.  Repayment will be required, and reasonable interest will be charged, but it’s a good source of funds.

#8 – Invest Using Your IRA

Now that interest yields have been low for so long, people are moving to invest in real estate using their  Individual Retirement Account (IRA).  Investments can be made in real property or personal property such as notes, coins, paintings, securities, and so on.  Basically, the method is to move your IRA account to a “custodian” and have them buy, manage, and sell your properties at your direction.  Custodians are plentiful on the internet, and they have literature galore.  Leverage by borrowing from banks can be used to enhance the return in your IRA.  Your custodian can steer you to banks that offer to do this.

#9 – Cash to New Loan

The most common method of purchasing real estate involves the buyer putting up a cash down payment, then qualifying for a new, long-term “purchase money” loan from a bank, credit union, or mortgage broker.  Sometimes, the seller will make (i.e., “carry back”) the loan.  Usually an institution will fund the loan and either keep it in their portfolio, or, more often, they will bundle it with others and sell it as a security on Wall Street.  This replenishes their lendable funds.

Down payments vary.  Commercial loans are usually 20 – 40% down, depending upon the lender’s guidelines and risk assessment.  Owner-occupied, residential loans can be as low as 0 – 3.5% with mortgage insurance usually required.  1 – 4 unit investment properties typically require 20 – 25% cash down, but no mortgage insurance.  Lenders’ programs vary widely, including rates and fees, so comparison shopping is recommended.

#10 – Gifting

Purchasing as described in #9, above, many times offers the opportunity for the borrower(s) to receive a gift of money toward some, or all, of the required down payment.  Acceptable donors include “a relative”, defined as a spouse, child, or other dependent, or any other individual who is related to the borrower by blood, marriage, adoption, or legal guardianship.  A fiancé, fiancée, or domestic partner can also donate.

Lenders will want a “gift letter” signed by the donor stating that repayment of the gifts is not required.  Many lenders will require proof of the funds being transferred, so it is important to learn the lender’s requirements prior to transferring funds around.

#11 – Buy Defaulting Note, Then Foreclose

This method involves buying notes or mortgages that are in default at a substantial discount, then foreclosing to acquire the property.  Notes can be purchased through advertising on Craigslist, newspaper ads, direct mail to purchased lists, or websites dealing with note transactions.  Searching on the  internet will provide organizations with courses on notes.  This method can be highly profitable, but is quite sophisticated.  Additionally, foreclosing on a note usually does not afford the opportunity to conduct inspections, and a title search is essential.  Some states provide a “right of redemption” for the foreclosed borrower to recover ownership, adding further complexity and risk.

#12 – Tax Liens and Tax Deeds

In order to stay solvent, when  owners fail to pay property taxes, countries will issue tax liens or tax certificates which are sold to investors at a certain yield.  Depending upon the state, yields run from 6% to 36%, with 8 -18% being most common.  Under some circumstances, investors can foreclose and obtain ownership of the property.  Searching the internet under “tax liens” will produce teachings and organizations offering to help investors get involved.  Be advised, however, that this axquisition method is also sophisticated and has the same warnings as #11, above.

#13 – “Trade” or 1031 Exchange

A “trade” of real estate involves swapping one property for another.  An example would be if the owner of a vacant lot traded it with the owner of a mountain cabin, probably with some cash changing hands to even out the values.  One party might obtain financing, or one trader might carry back some “owner financing”.  Noteworthy here is that the trade is not a tax-deferred exchange, but just a swap.  These transactions are advertised on real estate and barter websites from time to time, saying “For Sale or Trade”, or similar.

A tax-deferred exchange is a transaction governed by Section 1031 of the Internal Revenue Code and is designed to defer long-term capital gains taxes for the “exchangor”, the one moving up in property.  The properties have to be “like kind”, such as real estate for real estate.  They do not have to be identical types of real estate.  For example, an airport hangar could be exchanged for a duplex.  However, they do both have to be either an investment property, or a property “used in a trade or business”.  So, a plumber who is retiring could exchange his shop building into a fourplex for retirement income.  However, an investment property CANNOT be exchanged into a property that is promptly turned into a residence after the close.  Capital gains taxes will be due.  The Internal Revenue Service (IRS) has issued “safe harbor” guidelines for a successful exchange, so real estate, accounting, and possibly legal experts need to be used.

#14 – Syndication

When investors get together to buy a property, it is commonly called a “group investment”, which is legally termed a “syndication”.  This is usually done to allow the purchase of a larger property and provide “passive” ownership benefits for the investors.  The common types of syndications are:  1) Limited Partnership 2) Limited-Liability Corporation (LLC), and 3) Tenancy-in-Common (TIC).  Each one has an organizer who usually becomes the manager of the project.  An “offering circular” is prepared describing the project, including financial projections, organizations, management, and risks.  Investors sign a “subscription agreement” and contribute their “share” of the project.  Syndicatiions are a “security” under federal and state laws, so there are regulations to be followed concerning marketing, disclosure, handling of investor funds, management, and reporting.  Larger projects typically require the investors to be “accredited”, which necessitates a substantial income and net worth.  Syndications are easy investments, but investigation of the project and the organizer is essential due to the potential for the promoter to take advantage of the investors through slick marketing.  Additionally, if the organizer is honest yet inexperienced, the project could fail.  Don’t be afraid, but be careful with syndications.

#15 – Equity-Sharing

Another method of investing with lots of potential is “Equity-Sharing”.  This is when an investor and a potential homeowner buy a single-family residence together, and the aspiring homeowner occupies it.  They are called the “resident co-owner” (RCO), and the investor is called the “investor co-owner” (ICO).  Percentage shares are negotiable with the RCO paying the property taxes, insurance, loan payment, and routine repairs, while the ICO puts up the down payment.  There is a “Shared Equity Agreement” or “Joint Ownership Agreement”, which sets the term, allocates the income-tax benefits, and specifies how the arrangement is to be wound-up.  One party could buy out the other, or the property could be sold and the net proceeds divided.

Equity-Sharing works well between relatives.  One Lockheed engineer has seven of these going to help his children, nieces, and nephews become homeowners.  College housing is another application where the son or daughter owns part of the house with the parents then rents bedrooms to other students.

#16 – Joint Venture

A “joint venture” is where two parties undertake a project together, such as a “fix and flip” of a property.  One party usually supplies the funds, while the other supplies the expertise and management.  This is often called a “rich man, poor man partnership” and is a great way to get started.  A “Joint-Venture Agreement” describes the arrangement.  These can be found on the internet.

#17 – Contract-of-Sale

The “Contract-of-Sale”, also called “Contract for Deed”, “Land Sales Contract”, or “Land Contract” is a method of acquisition that defers the buyer’s receipt of the deed (fee ownership) until all of the contract’s terms have been fulfilled.  Meantime, the purchaserhas what is known as an “equitable interest”, an interest under the contract.  It is a security device for the  seller who is financing the transaction.  It’s a good method for selling to a buyer with a low down payment or weak credit that can be improved over time.  Since it is a contract, foreclosure requires an action in court.  Additionally, most states have a “right of redemption” where the foreclosed party has a certain period of time to pay the arrearage plus costs and recover the property.  For a purchaser, it is an easy way to begin ownership of a property.  A good practice is to obtain a quitclaim deed and record it if the contract in not fulfilled.  This cleans up the title.

#18 – Shared-Appreciation Mortgage

When the market is appreciating rapidly it is sometimes difficult to convince a seller to sell on reasonable terms, or to carry back owner-financing.  One approach to this is to create a “Shared-Appreciation Mortgage” which the seller carries back.  Usually, it involves a low interest rate, but then gives the seller a percentage of the profit at the end of the loan term.  This approach also works well in a high interest rate environment because it helps the buyer achieve a reasonable cash flow to sustain the property.  A “standard form” for this type loan is not normally available, so it’s best to have an attorney draw one up, or customize an existing one.

#19 – Option to Purchase

An option confers the right, but not the obligation, to do something.  Real estate examples include the option to purchase, option to lease, option to renew, option to extend, and so on.  Usually, a prospective buyer negotiates an option to purchase when they want the property, but sometime later.  They give the owner some agreed “option consideration” for the right to purchase the property on mutually-agreed terms on or before a specified future date.  Option consideration is frequently cash, but it could be personal property, like a used tractor, or even “personal service” where the future buyer fixes up the property before buying it.  If the option is not exercised, the owner is entitled to keep the consideration.  A good practice is to obtain a quitclaim deed and record it if the option expires without being exercised.  This clean up the title.

Options are particularly useful for reserving properties without appearing on the public record until the options are exercised.  Developers do this to accumulate parcels without “tipping off” other players in the market that they are buying.  An individual can negotiate an option in an appreciating market and exercise the option later without the costs of ownership in the meantime.  It’s an excellent way to speculate, and fortunes have been made this way.

#20 – Lease-Option

A lease-option involves leasing and taking possession of the property being optioned.  Prior to exercising the option, the property can be occupied as a residence, or leased to a subtenant.  This is a way to “tie up” a property to take advantage of an appreciating market.

Another possibility is to enter into a contract-of-sale with an owner, then lease-option the property to a tenant.  If/when the tenant exercises the option, pay off the contract-of-sale, and realize a profit.  Option consideration from the tenant can be used for the down payment on the contract-of-sale, resulting in a (nearly) cashless transaction.  This can be done repeatedly as a business model.

Two cautionary remarks:  1) ALWAYS make sure the option and lease agreements are separate documents so a judge cannot order the refund of the option consideration to the tenant by characterizing it as a rental deposit.  2) Obtain a quitclaim deed any time an option is not exercised in order to maintain a clean title.

#21 – Master Lease-Option

This method applies primarily to commercial rehabilitation projects.  The idea is to find a building that has “gotten away from” its owner and become run-down with vacancies that are not being filled.  A “Master Lease” is negotiated with the owner to take over rehabbing and re-tenanting the building, along with an option to purchase the building before an agreed future date when financing the purchase is more likely to succeed.  Since the present owner is obviously short of funds, the purchaser will have to fund the project and receive a lower price or credit toward the purchase, or both.  It is best to have a real estate attorney draw up these agreements.

 

#22 – Adverse Possession

An interesting way to acquire a property is through what is called, legally, “Adverse Possession”.  It involves taking possession of a property and continuously possessing it for a number of years specified by state law.  The years vary by state from six to thirty, with California being just seven.  Possession has to be “open”, which means coming and going at will.  It has to be “notorious”, which means it can be readily observed.  It has to be continuous, so a break disrupts the timeline.  It also has to be “hostile to the interests of the owner”, which means overstaying an invitation by the owner does not qualify.  California also requires the possessor to pay the property taxes, as well.  If all conditions are met, the possessor will sue the owner in a “quiet title action” to obtain title in their name.  This situation occurs more with rural property, and is not common, but is fun to think about! See wikipedia to learn more.

#23 – Involuntary Methods

The other acquisition methods in this series are all voluntary, except two, which are involuntary.  These are: a) Inheriting a property and, b) receiving a property as a gift.  These are mentioned for completeness, but are too simple to warrant discussion.

#24 – “Leftovers”

There are three additional ways to acquire real estate which are more like techniques that can require no cash down payment.  Here they are:

“P-Note” iivolves giving the seller an unsecured promissory note for the down payment.  This works best if the parties know and trust each-other. But it’s a viable approach.

“Sweat Equity” involves the purchaser convincing the seller to allow them to fix up the property in lieu of a down payment while the seller carries back the financing.  Doing the repairs prepares the property to obtain a new loan and, at the same time, it secures the seller’s loan more as the repairs are accomplished.

“Personal Service Contract” Involves a purchaser providing some service to the seller in lieu of a cash down payment.  Examples include a plumber re-piping the seller’s residence, or a dentist providing dental implants to the seller.

These three techniques should probably be used with the help of a real estate attorney.

Conclusion

In many parts of the country, markets are tightening, and inventory is dropping.  Investors are finding it harder to make a deal.  While the 24 acquisition techniques presented here cannot increase the supply of properties, they can open up alternative ways to capture more properties that are available.


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Bruce Kellogg

Bruce Kellogg has been a Realtor® and investor for 36 years. He has transacted about 500 properties for clients, and about 300 properties for himself in 12 California counties. These include 1-4 units, 5+ apartments, offices, mixed-use buildings, land, lots, mobile homes, cabins, and churches. He is available for listing, selling, consulting, mentoring, and partnering. Reach him at brucekellogg10@gmail.com, or (408) 489-0131.

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Why Banks Do Not Lend on Certain Loans that Appear Conservative

By Edward Brown

Ever wonder why banks shy away from loans that appear to be relatively conservative?

There are numerous reasons banks avoid making loans that, in general, one would think have a high likelihood of paying back. According to a banker who works for a well known bank, during the mortgage crisis of almost a decade ago, one thread seem to run through all of the bad loans on the bank’s books; late payments on even the smallest of items, such as a department store credit card. This type of information led banks to steer away from otherwise good borrowers [after the mortgage meltdown], since the banks did not want to have borrowers who tended to be late or default on mortgages. Thus, a borrower who never missed a mortgage payment but may have been late on a small credit card was seen as a bigger risk for a future default on a mortgage should there be instability in the economy.

Banks are not in the business of taking over property and do not want to be seen as predatory lenders. Even if a borrower has a “good story”, banks would rather not even entertain a loan, which, on its surface, appeared to be more likely to fall into default. Banks are very cash flow oriented. They do not want to lend to borrowers where there may be a question of how a mortgage will be serviced. In commercial real estate loans, banks use a ratio called DSCR [Debt Service Coverage Ratio]. The DSCR is a measure of the cash flow available to pay current debt obligations [principal and interest in cases of a mortgage]. It shows the ability to produce enough cash to cover the mortgage payment. In previous years [before 2007], most banks required a DSCR of at least 1.1. For example, if the mortgage payment [including principal and interest] was $10,000 per month, the net cash flow [after paying normal expenses and before the mortgage] needed to be at least $11,000 per month. This was not usually an undue burden, as most real estate investors would have expected to have at least a break even cash flow after paying the mortgage. However, after 2007, almost every bank in the nation tightened up their standards to where they insisted on a DSCR of at least 1.25 and as high as 1.35. Although this may not seem excessive, the extra 15 to 25 basis point requirement severely restricted one’s ability to borrow. The investor found would have to put down a much larger down payment [thereby a lower loan needed] on the property in order to satisfy a much higher DSCR. Many real estate investors did not possess the mandated down payment and found they could not qualify for the new higher DSCR.

Another aspect that impacted banks’ ability to make loans to less than stellar borrowers is that they are similar to corporations in that they rely on their good ratings [from S&P and Moody’s for example] in attracting either deposits or floating paper themselves [through Wall Street’s ability to attract bond financing]. From a deposit standpoint, although deposits are FDIC insured up to $250,000, many banks that have lower than AAA ratings find they have to pay higher yields to depositors in order to attract money. From a bond offering standpoint, the higher the rating, the lower rate the banks have to pay their bond holders. If a bank makes loans that appear “questionable”, they risk having their rating lowered and it ends up costing them in the long run. They find it better to avoid loans that may potentially give the bank a blemish, even though they would have earned a higher yield on the mortgage being provided to the borrower who appears to be below triple A in terms of ability to repay.

Most banks work off of a fairly slim arbitrage [due to competition], so it is not worth having loans in their portfolio that appear riskier. When a loan goes onto a “watch list” or goes into default, more of the bank’s resources are tied up and not available to be deployed into new loans. Loans that are put onto the “watch list” would be those loans in which the loan to value is not as strong as the bank had originally determined. Although the borrower may not be late on any mortgage payments, the value of the property may have declined to where bank auditors have determined that there is a more than likely potential default. For example, if the bank made a loan on a property two years ago for $100,000 on a property that had a value of $150,000 at the time the loan was made [67%], the bank would set aside a certain amount of reserves as prescribed by the FDIC. However, if the property declined in value to $117,000, the $100,000 loan [presuming the loan was interest only] now stood at over 85% LTV [Loan to Value]. Under this scenario, the bank would be required to set aside more reserves. This creates a problem for the bank in that this means less money for the bank to lend out, as the extra reserves ties up more of the bank’s capital and less is available to make loans. If the loan actually goes into default, substantially more reserves are needed to be set aside. After the mortgage crisis, stringent guidelines were handed down to banks, as the Federal Government did not want to bail more banks out. Thus, most banks found it was just not worth using their resources for potentially non-income earning activity.

There is a lot of activity in the lending arena as the economy has strengthened, and interest rates are still attractively low. With the numerous requests for loans, many banks are finding that they do not need to attract borrowers. They do not want to spend time having to explain to auditors [or even bank board members] why certain loans are being made when they have many “slam dunk” loans that are “cookie cutter”. Banks are finding that they cannot charge enough to the borrower to justify the extra time, expense, and risk to make a typical “non-bank” loan.

An alternative to conventional financing can be found with private lending companies. Private lending companies do not have the same reserve requirements and will generally provide loans with much less hassle and more expediently. These private lending companies are more interested in “equity based” lending, meaning that they are more interested in how much equity is in the property at the time they make the loan as compared to the DSCR or credit issues of the borrower. This provides the private lending companies an opportunity to fill a gap where the banks have left off – loans that are not generally considered risky but still need funding. However, the price of capital is higher because the private companies do not have the same access to capital that banks do. They cannot provide FDIC insurance to their capital resources; thus, they have to pay a higher rate than depositors of banks. In conjunction with higher access to capital costs, these private lending companies must charge the borrowers a higher [than bank] rate for the money. The benefit to the borrower is the access to otherwise unavailable capital; in addition, the borrower usually does not have to jump through as many hoops as applying with a conventional bank and will almost certainly be able to borrow in a shorter time window. Many borrowers find borrowing from private lenders worth the extra cost.

Of course, if time is not of the essence, a borrower should first attempt to obtain funding from a conventional lender; however, borrowers should not be dismayed if they are turned down by banks. Alternative sources of capital are available for funding requested loans. One only need to do a little research. Many mortgage brokers, who deal with banks, also know of private lenders. If the borrower is able to go direct with a private lender, there may possibly be a cost saving to the borrower as there is one less mouth to feed; however, many times, the mortgage broker can assist the borrower with expertise as to the pricing of private loans and which companies are reputable and which are not.

In bring a deal to a private lender, the borrower should be careful not to do a shotgun approach, which is to say that it may hurt the borrower in the long run to try many brokers at the same time for the same request. One may think this is the best way to obtain financing at the best price due to attempting to force competition, but, many times, it backfires on the borrower, as some brokers broker to other brokers. What often happens in this scenario is that there may be a chain of brokers involved, all adding their fee into the loan. A two point deal may turn into a four point deal because, by the time the loan reaches the final funding so many brokers claim they had a hand in the deal and all want to get paid. The borrower may find that a better plan of action is to find one good broker who is well connected with an array of lenders. Many times, this broker will know ahead of time what terms the borrower can expect and communicate this with the borrower, so there are no surprises. Some brokers specialize in construction loans [as due some lenders]; some will not touch personal residence loans due to the Dodd Frank regulations. It is best for a borrower to seek out a broker who is well versed in the type of loan that the borrower seeks.

 


Edward Brown

Edward Brown currently hosts two radio shows, The Best of Investing and Sports Econ 101. He is also in the Investor Relations department for Pacific Private Money, a private real estate lending company. Edward has published many articles in various financial magazines as well as been an expert on CNN, in addition to appearing as an expert witness and consultant in cases involving investments and analysis of financial statements and tax returns.