Since 2009, Fannie Mae lending guidelines for mortgages have tightened. Since FHA is conservator over Fannie and Freddie and approves changes, most of the mortgage market is controlled by the government.
Now, loans require 20-25% down and require a 740 credit score. The best rate requires LTV of 60 percent, 700 credit score, the home be located in a market with no ‘adverse market delivery charge’, and the house must be owner occupied (no investors).
Causes
Here are the problems with these guidelines:
19% of owners who previously qualified will no longer qualify under new lending requirements, according to Laurie Goodman, Senior Managing Director, Amherst Securities. This means that we have 80% of the buyers available to purchase a home than we used to.
We also have a booming shadow inventory of homes.
The increasing shadow inventory leads to increasing time to turnover and decreasing sales, as shown by NAR data.
Consequences
From my experience as an auditor at a mortgage servicer, I can tell you that I expect a surge in new shadow inventory will continue to occur based upon existing 30-90 day delinquency rates of over 50% on the Alt-A and Subprime inventory that was in the portfolio of my company. I could literally visualize a tidal wave of new defaults and soon-to-be REO properties rippling through the company in the next 6 months if delinquency rates are not quickly reversed.
Given that mortgage servicers cannot modify loans nearly quickly enough to match mounting delinquencies; I see the number of foreclosures increasing in the near term. In addition, if unemployment, the largest driver of housing, does not get better soon, then we should expect the heightened rates of delinquency to foreclosure to REO to continue for quite some time.
It should be noted that the foreclosure timeline, or the time it takes a property to progress from the first day of delinquency to the completion of legal foreclosure proceedings and introduction into REO status varies by state, with some processes taking a year or more. In addition, the foreclosure timeline has been elongated by some state governments with ‘right of redemption’ rules, essentially giving the borrower one last month or two for a ‘hail mary’ pass to find funds to stop the foreclosure before the lender takes it back into REO inventory.
This means that we have a lag time between high unemployment and the subsequent drop-off in foreclosure activity of at least several months to account for impending foreclosures already in the system. So even if next month’s NFP numbers show 250,000 new jobs created (which is a stretch based upon current economic numbers), delinquencies and foreclosures would continue at their current pace for several months after a sustained job recovery.
As expected, Laurie expects 11 million new defaults based upon her data from Corelogic and Amherst Securities, which does not surprise me.
Based on expected future demand for new units, Laurie estimates we need to create an additional 3.6 – 5.7 million unit demand over the next 6 years.
Case Study
I am a real estate investor with 10 years experience in rehabbing, managing, and selling properties. I recently examined an investment deal that was squashed by the new lending rules and will prevent the rehabilitation of potentially hundreds of other properties in my town. This is extremely important because as I noted above, there are 20% less purchasers on a swelling inventory of available housing. Investors are a critical part of rehabilitating our housing market.
In 2009, Fannie Mae released announcement 09-02 with regards to investor requirements for purchasing properties. Remember that most conventional financing will have to adhere to these requirements.
The requirements for investors are:
- 25% down
- 720 credit score
- 6 months of reserves for all investment properties (2 months if the investor holds 1-4 properties currently, and 6 months if they hold from 5-10 properties).
- two years of tax returns and income documentation
The market has changed in the last few years. As noted above, sales are down considerably. The market for rentals is very strong. Rental demand is increasing and homeownership rates are decreasing to reflect the historical mean for home ownership.
Source: Census Bureau
With the existing inventory of homes and the increasing rental demand, the fastest growing investor opportunity is buy, rehab, and hold. The flip transaction, made popular on television, has taken a backseat. The dynamics of buy and hold are different than flip transactions. Investors will take a percentage return of all of their investment over a period of time. The return on investment each year is calculated by taking rents and subtracting all costs for financing (mortgage and interest), property taxes, insurance, repair and maintenance costs, and any other initial costs (holding costs, soft expenses to get the house marketed).
The problem is that while the opportunity exists for investors to clean up existing inventory and meet the increasing market demand for rentals, the aforementioned government rules on purchase with conventional financing kill the deal. Here is an example that I recently priced:
- Home Purchase Price $40,000
- Cash Down $10,000
- Cash In Reserves $2500
- Repair Costs $17,500
- Total Investor Outlay to Repair = $30,000
- Expected Rental Returns, Year 1 = $4000
- Rough Rate of Return 13.3%
That actually is not a bad rate of return (not taking into account soft costs of getting the property rented). The strong demand for rents equals a large premium over the monthly financing costs.
However, this is not the best case scenario for several reasons. In reality, investors may spend up to $20,000 rehabbing the typical 3 bedroom, 2 bath, 1300 square foot home. Often these neglected homes have lots of deferred maintenance and require new air conditioning systems, roofs, appliances, bath fixtures, etc .. Bringing an older home up to date, even for rental purposes, can be quite expensive.
But that isn’t the whole story, because there are other rules for financing on this deal due to the loan size. Fannie will charge points for the small loan size, increasing money down to about $32,000. That would be 80% of the original purchase price, before rental and marketing costs, to get the property moving. And for that outlay of money, most investors expect a much healthier return, and those returns can be had in other real estate deals like multifamily.
Again, the return doesn’t look that bad. But there are additional restrictions. The underwriter often rejects non-cosmetic repairs over $5000 as noted by the appraiser, who is required to record any major repairs and hand them to the lender. This means either the seller, which may be an estate or a federal agency, or the buyer, is on the hook for making repairs before the contract can be consummated. Neither party is going to foot the bill without knowing if the deal is going through.
Now, we are looking at alternative financing such as a hard money loan (with interest rates near $14%) or a small bank which portfolios it’s loans and does not package them for sale. These lenders are increasingly harder to find, and there simply is not enough of them to finance all of the current rehabs that need to take place.
In either case, there is not enough money at the right price to finance rehabs and get the housing market back into normal inventory and pricing levels. And even when the rehabs do happen, investors are losing returns by having to invest such huge sums up front, which prices many investors out of the full-time rehab market. They cannot support their businesses at those levels when other business costs are considered.
Cures
Rigid affordability rules will prevent liquidation of existing inventories to the market and will hamper the real estate investor as a healer of a damaged real estate. While the intentions of government regulation are to prevent a replay of 2008, the reality is that over-lending cannot happen now anyway. The average consumer is tapped out and risk appetite for more has been waning. Consumers, those that have steady jobs, are trying to pay down debts and get out of bad credit situations.
Reducing down payment requirements on established investors and encouraging rehab-based loans would significantly increase return on investments, and attract many more investors. We need more rental units, and we cannot convert existing inventory unless the deals are attractive to the money.
Appraisals need to be dropped. They are no longer accurate because the Home Valuation Code of Conduct reduces appraisal rates, and therefore appraisers spend less time on each appraisal. They rarely consider unique aspects of the home which would differentiate the value from another home on the market. In addition, the lack of current sales is reducing the effectiveness of market evaluations in assessing current price levels. At the end of the day, the price will be whatever the current buyer and seller agrees it is based upon a range of current economic factors, including employment, location, size, convenience, and amenities.
Good borrowers, such as independent contractors, are being declined even though they have a successful track record. Those on commission jobs have similar hurdles when applying for mortgages under the current rules.
The established limits on investor-financed properties to 4, and 10 with more restrictive requirements, has the affect of limiting rehabilitations to a smaller market. The truth about real estate investing is that many smaller investors are doing single projects at a time, often up to 4-6 per year. If you are a buy and hold investor, you have about 2-3 good years of work and then you have to move to greener pastures, or hope to sell your existing inventory in the face of a brutal retail market, before you can take on your next rehab job.
I don’t see the real estate recovery happening any time soon. It is time for the government to stop penalizing the market for its past transgressions, and to make sensible rules for encouraging a housing recovery. These rules include make more lenient, but sensible, national lending requirements and encouraging lenders to portfolio more loans on their own requirements so they can use their expertise to finance local investors successfully.
