Lending Advice
by Mark Levine
Looking back on my most recent column makes me feel as though a year has passed in the last three months. Back in the February issue of this magazine, I introduced the possibility that credit problems in the subprime mortgage market could have an impact on the broader financial markets. That seems like an understatement now. However, before I give myself any credit for anticipating the subprime issues, I must also point out that I predicted that the issues would remain under the radar and would not enter the mainstream media. Clearly that couldn’t be further from the truth as subprime woes are now a feature story in nearly every financial media outlet, as well as some general news agencies.
Because the subprime news is so widespread now, we won’t waste our time reviewing the causes and magnitude of the meltdown. However, there does still seem to be significant uncertainty surrounding the ongoing effects of the problem, so it’s worth weighing what might be around the corner for us. First, and most importantly, there will not be any devastating consequences to the economy or to most financial and banking institutions. Sure, there are a select number of lenders who made their fortunes making subprime loans over the past five years, and those companies will suffer, if not completely disappear. However most financial institutions are diversified and adequately protected by financial engineering, so we will not see anything close to the savings and loan crisis of the 1980s.
What we will see, however, is a reality check for lending standards. One of my friends (who is not in the financial industry) recently asked me how in the world anyone let the subprime market get to where it is now. With the current state of affairs, it seems like a reasonable question. I explained that markets constantly move and they often follow the laws of physics—most notably that they’ll move in one direction until influenced to move in a different direction. Positive trends—and more significantly, very positive profits—carried the residential mortgage market into uncharted territory over the past five years. One lender had to originate more mortgages than the next; credit standards consistently deteriorated so that volumes could keep growing. People and companies became somewhat blind to the risky loans they made, and that’s how we got into the troublesome situation we face this year.
But now, the direction has changed and I believe that there will be movement back toward the higher credit standards of the recent past. There will not be a sudden, dramatic tightening of funds or underwriting standards; instead, every deal will garner a closer, more thoughtful analysis. I think most of us agree that this is a good thing, both for lenders and investors. It will hopefully replace some of the discipline that has been lost in the market, and it should once again mean that deals will be financed at smart levels and based on good fundamentals.
As we have seen at the outset of the recent mortgage market hiccup, interest rates may actually decline due to these issues. Because residential real-estate woes are so widespread and so intertwined with the rest of the economy, market forces have kept treasury rates low in order to avoid much bigger problems. To be more specific, Ben Bernanke and the Federal Reserve Open Market Committee have opted to keep rates low and have signaled that they might even lower rates if inflation does not get in the way. We should expect this to continue until there is a full recovery in the residential housing market. However, aside from treasury rates, the other component of mortgage rates is the credit spread and we should expect this to perhaps increase in the near future.
The brief explanation for this upcoming trend is that investors who purchase commercial mortgages in the capital markets are the same investors who bought subprime mortgages in the past. There are two repercussions to this connection. First, subprime mortgage investors are suddenly faced with much lower profits on their investments. Therefore, they need to make up their returns somewhere else, and it will start with their other mortgage investments, such as commercial and apartment loans. Second, there will be less competition in the market, which nearly always means higher prices. As some lenders decide that they no longer want to be in the real-estate market due to subprime shocks, there will be fewer lenders competing for the same customers. Less competition generally means higher prices.
Credit standards and borrower options should also go through a slight pullback in the near future. Certain aspects of loans that have become very aggressive lately might not be around for long. For instance, lenders will likely be less willing to extend full interest-only loans on lower quality or higher leverage deals. Also, some lenders have been very aggressive recently by underwriting future cash flows and above-market rents. This is based on the expectation that property revenues will continue to grow forever. Expect this trend to slow down quickly. As previously mentioned, these developments are actually positive in the long run for the industry and for borrowers because they will insert some much needed discipline back into the market.
In sum, my advice is to take advantage of lender terms that are currently available because I believe that the purse strings will get slightly tighter in the near future. It would be naïve to think that our world of commercial and multifamily lending is too far removed from subprime lending to be affected. The changes will not be significant enough for anyone to change their overall investment behavior; however, they will be felt in our business and throughout the world of real-estate investing. I do believe that some changes in financing standards will be among us in the very near future.
For apartment owners, another result of the subprime meltdown will likely be increased occupancies and rents. Many homeowners with lower credit scores and lower incomes are currently facing very tough times making recently increased mortgage payments. This is, in fact, what is causing the problems in the industry. As these homeowners default on their mortgages—thousands already have—they will leave their homes and need to move elsewhere. I, for one, do not think that they will be rushing back into purchasing a new home.
Even if homeowners who have recently defaulted on their payments want to buy a new house, they will face a difficult battle to get financing. One obvious reason is that their credit will be negatively impacted and few lenders will extend financing to someone who defaulted in the very recent past. The problem snowballs beyond that, however, when you consider that many lenders who originated these types of mortgages to risky borrowers in the past are going to be out of business. If they don’t shut their doors completely, they will at least be much more conservative in their lending practices. Because of these issues, I believe that the many thousands of subprime borrowers who are unable to make mortgage payments will no longer be homeowners in the foreseeable future.
Where will they go? The answers are both obvious and perhaps not so obvious. We are all in the apartment business, so the first thing that comes to mind is apartments. Indeed, I do believe that apartment occupancies will benefit most. Perhaps less obvious, however, is manufactured housing, otherwise known as mobile home parks. Expect a strong few years for this property type, especially in areas where the subprime woes have hit hardest. Although most residents of manufactured housing communities are still required to purchase a home (unless they rent the home also), both the credit requirements and the prices are significantly lower than purchasing a permanent home and land.
Another less-than-obvious beneficiary is the single-family home rental market, again for two reasons. First, this is a great option for families who still want the luxuries of a single-family home, yet can no longer afford it or qualify for a purchase. Second, there should be a significant increase in the supply of home rentals as defaults increase and sales slow down. Financial institutions who have repossessed houses and home builders who have recently completed projects will be willing to do whatever necessary in order to generate some income from their portfolios of empty homes. By simple economics, the increased supply of homes should result in lower rental prices, thus making this option even more attractive.
Back on the apartment front, I expect owners of multifamily units to witness very favorable market conditions in the near future. I know that every landlord who reads this magazine has very high credit requirements for their tenants and can’t imagine renting a unit to someone who just defaulted on their home mortgage. But lowering your standards won’t be necessary. Those tenants with recent credit issues will rent apartment units in your competitors’ buildings, where the tenant credit qualifications are lower. The result will be higher occupancies and increased rents as the demand grows. In turn, the tenants with good credit who had been renting in that other building will now be looking for other buildings where they can get more for their rental money. This is where you should benefit.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2007 by SF Apartment Magazine. All rights reserved.