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Financing Frustration

September 2021 Insight

Home prices are all over the news these days, with the August numbers showing a roughly 20% increase in prices for the entire country year over year. As has been discussed in previous Altus Insights, there are more and more questions about whether home prices are in another bubble with potential for a crash.

Meanwhile, interest rates have risen slightly from all times lows, but are still on the far low end of the historic scale. This low interest rate environment allows buyers to afford more purchase price than they would otherwise be able to, and enables homeowners to tap into high levels of home equity through refinances and equity lines. Over the past two weeks Treasury rates have increased. Mortgage rates roughly track Treasury rates, so with this slight uptick in rates, there is considerable competition among lenders to find borrowers and fund loans.

As a potential offset to increasing mortgage rates, income rate increases have shown acceleration over the past couple months due to severe labor shortages. Increased incomes result in buyers being able to afford more expensive properties at a ratio of roughly $3 of purchase price for each $1 of increased income.

On a personal level, I recently purchased a property in Utah. In order to compete in this crazy seller’s market we made our purchase all cash. After the short escrow and close I then started the process of obtaining financing on the property to recapitalize my accounts and take advantage of the low interest rates. Residential financing is always a pain in the neck. A BIG pain in the neck. I knew that going in, but I never considered that I would have so much trouble obtaining financing based on the amount of debt flying around the residential markets and how easy it is to obtain said debt.

In my confusion I reached out to David Gunning, a friend with decades of experience in residential real estate debt. I knew he wasn’t licensed in Utah but hoped he could help me wrap my head around what is going on. The following is a recreation of that conversation which I thought may be helpful for other people in similar situations that are also frustrated with their ability to take advantage of these historically low rates.


Forrest: I recently bought a residential property in Utah and have struggled to obtain financing through traditional sources. I have good credit and good equity in the property. Why is it that someone can get financing to purchase a property with 3% and not great credit, yet other borrowers with sizeable down payments and great payment history/credit struggle?

David: This is a question I get frequently, and I feel your pain because I ran into this same situation myself during the first year or two of my current lending business – even though I have been a lender and owned previous lending businesses for over 30 years. Unfortunately loans these days are not based on common sense but on salability. When a lender gets a loan application, rather than asking themselves “does this loan make sense?” they ask, “if I make this loan will it be saleable in the secondary market?”  To determine whether a loan would salable they start by looking at: Loan Type (Conventional, FHA, VA or USDA), occupancy (primary residence, second home or investment property), transaction type (whether it’s a purchase, rate and term refi or cash out refi), property type (single family residence, condo, 2, 3, or 4 units), debt-to-income ratio, loan-to-value ratio, and where the property is located.  When a loan is being underwritten (analyzed in detail by the lender) they look at the guidelines for the various agencies who provide loan programs to make sure everything “fits” into the guidelines. They are primarily looking at the borrower’s Income, Credit, Assets, and Collateral.  If a borrower’s profile doesn’t fit into any one of these four categories, then borrowers need to look outside of the typical traditional lending programs.  In the example you gave, if the person had great assets, credit and a nice property, but their income documentation was such that the underwriter couldn’t figure out a way to get the income to fit program guidelines, then that person would need to look outside of the traditional loan programs. Lenders like to see at least two years with the same employer (or similar industry) with escalating income. In your case, as, you may check that box, but as an active real estate investor you have highly complicated taxes showing all kinds of income streams, deductions, and tax impacts. This can be tricky because underwriters rarely see that level of complexity, and especially when the various holdings are changing on a regular basis as they are in your situation.

As to why 3% down payment loans are prevalent, even for borrowers with marginal credit, the answer again has to do with salability. Conventional Conforming programs (Fannie Mae and Freddie Mac) and Government programs (FHA, VA, and USDA) all allow for low down payments. In fact, VA and USDA allow zero down payment loans, FHA allows 3.5% down payment loans and Fannie and Freddie will allow as little as 3% down for certain loan programs.  This is because to one degree or another the government is involved in all these programs, whether sponsoring, insuring, or regulating them.  All these programs were created to facilitate liquidity, stability and affordability in the mortgage markets, particularly for buyers of owner-occupied properties. Again, each of these programs have their own guidelines, and are often aimed at helping first-time home buyers, and include features allowing for leniency with respect to both Assets and Credit: allowing for low down payments and marginal credit history (sometimes allowing as low as 580 credit scores in the case of FHA).  However, even these programs are conservative with how they look at Income and Collateral.

Forrest: Along the same lines as above, why are interest rates on high leverage, poor/no payment history, owner occupancy loans higher than for borrowers buying rental properties with sizeable down payments and solid payment history, even when the rents from the property covers the loan payment. The risk of default is higher with the first loan than the second, and more overtly, the risk of loss of principal is considerably higher with the first loan than the second. Why aren’t rates tied to the risk?

David: Rates are tied to risk but are also tied to marketability and the demand for that particular loan’s characteristics.  Prices vary by which agency’s guidelines are being followed, along with occupancy, property type, loan to value, and several other loan characteristics.  Some characteristics are considered riskier than others, resulting in higher price adjustments. For example, on a FNMA loan the “hit” (pricing adjustment) for a SFR (Single-Family Residence) investment property is 2.125 points (a point = 1% of the loan amount).  And the hit for a 2-unit property, versus a 1-unit property, is 1 point.

On the example you gave, the risk would be perceived by the market as similar. If someone was buying a single-family residence as an owner occupant and they were putting 5% down and had a 620 credit score their rate would be 3.625% with no points.  If they were buying a single-family investment property, putting down 25% and their score was 720 that rate would also be 3.625% with no points. So, the market would perceive them as having equal risk.  If the person buying the investment property were to put 40% down (instead of 25%) there rate would go down to 3.5% with no points. But if they were to put 90% down (so only a 10% loan to value), the rate would still be 3.5% with no points. So risk is factored in, but only to a certain degree.

As to the part of your question “even when rents from the property itself covers the loan payments”: Residential lending is different from Commercial lending in how it looks at investment properties from a qualifying point of view (debt-to-income ratio).  In Commercial Lending, the primary variable a lender looks at is the debt-service-coverage ratio. If a property debt services, there is a very high likelihood the loan will be approved. In Residential Lending, the lender looks at the same 4 categories mentioned above: Income, Credit, Assets, and Collateral – of the borrower – as well as the potential income from the subject property.  In the case of rents, they give credit for 75% of current rents, or on a vacant property, market rents as determined by a real estate appraiser. Sometimes even if “the numbers” on the investment property itself work, the cumulative Debt or Income of the borrower may weigh in on the overall debt-to-income ratio and the loan won’t fit. This is particularly frustrating from the point of view of Commercial Real Estate investors, but the unfortunate reality is the residential lending programs were not designed to look only at property’s ability to debt service. Consequently, the agencies that set the guidelines for these loans focus on providing liquidity more for primary residences and less for second homes or investment properties.

Forrest: I am getting more and more frustrated as we go through this conversation because what I am hearing is that the government is saying (through all these various programs) – we reward simplicity over the things we say we value; credit history, equity, income, etc. Where does that leave someone like me who commercial banks see as a good credit risk but then struggles to refinance a 33% LTV loan on a SFR rental property? And what implications does that have on loan options and pricing? At Altus we are obviously familiar with private financing, but that is not an acceptable option for properties intended to be held for long term use or cash flow.

David: For loan amounts that are above conforming limits, there are non-conforming loans (also known as Jumbo). Conforming loan amounts go up to $548,250 and as high as $822,375 in high-cost areas, so Jumbo loans would be in excess of those amounts. Underwriting guidelines for Jumbo loans are very similar to traditional conforming loans although Assets, specifically reserve requirements, are higher. Interest rates are typically a little bit higher as they are less liquid. By less liquid I mean that there are no government related entities such as FNMA, FHLMC or GNMA that exist to buy these loans and provide liquidity to the secondary markets (investors who buy packages of loans for investment purposes). These loans are purchased mainly by asset surplus entities such as pension funds or insurance companies; however, other options include selling them through Mortgage-Backed Securities or REITS, or selling them directly to other banks.

For loans that require expanded guidelines or more creative underwriting the other options would be a) non-QM loans, b) Portfolio loans or c) the Private money loans you referenced above.

QM Loans vs. Non-QM loans

QM (Qualified Mortgages) are required to have debt-to-income ratios of 43% or below, unless being purchased by one of the Government Sponsored Entities, and do not contain and risky features such as negative amortization, interest-only payments, balloon payments, or loan terms longer than 30 years.

Non-QM loans on the other hand, allow for slightly higher debt-to-income ratios, can have interest-only features, and have more creative underwriting guidelines. Examples of the more creative guidelines would be a) allowing 12- or 24-months bank statements to prove income in lieu of tax returns, b) using the property’s debt service coverage ratio to qualify for an investment property, or using an ITIN to qualify a non-resident.  Rates for these programs are often 1-3% higher than a more traditional loan.

Portfolio loans

Banks or credit unions may sometimes make loans to hold in their portfolio. Since they don’t need to sell these loans, they can make their own guidelines. These guidelines still must meet the tests of the regulators and fall within the risk levels of their charters, but they can add some creativity. These programs typically come in the form of Equity Lines of Credit or Equity Loans (usually 2nd mortgages), or ARM’s (1st mortgages).  Equity lines are variable rate loans and are typically priced around Prime or Prime+2% margin. Equity loans have fixed interest rates and are typically priced at 2-4% above prime. And ARMs are typically offered for 5- or 7-year terms and are often priced similarly to, or 1% above, a typical 30-year fixed rate traditional mortgage.

And of course, you are familiar with private money loans.

Forrest: Previously I put a line of credit on my primary residence and then use that line of credit like liquidity, being able to tap into when I want cash and pay it down rather than hold sums of cash in a checking or saving account, and rather than having a larger loan on my house. This scenario gives me money to invest elsewhere, including stock and bond investment opportunities. In effect, by using cash to pay down the LOC I am locking in a sure ~3.5% return on that cash, far better than I can get in a bank account or CD, and on a risk adjusted basis even on most bonds. Since real estate prices have increased so dramatically over the past couple years, most real estate owners have considerable amounts of equity in their homes. What other strategies have you seen employed to take advantage of that equity and the historically low rates to improve people’s overall financial or investment picture?

David: With rates being so low we are seeing a big uptick of people taking advantage of these historically low rates. The most common way I am seeing people take out equity is to do a “cash-out” refinance of their primary residence. Many customers are even taking cash out of their second home or investment properties – typically as 30-year fixed mortgages. There are several different ways people are strategizing to take advantage of the low rates. We’re seeing customers take cash out of real estate for these main purposes: home improvements, debt consolidation, college or other tuition, purchase of a second home, purchase of a residential investment property, invest in securities, invest in private loans (especially powerful with a LOC), or invest through limited partnership opportunities like Altus sometimes offers. In some cases, people are getting bridge loans or taking cash out specifically to make “all-cash” offers on other properties.

Forrest: For the past several months inflation has been running as hot as it has been for many years. Additionally, there are considerable unknowns due to COVID and its impact on the economy. Further, the government has made unprecedented moves into the private lending markets to restrict lender rights. And yet, with all that, rates are the lowest they have been in 6 months and in the range of the lowest they have been in many decades, why?

David: It is a paradox that we as consumers can see and feel the effects of inflation all around us in our daily lives, yet interest rates are so low. Rates as we see them on mortgages and car loans etc. are largely based on what “the Fed” (Federal Open Market Committee or FOMC) is doing and saying.  The Fed meets eight times a year to establish near-term monetary policy and interest rates. Their primary interest rate control tool is the Fed Funds rate, which is the rate at which banks lend funds to each other on an overnight basis. Typically, when inflation is running too high the Fed will increase short term rates with the intention of cooling things off and keeping inflation in check.

Why is it a different now?  The Fed would like to get employment back to pre-pandemic levels before scaling back, so for the time being they are keeping rates low, and they keep pumping money into the economy. The argument (hope) is that while inflation is high (and will likely remain elevated in the coming months before moderating), this inflation is transitory and will cool down on its own once a) the pent-up buying demand subsides, and b) supply issues and production bottlenecks work themselves out.

A major component in rates staying low is the demand for Treasury Bonds, which are closely tied to mortgage rates. The higher the demand for Treasuries, the higher the price. With bonds, higher price = lower yields (or interest rates).  The global demand for Treasuries as a safe haven is still high from China, European Central Bank, Bank of Japan, Bank of England, as well as asset surplus companies such as pension funds and insurance funds. And thanks to the Fed’s quantitative easing, our own Fed now owns nearly 25% of the Treasuries market, in addition to investing heavily in Mortgage-Backed Securities.  All these factors keep interest rates low. Expectations are that as employment improves and the economy continues to improve the Fed will increase short-term rates (Fed Funds rate), which will in turn put upward pressure on Treasury rates, mortgage rates and other borrowing rates. Simultaneously, the Fed will taper the purchasing of Treasuries and mortgage-backed securities, which will effectively decrease the demand and increase rates. Lower demand of debt instruments means lower prices. Lower prices mean higher yields. Higher yields mean higher rates.


Our conversation continued to discuss family, friends, and upcoming travel plans (David and his family especially enjoy Hawaii), but when the phone call ended I was still stuck with the same conundrum as when I started the call – a seemingly great credit risk wanting to obtain a low leverage loan on a single family property, but without any known path to do so without paying considerably higher than “market rates”. Hopefully the recap of my and David’s discussion can be helpful to you in taking advantage of the current borrowing opportunities, while avoiding the trap in which I find myself.

For anyone looking for finance in California, David is not just a friend but also someone I have used for financing in the past. I can attest to his level of professionalism and expertise. We have other lenders in our network that we can refer as well.

Happy Investing.

David Gunning grew up in Sonoma County, currently resides with his wife and two daughters in San Francisco. He is 30+ year veteran in the mortgage business, an advocate of youth leadership, education and women’s rights, and has been a partner of Altus in the capacity of Investor, Co-fund Manager and Guarantor.  Feel free to reach out to David directly at: 415-390-5200 or david@independentlendingcorp.com.