Wall Street took heavy hits in February and March of this year when COVID-19 hit, causing investor appetite for rental loans to dissipate. As the economy reopens, rental loan products are making a comeback. But, in response to COVID and its effects on the market, lenders have transformed terms and requirements for rental loans.
This article will go through the new expectations and practices lenders should incorporate to accommodate to the new market. These lessons include: 1) what rental products institutional investors are currently interested in; 2) what the minimum borrower expectations are for rental loans; 3) how to market rental loans to different borrower bases; 4) how to expand your loan portfolio; 5) how to underwrite a rental loan; 6) how to document a rental loan and understand investor expectations through these documents; and 7) how to understand the capital markets behind rental loans, including loan sales, correspondent programs, and origination programs.
Rental Loan Programs Before COVID
Unlike some other loans, rental loans are almost always securitized, meaning that the lender looks not only at the value of the property, but also the borrower’s creditworthiness. Before COVID, rental loans typically had 30-year terms and up to 10 years of interest-only, but could also have full thirty-year amortization. The typical Adjustable Rate Mortgage (ARM) product was usually limited to 5/7/10 year locks with annual changes thereafter. The typical industry maximum approved loan-to-value (LTV) ratio was 80%, though many prominent lenders were more conservative trending closer to 70%. Note rates tended to range from 5.5% to 7% and prepayment penalties varied on a sliding scale with preferential pricing based on the prepayment option the borrower selected.
New Rental Loan Programs
Rental loans have transformed after the effects of COVID and in a newly reopening economy. Rental loans were some of the first products to disappear from the market. Once COVID froze the capital markets, 30-year rental loans had no place to be traded. After the markets began to thaw and the economy reopened, the rental market performed surprisingly well. Delinquency rates stayed low during the past few months and investors’ interest in purchasing rental loans has been reignited.
Post-COVID loans now tend to be 30-year fixed with full-term amortization. Typical loan amounts for private lender originated rental loans still usually hover around $200,000. Lenders now make purchase loans and rate & term loans with loan-to-value (LTV) ratios of up to 75% on purchase loans and rate & term loans, and cash-out refinances with LTVs of up to 70%. Our clients typically aim for a maximum LTV of 65% for post-COVID loans. Lenders have adjusted their FICO requirements and now require a minimum FICO score of 680, but prefer scores of 720 or higher. For added security, lenders typically require 9 months verifiable reserves.
ARM products are now limited to 5- or 7-year adjustable rates, but with relaxed lease requirements. Unlike the new 30-year fixed mortgages, these new ARMs typically require only 6 months of verifiable reserves.
Sourcing Rental Loans
One of the reasons private lenders have been able to quickly adapt to rental loan products is that their current existing pipeline of fix and flip borrowers often maintained portfolios of rental properties as well. Ultimately, the borrowing base consists of real estate investing professionals. Additionally, lenders tend to use other traditional marketing means such as search engine optimization, search engine marketing, and buying leads from exchanges that are tailored towards real estate investors. Lastly, many larger lenders have created correspondent lending programs and utilize the ground loan originators in each market to be the primary source of origination.
Underwriting Rental Loans
Unlike other loans, lenders of rental products move away from a property-only mindset and instead consider both property and borrower credit. Additionally, many lenders require the borrower to form an entity and refuse to lend to individual borrowers. The primary underwriting criterion for most lenders is looking at the borrower’s debt service coverage ratio (DSCR) to determine repayment ability. Lenders weigh the DSCR heavily for determining loan eligibility.
Most lenders look to DSCR and also underwrite to FICO, credit events, and cash reserves, and prudent lenders typically place significant weight into investor track record.
Documenting Rental Loans
To facilitate free trading, rental loans have some heightened requirements for documentation compared to fix & flip loans. Rental loans with consistent documentation are more marketable on the secondary market and allow lenders to more easily originate, sell, rinse, and repeat.
Most loans require the use of impounds for taxes and insurance. Many investors and end purchasers of these loans also prefer the borrowing entity to pledge an interest in the underlying entity as additional collateral for the loan. This is even more relevant for larger loan transactions and blanket loan portfolios. The DSCR requirements should be documented with specificity, and insurance requirements are usually fairly specific with additional mandatory requirements such as business interruption/rental loss insurance. Finally, many documents require interest rate step-up triggers based on occupancy. For example, the interest rate may spring up by 100-200 basis points if the property remains vacant for an extended period.
Expectations of Parties
When it comes to rental loans, there tend to be three major parties. Often, a party may wear one or more “hats” in any given transaction. There is a loan originator, a loan funder, and an end purchaser. Each party has different expectations.
Loan originators prefer to control as much of the transaction as possible and will need to work with a correspondent/loan funder to determine who manages most borrower communications.
The funding source will require agreements between the loan originator and end purchaser. Said agreements will require some form of line of credit or other funding vehicle to permit the loan originator to ideally white-label loan origination. Once these expectations are met, the funding source can sell the loan off to the end purchaser.
In order to mitigate risk, the end purchaser will want extensive due diligence from the funding source/seller of the loan. Thus, the end purchaser will want consistent documentation and significant representations and warranties from the funding source to offload some of the risk in purchasing a rental loan. Funding sources should expect audits on underwriting and other practices from the end purchaser.
There is an expectation among all parties to ensure consistency in risk, documentation, and credit. Since rental loans are almost always securitized, assessments in the risk of the loan, the borrower’s creditworthiness, and the records documenting and attesting to those assessments should be consistent and communicated clearly among all parties.
Although COVID slowed the initial growth of rental loan programs, the market is now seeing the appeal and potential for rental loans. Although some of the borrower requirements and lender practices of rental loans are heightened compared to other loans, these expectations serve to mitigate and disperse risk between the parties and improve the marketability of these loans. Each party to a rental loan should keep in mind the expectations placed upon them and the market forces that drive those expectations.
Despite the effects of COVID, rental loans have adapted to the new market and lenders, investors, and originators should recognize the evolution of rental products to take advantage of the growth of this newly-burgeoning market.
Learn More about Rental Loans
Watch our past webinar, Making Rental Loans in the New Normal, to learn more about rental loans in this new normal.
About the Authors
Geraci LLP is the nation’s largest law firm that focuses on representing non-conventional lenders.
Nema Daghbandan, Esq. is a Partner in the Banking and Finance Practice. His practice encompasses all facets of real estate transactions representing mortgage companies and professionals throughout the country. He can be reached at email@example.com.
Daniel Park is a Summer Associate. He is a law student at the University of California, Irvine School of Law. He can be reached at firstname.lastname@example.org.