It is no secret that the U.S. housing market has been on fire. Despite the COVID-19 pandemic and ensuing recession, already record home prices rose year over year by double digits on a national basis this past summer. This also is true of homes sold to investors that intend to rent or flip properties for a profit.
Commercial mortgage lenders, however, have remained cautious. Even aggressive, asset-based private lenders that look most closely at the value of a property have been reluctant to approve high-leverage loans on homes that have recently seen huge increases in prices. Consequently, commercial mortgage brokers may wonder why lenders aren’t providing loans to help them and their investor clients catch up to the blazing market.
When the pandemic first appeared in March 2020, lenders feared the housing market would see a significant downturn. Anyone with money in a project faced several unsettling possibilities. Is the market going to go down? How long will distressed properties be tied up in foreclosure given the federal moratoriums and health mandates? Will an investor be able to carry the property for an extended period and pay both principal and interest if the home can’t be sold or rented within a reasonable time?
Everyone held their breath to see if another Great Recession-like crash was about to happen. Fortunately, so far, the opposite has occurred. Not only has the housing market avoided a downturn, it has rarely been stronger. Even investors that made bad bets on properties have been saved by a market on fire, with over-budget projects breaking even or turning a profit as values climbed.
Projects that ran into money problems and still needed renovations could be resold to other investors. Effectively, the past year has bailed out numerous investors in tight spots and has yielded unexpected profits to almost everyone involved in the single-family housing market. So, again, why aren’t lenders matching this hot market while things are going so well?
Every lender is different and some are definitely comfortable making high-leverage loans in a market with rapidly rising prices. The majority of commercial mortgage lenders, however, remain in a defensive posture. In general, lender confidence in this market does not match the rapidly rising sales prices seen around the nation. To explain their hesitancy to accept these new values, it is worth looking at some of the major areas that factor into a lender’s thinking when establishing a loan size.
In general, lender confidence in this market does not match the rapidly rising sales prices seen around the nation.
Underwriting a deal involves many factors but, in the end, it boils down to accurately assessing the value of a project in the current market. In today’s market, record-high prices have combined with record-low inventory. To establish a value on a property, the typical investor will use the closest comparable property and expects that their lender will use the same information to approve the highest possible loan amount. But this isn’t what’s happening.
When home prices shoot up, lenders have a tendency to err on the side of caution. It takes time for lenders to trust the market’s new price point. Lenders are always worried about a price correction following periods of rapid price increases. This attitude can be viewed as a seasoning period for lenders that are looking for clues on the market’s true value. There is no hard formula, but given how sharply values have increased since June 2020, do not expect commercial mortgage lenders to use the latest comparable prices unless these properties can hold their current values until the start of next year.
The faster a price grows, the longer that a lender will typically need to confidently move to the new price point. For example, starting in 2012, home-price growth gradually accelerated, but lenders still felt confident in using the sales prices of comparable properties to determine value. In 2017, for instance, home prices rose by about 6%. This spike caused the typical lender to temporarily look back for a few months, but any delays were hardly noticed as the market began to steadily gain value again for the next three years.
The recent surge in prices reached a level unseen since 2006. The run-up doesn’t necessarily mean that the market is headed for a crash, but lenders are naturally going to be cautious. When home prices rise quickly and reach new heights, lenders typically prefer to use comparable sales of similar properties anywhere from six months to a year earlier. Lenders become defensive in extreme buyer or seller markets, and they stay conservative with underwriting until the market reveals where it is headed.
Aside from closely watching the course of home prices, lenders also are concerned about foreclosure trends. During the COVID-19 crisis, the federal government and several states placed moratoriums on evictions and foreclosures. Since each locality has tended to implement its own rules during the pandemic, the foreclosure process has largely been outside of a lender’s control and it remains in flux. This has made it difficult for lenders to estimate the cost to recover an asset, if need be.
When foreclosing on a property, lenders also need to account for legal fees, taxes and carrying costs that go into a typical foreclosure. Early this past summer, it was still unclear how long foreclosure proceedings would take in many cities and whether the residents of these properties could be evicted so the properties could be resold. There also is a backlog of foreclosures that dates back to 2020, further complicating the calculation.
Additionally, on behalf of their clients, attorneys can use pandemic-era laws that forestall evictions or foreclosures, so foreclosure cases that were once considered routine aren’t likely to be so easily resolved. In response, many commercial mortgage lenders are tightening their requirements on borrowers by demanding higher credit scores, more experience and higher reserves than in pre-COVID days. Borrowers with lower credit scores will likely need to put in significantly more equity or show other mitigating factors. Otherwise, lenders need assurances that they can weather a multiyear foreclosure process without losing money, should the process go sideways.
Although much of the country has reopened, and some foreclosures and tenant evictions are being allowed again, lenders will need to see foreclosures and evictions moving through the system for at least six months before believing the process is returning to pre-pandemic norms. With so many municipalities adopting their own policies, there are too many unknowns. Also, even though progress has been made with vaccines, the health crisis has yet to end and there remains a possibility of more lockdowns. Lenders are factoring all of these issues into their calculations when assessing a deal.
The faster a price grows, the longer that a lender will typically need to confidently move to the new price point.
Lastly, lenders also are troubled by rising costs for construction materials. Typically, homes sold to investors need substantial renovations, so lenders must factor any spikes in construction costs into the overall project cost. Lumber costs rose by 180% from June 2020 to April 2021. Although lumber is by far the fastest-increasing material cost, almost all materials used in renovations or new construction have increased by at least 20% in the past year. Whether vendors are inflating prices to make additional profits or there is a legitimate material shortage as a result of supply problems caused by the pandemic, the fact is that the typical home renovation costs more than it did a year ago.
So, a renovation budget that normally would cost $40,000 now is closer to $50,000. Mortgage brokers and investors, however, often are not accounting for these added costs when they approach lenders. Prior to COVID-19, lenders would normally account for a 10% variable in renovation costs due to unexpected events, but now that variable is about 20%.
Even projects that have gone smoothly are winding up 10% to 20% over budget due to rising building-material costs. Until these costs show signs of slowing down, lenders need to account for this additional expense in their maximum loan size. As a result, your investor clients may have to contribute more equity toward the overall project costs.
While it does appear that the country is slowly returning to pre-pandemic norms, expect many commercial mortgage lenders to take some time before their behind-the-scenes processes match the current market prices. Wait for material costs to stabilize, for foreclosure and eviction courts to no longer be behind schedule, and for home-price growth to cool off to a more steady level. When these things happen, lenders will begin to catch up with the market. ●