While the mortgage industry frequently goes through ups and downs, few were prepared for the drama that took place in the non-qualified mortgage (non-QM) market over the past two years. After heading into 2020 with strong momentum, the market for non-QM products vanished due to the onset of the COVID-19 pandemic, only to slowly crawl back out from hiding later in the year.
Today, the non-QM market looks brighter than ever. As the economy rebounded and growing numbers of Americans turned to self-employment, these alternative loans bounced back in a big way.
Non-QM mortgages are designed for consumers who can’t meet the strict qualifying criteria needed for the loans to be purchased or insured by Fannie Mae, Freddie Mac or other government agencies. The number and volume of non-QM securitizations also continues to grow.
While bank-statement loans remain the darlings of the non-QM world, debt-service-coverage ratio loans — also known as DSCR loans — place a not-so-distant second. There are a number of reasons why this is the case.
A DSCR loan is based on the income generated by a property and the expenses associated with managing and operating it. The main reason that these loans are growing in popularity is that sales prices and rents are soaring nationwide.
According to CoreLogic’s Home Price Index Report, nationwide prices grew by 18.1% between November 2020 and November 2021 — the highest year-over-year increase since CoreLogic began tracking prices in 1976. More importantly for real estate investors, massive housing shortages and affordability challenges pushed rents higher.
Single-family home rents jumped by 10.9% between October 2020 and October 2021, according to CoreLogic, which was three times the growth rate from one year earlier. Rents rose everywhere, too, topping off in Miami at a 29.7% annual increase. Even in Chicago, which experienced the lowest increase of all major metro markets, rents rose by 4.2%, or twice the rate recorded before the pandemic.
No wonder there are more single-family home investors today than at any time in recent history. During third-quarter 2021, investors accounted for a record-high 18.2% of U.S. home purchases, according to a Redfin report. A year prior, only 11.2% of purchases were made by investors. Meanwhile, the volume of investor transactions vaulted from $35.7 billion to $63.6 billion during the same period.
Today, DSCR loans stand as the second most-popular non-QM product behind bank-statement loans. There are reasons why many investors choose these loans over hard money loans. For one, you don’t have to be rich to get a DSCR loan and become an investor. Assuming the investor has a high FICO score, they can put down as little as 20% of the purchase price. First-time investors can get a DSCR loan with a 75% loan-to-value (LTV) ratio. There are millions of homeowners with enough equity in their existing home to cash out, get a DSCR loan and invest in a rental property. Compared to hard money loans, DSCR products typically feature lower interest rates, too. With rates already increasing, this means that an investor won’t have to refinance anytime soon.
Borrowers can get tax credits for investing in low-income housing and they can take deductions for depreciation. Finally, the increasing rental rates for residential properties provide investors with a steady stream of residual income. Yet there are still some misconceptions about DSCR loans that keep more borrowers from taking advantage of them.
Despite the growing appetite for these products, mortgage brokers still have questions about how DSCR loans work. Many don’t completely under-stand how they differ from other types of non-QM products, what kinds of properties they can be used for or the many benefits that DSCR loans provide. That’s a hindrance for originators looking to boost their business as DSCR loans have enormous potential in an increasingly competitive market.
By far the biggest misconception about DSCR loans is that lenders qualify the property being purchased, not the borrower themselves. A lender calculates the ratio by taking the gross monthly income from the property — comprised of rent payments — and dividing this number by the monthly expenses, which includes the loan principal and interest, insurance and homeowners association fees, if any.
Rents used in DSCR calculations are based on rental surveys compiled by an appraiser. A DSCR of 1.0 or higher means that the investor will earn enough money to sufficiently repay the loan. Conversely, any-thing lower than 1.0 means there’s negative cash flow. The higher the ratio, the less risk there is associated with the loan.
The borrower’s credit history and FICO score do matter — borrowers must have decent credit — but DSCR loans do not require the complexities that come with owner-occupied financing. In other words, no income documentation or verification of employment is needed. This also means that DSCR loans are not subject to the TILA-RESPA Integrated Disclosure (TRID) regulations. Additionally, many states do not regulate investment-property loans either.
Many people also aren’t aware that DSCR loans can be used for almost any type of property in any location, including multiple-unit and mixed-use properties. DSCR loans are becoming increasingly popular for nonwarrantable condominiums in destination areas and resort-type communities, such as coastal areas, where rents are generally higher and increasing faster than national averages. The only difference is that the condo fees are wrapped into the ratio calculation along with the loan principal, interest and other expenses.
The only type of property for which these loans often can’t be used are condotels, as there are relatively few lenders that will finance them. Other than that, the sky’s the limit. There are even no-ratio DSCR loans for homes that fall below the 1.0 calculation and have negative cash flow. With a no-ratio loan, there is no additional borrower verification tasks other than credit — the only difference is that the rate is slightly higher to accommodate for the additional risk.
Of course, there is always a risk of depreciating value or not receiving rent to make the loan payments. That’s not likely to happen anytime soon, given the nation’s shortage of housing inventory. Plus, because the LTVs are relatively low and the borrower has a lot of skin in the game, there would have to be a serious price decline for these properties to turn upside down.
Because DSCR loans are becoming so popular, brokers are likely to run into a lot of lenders that say they can do them. But few lenders truly specialize in these products because they are so different from conventional loans or even other types of non-QM products.
Keep in mind that many lenders remain focused on conventional or government-backed loans. When they decide to explore the non-QM market without fully understanding the different products, they only create chaos for themselves and their clients.
For this reason, anyone thinking of selling these loans should partner with a lender that can help them understand the loan guidelines, criteria and general structure well enough to confidently explain them to investors. Generally, the best lenders are those that specialize in non-QM loans and have been selling DSCR loans for years, long before the market for these products took a pause during the pandemic.
Only a handful of lenders fit this description. Those that do offer programs that allow investors to borrow up to $1.5 million at 80% LTV and up to $3.5 million at 70% LTV, with a FICO score in the 700s.
As the spring housing market gets underway and competition heats up among lenders, DSCR loans are a great way for brokers to set themselves apart, regardless of what market they serve. They’re a fantastic and versatile tool for helping first-time investors build residual income without going through the rigorous qualification process involved in other types of mortgages. If making the most of this year’s origination market matters to you, DSCR loans can provide the edge you need. ●