What’s My (Lender’s) Motivation?

What’s My (Lender’s) Motivation?            

In the game of lending money, one would think that all institutions originate mortgage loans to make money on the interest rate. However, nothing could be further from the truth. Many times, depending on where the “lender” falls in the capital stack, the end goal may not be “net interest income,” but something else. Once the veil is pierced and borrowers understand a lender’s true motivations, it may help to understand why certain deliverables must be met for one institution but not another. 

Mortgage Companies and Correspondent Lenders

Let’s be 100% honest, these lenders have no long-term interest in a borrower’s loan. These “Direct lenders” are transactional in nature; accordingly, they underwrite to the “guidelines.” They follow the Fannie Mae and Freddie Mac rulebooks to insure that they can sell a loan within two weeks of closing. Often, these lenders have “warehouse lines” whereby they use cheap borrowed money from a real bank to lend money to a borrower, close the loan, and finally sell it to the secondary market, collecting spreads and premiums along the way. Once they’ve been paid for their loan services and collect all of their fees, they pay down their line, bank the profits, and recycle the funds to be used again for more transactions.

Money Center Banks

The Wells Fargos, Citibanks, US Banks, Chase Banks, and BofAs of the world have extra reasons to provide real estate capital. Not only do they underwrite to Fannie Mae and Freddie Mac (FNMA/FHLMC) guidelines for a portion of their business, but they also make loans with a particularly strong interest in servicing them. Many, if not most borrowers believe that when they receive their monthly mortgage statement, their loan is owned and held with Chase or one of the other large institutions.  Typically, this is not the case. Most of these banks have underwritten these loans to “the guidelines”, sold them to FNMA or FHLMC and pocketed the premiums.

Surprisingly, a large payment collection infrastructure is even more lucrative to these banks than booking new loans. Many of the banks have been processing checks for years; accordingly, they are quite good at it, and do it for other owners of loans, namely Fannie, Freddie, and private investors. As a consequence, if an inquisitive borrower is curious about this fact, they should call their servicing lender and ask, “who owns my loan?” Within 30 seconds, the customer service representative will say “Fannie Mae,” “Freddie Mac,” or “a private investor.” With millions of checks being cut and the vast number of online payments made, money center banks make significant, risk-free income from processing payments and servicing loans. Moreover, these institutions have investment banking divisions which give them the ability to package the loans, securitize them, and sell them as mortgage backed securities, earning fees for their distribution efforts without assuming any risk. Clearly, as one can see, money center banks have a variety of reasons to be in the mortgage business.

Insurance Companies

Most baby boomers and members of the silent generation are accustomed to pensions.  After 20, 30, or 40 years of work, pensioners have earned their just desserts and deserve the right to have a stable income in their golden years. Accordingly, they need stable cash flows to sustain their existence. Where rubber meets the road, a pension is an annuity; which is nothing more than an insurance product that guarantees a stream of payments for a certain period of time. As such, insurance companies look for stable, high quality assets to back the cash flow provided for by their products. Therefore, insurance companies will never make a subprime, Alt-A, or high LTV loan with mezzanine (2^nd TD) financing to sketchy borrowers. Instead, they are looking for class-A, low-levered properties that are attractive, in good areas, with strong stable cash flows. Sexy office buildings, well-anchored retail projects with national tenants and 100+ unit apartment complexes in pristine condition with LTVs under 70% are great candidates for financing by insurance companies. Conversely, high-risk borrowers, older properties in disarray, and retail malls with less than A-credit tenants need not apply. Transaction fees don’t mean much to the Met Lifes of the world, as it’s all about stable cash flow.

Regional Banks

Chase’s motto, the Right Relationship is Everything, is a partial truth. For regional banks and community banks, it’s all about the relationship. They want your deposits, plus your business and cash management accounts. They want to sell lines of credit and provide equipment loans. They don’t prioritize transactional business as those are considered “one-off transactions.” Fannie Mae manuals are in the branch, but they aren’t the mainstay of the bank’s existence. They’re too small to have well established infrastructure, so servicing isn’t their bread and butter either. Instead, their goal is to identify quality borrowers and business owners and wrap them completely up in their full suite of financial products. As such, the majority of their mortgages are portfolio loans, so they own them. They are not sold to the secondary market as securities. Regional banks know their borrowers well and will originate a loan that may not meet Fannie Mae’s guidelines or fit in any traditional black box. Therefore, for the right relationship, a regional bank may do just about anything.

In summary, no two types of lending institutions look at originating mortgages the same way or book them for the same reasons. Some sell them off, while others keep them in their portfolio as valued assets. Some pool them for sell off on Wall Street while others service them for fee income. The main point is that it pays to know a lending institution’s motivation, as it dictates how they look at a file. Know thy lender, as it can and will make all of the difference in the world of real estate finance.

 

Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance, he can be reached at howardpr@rosecityrealtyinc.com.

 

Real Estate Finance for those Who Work for Family Members

Real Estate Finance for those Who Work for Family Members

I can think of no dicier proposition when financing property than proving the veracity of someone who works for a family member. The lending pendulum has swung completely from one side to the other. This is equally true for borrowers who work for their families. Many from the outside looking in may wonder why this is the case, but in some instances, from an underwriter’s perspective, it’s easy to see why intrafamilial transactions receive more than a cursory review during the underwriting process.

First of all, documents have, can, and will be forged to obtain financing. During the mid 2000s, any and every document imaginable was forged. From paystubs, bank statements, and tax returns, to divorce decrees, business licenses, and CPA letters were created in order to lure banks into the trap of deception. With the advent of high tech software and top of the line printers, every document, which led to a loan approval, could be created. The heightened scrutiny for employees of family members is that if the company exists and Mom, Dad or a sibling owns the company, they have the legal ability to print the checks that can get their loved one to the finish line. Accordingly, a lender will ask for not only the last two paystubs, but also for the last six months’ paystubs (and have done so). Moreover, the lending institutions may want the last six months of bank statements with pay stubs to verify payroll deposits into the account. As such, one wrong deposit made before a check is issued and the loan will be declined.

Another issue of concern for those employed by a family member is ownership. Many companies, particularly small ones, have a short list of corporate officers. When the CEO, COO, CFO, and HR manager all have a last name of Smith, the idea that David Smith isn’t a shareholder, but merely a W-2 wage earner is suspect. Lending institutions will look into corporate filings with the secretary of state and other government agencies to determine the true shareholders of a company. Also, it increases the likelihood that an underwriter will demand three years of tax returns with all schedules to look for and review any Schedule Cs, 1065s and/or 1120s that may tip them off to shareholder profits, and more importantly, losses that a borrower may be hiding. Accordingly, many lenders are requiring IRS 4506-Ts (tax return transcript request forms) upfront in order to compel the truth from the borrower. By and large, the vast majority of self-employed borrowers show losses on their returns to reduce their tax bite. As such, it is very difficult to qualify once it is proven that you’re a self-employed shareholder, as opposed to a W-2 wage earner.  Therefore, as one can see, obtaining a loan while working for one’s family can be a daunting experience.

In summary, borrowers who work for family members can get loans, but they don’t come easily. It takes a lot of perseverance and patience, as banks are skittish about any file that isn’t a cookie cutter 740 FICO, W-2 wage earner, 35% debt-to-income ratio deal with 25% equity built in. Therefore, borrowers must gird and arm themselves with the right information. If not, you may be in for a fight for your funds, but with the right preparation, it doesn’t have to be.

Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance; he can be reached at howardpr@rosecityrealtyinc.com.

The Power of the K-1

The Power of the K-1

The fastest deal killer for someone who is self-employed or a borrower who owns multiple properties is the Federal Tax Return (1040 and all schedules). Most bank underwriters will review line #37 (Adjusted Gross Income, AKA “AGI”) to confirm that they are dealing with a negative number or an income figure is too small to cover 125% of the proposed monthly debt payment of a particular property. However, a loan transaction doesn’t necessarily have to end up in smoke, especially if a borrower knows the components of their tax returns intimately; that is, with regards to one’s K-1s

For those who may not know the document, the Schedule K-1 is the IRS tax form issued for an investment partnership interests. The purpose of the Schedule K-1 is to report one’s share of the partnership’s income, deductions, and credits. It is issued around the same time as a 1099 and serves a similar purpose for tax reporting. By and large, the majority of the investing public waits until January or February of each year to collect their W-2s, 1099s, charitable contribution statements and K-1s, eventually turning them over to a CPA or tax person in a shoebox (or if they are technologically savvy, they scan them and then use the Dropbox system to organize them) to prepare. The normal exercise entails identifying tax reductions that can reduce their taxable income as much as possible. Unfortunately, when this is the goal, the AGI is normally hammered and may show losses or very little income to support new debt from any lender. However, strong K-1s and the right lender can save the day.

Many investors have been wise with their investments in outside interests, such as real estate partnerships, venture capital funds, and other investment LPs, LLPs, and LLCs. Some of them generate significant amounts of cash to the point where the income can cover more than the monthly debt service of the loan requested. It just predicates that the borrower is astute enough to point it out to their broker or loan officer and lender that is wise enough (with experienced underwriters who are seasoned enough) to look past the AGI and inspect the K-1s for consistent cash flow.

For instance, I worked on an apartment complex deal whereby the borrower loved to write off everything, including the kitchen sink and put them into his 1040. His AGI was an average of $40,000 over a two-year period. This was certainly not sufficient to support the $700,000 loan requested. However, upon close examination of the K-1s, the borrower had an investment in a carwash out in the middle of nowhere which yielded him $170,000 in annual investment income. It was just washed out by the borrower’s losses shown on his 1040 by his primary business activities. In this case, the lender looked past the 1040 and noticed the ongoing cash generated by the borrower’s K-1s, which allowed the loan to proceed through underwriting and on to closing. Additionally, a 2011 report evidencing a third year of strong partnership income from said car wash was icing on the cake. The net result was a loan approval. Hence, it is easy to have a ray of hope on a transaction when a borrower’s K-1s show income that can cover your loan.

In summary, never give up on a deal when the 1040s look bad. Look past them and identify profits that may exist within a K-1. People have been making wise investments for years; as such, they seek to bury their strong profits amongst a bunch of losses from other activities to reduce their bill to the IRS. Understanding the tax return and all of its components can save a deal, especially when the 1040 shows otherwise. Therefore, take a moment to examine the entire tax return and know all of your sources of income. It can make the difference between an approval and a denial.

Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance, he can be reached at howardpr@rosecityrealtyinc.com.