Section 1026 of the Truth in Lending Act (Regulation Z) details the scope of the QM provisions, identifying a list of exempt transactions. In short, this section says that credit extended to purchase, improve or maintain non-owner-occupied rental property is deemed to be for business purposes. This means that residential mortgage loans to be secured by non-owner-occupied investment properties are exempt from the QM provisions of section 43 of Regulation Z. An opportunity has been born as a result.
Enter commercial lendersDespite express statutory exemption for business-purpose loan transactions secured by investment properties, most residential lenders have decided that such loans must comply with the QM provision in order for them to be eligible for financing. This has opened the door for commercial lenders to take advantage of what would appear to be an underserved niche for financing, one that also happens to be a primary driver of the residential sector.
This past first quarter, all-cash purchases, many by investors, accounted for 42.7 percent of the U.S. residential market’s sales. Although that may have helped bolster the residential market overall, it did little to help profitability of residential mortgage lenders.
Many commercial real estate lenders have seized this opportunity and are now offering one-to-four-family investor purchases and refinances as commercial loans. In order to do so, they must structure the transactions with the owner being a limited-liability company or corporation, and the property, in most cases, must meet minimum debt-service coverage ratios.
Some lenders, however, have taken this a step further and allowed for stated-income loans in this category, as there is nothing prohibiting them from offering alternative-documentation loans, given that these are now deemed to be commercial, not residential, loan transactions — and as such, are exempt from the QM provision.
Some lenders are even allowing co-ops and condos to be eligible property types. Many offer blanket transactions so investors may buy multiple properties at once. Some offer nonrecourse loans, and still others allow for foreign investors. With loan-to-value ratios as high as 75 percent and rates being offered as low as 3.5 percent with no limit on the number of properties financed, residential lenders, even those that interpret the QM provisions literally, may have difficulty competing with these offerings.
The implications of this are important to note. Investors now have an opportunity to buy multiple properties and can obtain financing where previously they had been denied. The residential sector also will benefit from this, given the liquidity now available to investors, which gives them the ability to buy more investment properties. Commercial lenders, meanwhile, will reap their rewards via profitable loans in a category untapped by them until recently.
DrawbacksThese products do have their flaws, however. For example, because they’re now construed as commercial mortgages, fixed-rate options — at least those longer than three to five years — are not being made available. For investors seeking to buy a one-to-four-family property and hold it for steady cash flow, this is a drawback.
In addition, because these are commercial loans, lenders are now able to impose a prepayment penalty, which will not benefit the fix-and-flip crowd. Also, lenders may be far less inclined to originate deals under certain minimum loan-amount standards, which may range from $250,000 to $1 million. These same lenders will likely also place a maximum on the dollar amount they will finance for any one loan or blanket transaction, which also may hinder investors seeking financing.
Lastly, for lenders that use a true debt-service coverage ratio (DSCR) calculation to qualify, many markets will be excluded because market rents will not exceed expenses with a 1.25 DSCR. Even some high-end markets will have trouble with properties qualifying this way because higher expenses — for example, property taxes because of recent value appreciation — cannot be offset by rents to the extent that ratios fall within lender guidelines.
CompetitionAlthough these products are being welcomed with open arms by originators and lenders alike, it will be interesting to see how this all plays out. Residential lenders are going to find themselves in competition with their commercial-lending counterparts.
For lenders that offer both residential and commercial lending platforms, it allows them to retain far more originations given the increased options afforded to investors. If a loan does not work under their residential platform, they can simply flip it to their commercial division in order to accommodate the transaction.
For the time being, commercial lenders have found themselves in an enviable position to benefit from a sector once off-limits to them: multifamily properties with fewer than five residential units.
Rob Diodato is the president of York Commercial Finance, a commercial mortgage advisory company with offices in Dallas and New York. Diodato arranges financing for commercial real estate transactions nationwide for all property types and is an expert in Small Business Administration 504 and 7(a) loans. Diodato has more than 26 years of experience in the commercial and residential mortgage industries.