DSCR: Loan In Vogue

Debt-service-coverage-rental loans (DSCR) have risen in popularity recently, according to numerous lenders that offer the product, but will they perform well this year if there is a recession?

As volume started to wane with qualified mortgages of owner-occupied single-family residential, many lenders started to pivot to DSCR loans. Most Non-QM and private investor lenders that provide DSCR loans reported back that all is well, even among their short-term rental borrowers.

Why look out for short-term rentals?

Because throughout the pandemic-induced housing boom, many people saw shortterm rentals as a way to make money, so platforms like AirBNB and VRBO blew up quickly. DSCR lenders made programs available for short-term rentals, like those on AirBNB and VRBO, so if the AirBNB bust is going to happen, it would have an impact on these companies.

There’s been a rise in inventory on AirBNB and VRBO, but it seems like the Average Daily Rate (ADR) is still holding. Back in October, numerous AirBNB super hosts started talking about the “AirBNB Bust” in select metro areas, saying they’ve seen fewer bookings.

Reports from other lenders and leasing companies suggest this might be true. In the third quarter of 2022, mega landlords like Invitation Homes saw occupancy drop 60 basis points year-over-year. Also, HouseCanary’s report for the second half of 2022 shows that rental listing inventory is up 93% year over-year and days on market is up 52% year-over-year. Typically, this would bring prices down, causing issues for DSCR borrowers who rely on cash flow, but so far rent prices remain historically high.

But most DSCR lenders and Non-QM lenders that provide DSCR loans say everything is fine.

Over at RCN, these loans are performing just fine.

“We’ve seen performance stay very steady, despite the economic turbulence that we’ve been kind of going through over the last 9 to 12 months here,” RCN Chief Financial Officer Justin Parker said.

From a portfolio perspective, performance of these loans have also remained steady. Parker admits short-term rentals are slowing down a bit in terms of volume and activity, but performance wise, it’s still very strong due to the sizable cash flows attributed to the product type.

RCN does lend on AirBNB and VRBO properties, and Parker says the company has not seen the effects of an alleged bubble in the AirBNB market.

Look At The Map

Analyst Howlett weighs in saying that this increase in vacancies and drop in rental prices are geography-based.

“I think if you looked at San Diego, Seattle, Las Vegas, Phoenix, there could be certain markets where you could see bigger rent declines,” Howlett said. “But from a national basis, the rental market and the single family rental market are in really good shape.”

Still, Parker admits this upcoming recession could have an impact on these DSCR borrowers and their lenders.

“The Fed is pushing for recessionary activity and in times of recession you start seeing a lot of people stop spending and stop vacationing,” Parker said. “So there does become a concern around how much short-term rental activity can you generate not only in a good market, but a down market as well. Do I think that there’ll be some properties that maybe struggle a little bit? Sure.”

Slyusarchuk says he’s not worried, though. DSCR loans only make up a small portion of loans in a pool, and short-term loans are an even smaller portion.

“Most DSCR loans are based on longterm contracts. There are some short-term in the pool. But it’s like, I don’t know, under 10%, something like that,” Slyusarchuk said. “You just have to control how many loans you put in each pool.”

The key in getting these loans to succeed in the secondary market is to ensure sound underwriting.

“Secondary markets are having a tougher time with short-term rentals,” Parker said. “A lot of it really boils down to how you underwrite the property. Some lenders will look at historical income and underwrite it to that. Some lenders use third party sources such as airDNA and they’ll utilize that. And there’s some lenders, like RCN, where we don’t only look at the short term rental, but we also look at the property on a long term basis. We ask the question, ‘what if this property’s utilized on a long term basis, and what do those rents look like?’ And we make sure that when we’re underwriting it, we’re taking all of those things into account.” and lenders don’t hold these loans on the balance sheet, the only natural buyer is the wholesale market, Howlett explains. All Non-QM loans need to be securitized and sold to secondary market investors, who are most attracted to loans with higher interest rates (or coupons).

“And I think where you see most of the struggles from trading and secondary markets is those that only lean into the AirBNB rental income and don’t necessarily take into account a long-term strategy,” Parker added.

So when rates suddenly shot up, lenders holding older loans with lower interest rates (lower coupons) couldn’t sell or exit them, causing pipelines to freeze. This is what caused shutdowns, bankruptcies, and layoffs across the Non-QM space.

The first sign came when Angel Oak account executives announced on social media the lender would revert all programs and guidelines back to where they were before the pricing and liquidity crisis. Since Angel Oak Capital buys the production, moving guidelines back is a big indication of a comfort level with loan securitization.

“They’re completely correlated,” Tom Hutchens, executive vice president at Angel Oak Mortgage Solutions, says. “We’re increasing the guidelines because there’s been an increase in liquidity in the market. Anytime liquidity starts to shrink, guidelines follow suit. So when liquidity starts to grow, guidelines grow.”

NON-QM RESURGENCE

Angel Oak’s first securitization of 2023, the senior tranche of the AOMT 2023-1, received a AAA rating from Fitch Ratings. Namit Sinha, chief investment officer of private strategies at Angel Oak Capital Advisors, said the company is pleased with the execution of these loans and believes Non-QM will have a resurgence this year.

In February, Fitch Ratings gave A&D Mortgage quite the endorsement providing AAA, AA- and A- ratings to the biggest, best pieces of the securitization — especially considering more than 43% of the loan pool are Non-QM loans.

“I can tell you that securitizations on Non-QM are pretty close to securitizations on other classes,” A&D Mortgage CEO Max Slyusarchuk says. “January spreads have tightened a lot due to the fact that the Federal Reserve has been more optimistic and not in hiking mode. So that’s why Non-QM is doing so much better than before.”

Although Non-QM is susceptible to issues when there’s a liquidity squeeze in the market, both lenders maintain that the loans perform well — nearly as well as agency loans.

“Non-QM loans are still viewed by the end investors as really good loans,” Hutchen says. “If we had just started Non-QM last year, that’d be a different story. But, we have a 10year track record of Non-QM originations and securitizations, and the performance of them kind of speaks for themselves.”

Do Your Research

Non-QM’s comeback arrives just in time for loan originators and brokers to add it to their portfolio. Throughout most of the pandemic housing boom, move-up buyers were the center of attention — clean, pristine borrowers with excellent credit looking for a simple conventional loan. They could go to any lender and get what they’re looking for, but now some loan officers are seeing more complex customers knocking on their door, wondering if they could get loans.

Slyusarchuk said borrowers and brokers are willing to embrace non-traditional options, but for smaller lenders it’s still a challenge. Many were spooked due to the liquidity crisis that happened during the onset of the COVID-19 pandemic.

“Some of the lenders originated loans before the pandemic and then pandemic came, and they had to sell at a big discount. It was a huge disappointment,” Slyusarchuk said. “Warehouse lines got scared; everybody got scared.”

Eventually, fears began to taper off and more lenders went back to doing NonQM loans, but in 2022 there was another liquidity squeeze due to rapidly rising rates, and lenders had to sell their loans at a discount once again. So, even though these non-traditional loans are becoming more widely accepted in the broker community, lenders remain hesitant.

“It’s easier for brokers where you lock the loan with a lender and you’re done,” Slyusarchuk said. “But for guys who close on their name and have to be part of the market, it’s a little more challenging.”

But if investor appetite for these loans are increasing, why shouldn’t lenders, brokers, and originators return or begin working in Non-QM? Well, depending on the severity of this upcoming recession in the second half of 2023, it could have an impact on Non-QM.

“They were well-qualified borrowers, typically because they were selling a house that had appreciated in significant value. So, a conventional loan was pretty much the best option. But I think right now you have a real opportunity to explore some NonQM loans as well,” Kellen Vaughan, branch manager for Trademark Mortgage, says. “That’s certainly a conversation that we’re having with a lot of folks, especially those wanting bank statement loans.”

But adding product lines and partnering with new lenders takes time and research. Slyusarchuk says loan originators and brokers need to be well educated on the products and able to recognize a Non-QM borrower right away.

“It’s good, but we have to teach them how to spot the proper customer,” Slyusarchuk said. “It’s not that easy when somebody is narrow minded and has only been doing conforming loans for the past 10 years. You know, it’s a little bit of a challenge.”

Per the last Federal Market Open Committee meeting, Federal Reserve Chairman Jerome Powell expects the U.S. economy to soften in 2023, and achieve its 2% inflation target without a big downturn in jobs and the economy. However, he warned no one should assume that the Fed can protect the economy if default occurs.

Both Angel Oak and A&D Mortgage are predicting the Fed will make a soft landing and the upcoming recession will be mild, but more importantly, that’s what analysts are predicting as well.

Overall, Howlett believes the remaining Non-QM lenders in the marketplace are prepared for this upcoming recession, which is likely to be mild.

“Right now, housing looks like it’s in good shape to handle a rising unemployment rate and it looks like it’ll be a soft landing, at least for the housing market at this point in time,” Howlett said. “But you’re right, I mean, the difference between a soft landing and hard landing could really make or break the model.”

It’s time to let your skills shine. Find resources for breaking through barriers like degree screens and stereotypes. It’s time to tear the paper ceiling limiting STARs: workers Skilled Through Alternative Routes rather than a bachelor’s degree.