7 minute read
FLIP? OR FLOP?
FLIP? OR FLOP?
Uncertainty In Home Values Could Tighten Lending Market
BY CHUCK GREEN | NATIONAL MORTGAGE PROFESSIONAL CONTRIBUTING WRITER
With nerves already frayed by COVID-19, some financial backers are fretting over the prospect of doling out cash to private lenders considering financing the purchase of a foreclosed or distressed property.
After all, how does anyone know whether it’s really a “good buy?” Plus, profit margins as a percentage are at their lowest in almost nine years.
That’s never been an especially easy question. Loan originators have always been unable to forecast what a future sale might look like with complete certainty; there’s always going to be some inherent degree of risk, said Than Merrill, CEO and founder of real estate education company FortuneBuilders, and founder of CT Homes. That said, today’s most prolific lenders aren’t those who can “realistically” forecast. Instead, they can mitigate risk by working with tools already at their disposal; namely, comparables.
Frank Gallinelli
Frank Gallinelli, founder and president of RealData Software & Education for Real Estate Investors, said his first inclination is that in this new abnormal, one would be hard-pressed to have a basis for a realistic forecast of value. However, while one would normally want to take a long view of market data to make a credible forecast, investors and lenders might want to refocus on data’s short tail.
PARADIGM IN QUESTION
Up until March, he added, young -- and often not-so-young – professionals, preferred to be where the action was. That entire paradigm is now called into question, with implications for markets that are in reach of, but not within, big cities. Investors and lenders would need to tap into a more immediate heartbeat in order to recognize if this may becoming, to coin a phrase, ‘the new normal’.
Then there’s this research from ATTOM Data Solutions, a property data provider. In the first quarter of 2020, the gross profit on the typical home flip nationwide (the difference between the median sales price and the median paid by investors) did increase to $62,300: a step up of $300 from the previous quarter and up $1,625 year-over-year.
But with home prices rising, the typical gross flipping profit of $62,300 translated into only a 36.7% return on investment compared to the original acquisition price, down from a 39.5% gross flipping ROI in the fourth quarter of 2019 and 40.9% a year earlier. The latest profit margin on a percentage basis sits at the lowest level for home flipping since the third quarter of 2011.
The first-quarter pattern of investors unable to fully keep pace with soaring home prices revealed a soft spot in the nation’s nineyear market boom, just as the major impact of the worldwide Coronavirus began damaging the United States economy. While it remains unclear how hard the housing market will get hit by the pandemic fallout, a drop in prices could further erode investor profits and cloud the future of the home-flipping industry.
“Home flipping has gradually taken up a larger portion of the housing market over the last couple of years. But profits are down and are lower than they’ve been since the dark days following the Great Recession, which is a sign that investors aren’t keeping up with price increases in the broader market,” said Todd Teta, chief product officer at ATTOM Data Solutions.
NOT EDUCATED GUESSING
Lenders won’t solely base their decision on an educated guess of where the market will be in the future. Instead, they’ll compare the subject property to comparables within the context of the market cycle. A home that’s more likely to sell than its competitors is inherently less risky, which bodes well for today’s lenders, added Merrill.
As asset-based lenders, historically, private lenders have based their decisions on the quality of a property compared to nearby comps -- not the prospects of a future sale. It’s only once a property can accurately be compared to similar, nearby homes that lenders can determine the relative safety of their investment, he continued.
The value indicated by recent sales of comparable properties, the current cost of reproducing or replacing a building, and the value that the property’s net earning power will support are the most important considerations in the valuation of real estate property, said Brent Roberts, senior manager of communications at the Appraisal Institute. It serves neither the lender nor the consumer to enter into a mortgage loan that’s more than the value of the property, he added.
In some cases, the appraisal may not match the contract price. But just because an appraisal comes in below – or above – the contract price doesn’t mean it’s flawed, he said.
Lenders will want to see the subject property’s after repair value (ARV), acquisition cost, and the amount rehabbers will need to spend fixing it up, Merrill added. In the event all of the costs justify the home’s ARV, the lender might find itself with a good investment. However, if there isn’t enough room to warrant the risk, investors may wait for something better to come along.
Mark Ferguson
–Mark Ferguson, founder, investfourmore
NO TREPIDATION … YET
Mark Ferguson, founder of Investfourmore, said value also hinges on timing and could change based on the project’s longevity. If someone’s flipping in three months, there might not be much risk since it usually takes the market a while to correct. On the other hand, there could be considerably more risk if someone’s taking one year to flip.
As a house flipper himself, Ferguson said his private lenders haven’t had any trepidation loaning money to him. “I’ve seen some hard money lenders tighten up a lot, but other hard money lenders keep asking me if I have any deals they can lend on.”
The underwriting decisions, he believes, are based more on the operator than the property. The big operators who have reserves, systems in place to work quickly and a track record, are less risky than the small operators who may make big mistakes that take time to correct.
All that said, lenders should allow the data to guide them, said Jeffrey Tesch, CEO of RCN Capital. “They’re nervous because their financial backers are, so lenders are holding back properties, on getting involved,” he noted. Like everyone else, his company was ill at ease. The issue was: is there going to be a housing crisis? “The data’s showing that that’s just not the case.”
In March, overall transactions were up 20% over the previous March, while the volume was down 70% in April. April. May lagged 50%. Markets are come backing back, said Michael Tedesco, CEO of Appraisal Nation.
Tesch noted that lenders must see that while they’re inclined to remain on the sidelines, ‘here’s why a property’s a good buy’ and jumping into the market would be wise. Current data clearly shows that the transaction market’s active and at or above January and February levels, predating the pandemic, Tesch continued.
Jeffrey Tesch, CEO of RCN Capital
RISK TOLERANCE
As a lender, in terms of risks, Tesch said when his firm underwrites loans for investors and almost every loan it originates, it does so as a wholesale lender. As such, it taps independent mortgage brokers from across the United States, and mostly residential mortgage brokers to originate its non-owner-occupied lending products. His firm’s been advising its independent originators that it’s comfortable originating non-owneroccupied loans.
For his part, Eddie Wilson, president of real estate investor Thinkrealty.com, said that before anything, originators must choose their risk tolerance, Given the market’s current position, a lender can reduce their risk by changing their lending terms. For instance, most economists are saying that we will see at least a 10% reduction in value of the housing market.
If the lender was lending at 85% of the value of the home, then they should be reducing their terms to 75% of its the value. It helps mitigate risk if they end up with the property. “The lending box for the time being should be getting a little tighter so that it puts the burden of the risk on the borrower.”
Added James Baisley, national outside sales manager at Temple View Capital: “With the future unknown all that can be done is lend to a lower LTV so that we are in for a safer deal in proportion to uncertainty in selling market. We (and most lenders in our space) are also currently requiring a payment escrow for 6-18 months to mitigate a potential cash flow issue with the borrower. Finding a good deal from a borrower perspective is relatively unchanged, but borrowers should be very conservative on their after-repair value calculations at this time.”
Real estate appraisals also are critical components in real estate financing and risk management, pointed out Roberts from the Appraisal Institute. Lenders order appraisals to get a stronger understanding of risk relating to the underlying collateral offered in a mortgage. Lenders want to know how much that property would bring in an open market so they can ascertain the loan’s well enough supported by the collateral. Technically, mortgage appraisals are provided to confirm a sales price, although they can help both lenders and consumers in making sound financial decisions.
