This article series examines how proactive Department of Real Estate (DRE) licensed consumer mortgage originators — MLOs — will survive the ongoing downturn in origination fees. Part 4 explains how to solicit and work with property investors during a recession.
Look back at Part 1 for how a recession disrupts fees earned by MLOs, and the timing of the consumer mortgage industry’s recovery from what is fast becoming the 2023 recession.
Read Part 2 for how to continue to earn fees from an evolving recession base of homebuyers and sellers, even as the volume of traditional cash-to-new-loan sales and refinancing slows to a trickle.
Read Part 3 for a guide on earning fees from real estate owned (REO) property.
Investors need business-category mortgages, not consumer mortgages
In the years since 2010 when mortgage loan originators (MLOs) were federally created to package consumer-type mortgages for home purchase and refinancing, a typical year swelled with traditional cash-to-new loan sales and refinances. In turn, this generated consistent consumer mortgage demand. Naturally, MLO income consists of fees earned on consumer mortgage originations.
However, those years saw next to no contact by MLOs with real estate investors.
MLOs are not in the business of packaging mortgages for investors who look for purchase-assist financing to acquire income property, or refinancing an income property they own. That’s because investors seeking financing need access to business mortgages — also known as commercial loans — a different category of mortgage controlled by different rules and practices than the consumer mortgages MLOs have authority to originate for a fee.
During an economy’s recovery period, prices rise, temporarily escaping from the mean price trendline to which they eventually return. During the years of property price distortions, prudent investors sit on the sidelines. They strategically wait for real estate prices to normalize — a return to realistic capitalization rate levels indicative of a long-term investment in income producing property. This long line of individual investors has built up rapidly in recent years of unjustifiably escalating property prices here in California.
Now that prices have begun to decline in what is fast becoming a long, drawn-out face plant for owners who sell, these investors are ready and prepared to jump in once prices reach their cyclical bottom.
They have been a silent, patient group.
Around 2025-2026, this buildup of long-term, buy-to-let investors will flood the market, competing at the same time with the cyclical arrival of short-term investors — speculators. Collectively, they will propel the market out of the recession, likely in 2026-2027.
The various types of investors an MLO gears up to work with during a recession include:
- equity purchase (EP) investors, who purchase property from sellers-in-foreclosure; [See RPI Form 156; RPI e-book Buying Homes in Foreclosure]
- investor assumptions on seller-occupant sales, or mortgage takeovers by an investor with or without written due-on-sale waivers from the lender;
- local syndicators who form and manage real estate acquisitions of any type property, the purchase price paid using commercial mortgage funds coupled with equity funds raised from investors joining the syndicate, structured always as a limited liability company (LLC); [See RPI e-book Forming Real Estate Syndicates] and
- speculators or flippers who purchase with short-term, hard money mortgage funds in anticipation of a resale at a profit in a matter of months based solely on an upward wave of market momentum.
MLOs pivoting to cash-in on fees from services needed by the coming wave of investors will offset the dearth in consumer mortgage origination fees during a recession.
However, they first need to learn a few necessary additional skills to arrange commercial loans for funding by private lenders, and some community banks who make these commercial mortgages.
Mortgage loan brokers, please step up
In contrast to an MLO, whose authority is limited to “originating” consumer mortgages secured by one-to-four unit residential real estate for a fee, a DRE-licensed broker with their licensed agents may hold themselves out and provide services as a mortgage loan broker (MLB). MLB services deal with all aspects of arranging and funding commercial mortgage originations and real estate related investments.
Yes, a DRE-licensed broker and their agents who are MLO-endorsed may negotiate both consumer mortgages and business mortgages. The dichotomy in mortgage categories, which did not exist prior to Dodd-Frank in 2010, is the result of the federal preemption of rules and licensing for consumer mortgage originations. When the federal government carved up mortgage lending arrangements, they created two distinct categories:
- the consumer mortgage — funding buyer-occupant home purchases and refinancing; and
- the business mortgage — funding investments, businesses or agriculture, commonly called commercial mortgages.
While federal law primarily controls the origination of consumer mortgages, business mortgage originations — commercial mortgages — were left to be controlled by state law requirements.
Thus, in California, a DRE licensee holding an MLO endorsement has the authority to offer services as an MLB able to originate both consumer and business mortgages.
An MLB may:
- arrange a business mortgage, negotiating the terms of a business-purpose mortgage on behalf of an investor and with the lender who funds the mortgage, often an individual, individual retirement account (IRA), pension fund or small local bank;
- originate a mortgage using their own funds; and
- operate as a trust deed broker to negotiate the sale or purchase of an existing trust deed note on their own behalf or for a client.
Business mortgages and other non-consumer mortgage-related transactions include arrangements such as:
- representing hard money or private lending to originate business category mortgages;
- mortgage-backed loans (MBLs) — when a trust deed note is assigned as security, not the property directly;
- carryback financing; and
- trust deed investments other than consumer mortgages.
When originating a business mortgage, the MLB may also be employed by the lender to act as a servicing agent or contract collection agent on the mortgage for an additional fee. [Calif. Business and Professions Code §10233]
Evaluating investment property for mortgage funding
While all qualified consumer mortgages are guaranteed or backed by the federal government in some manner, commercial loans present a vastly different bet by lenders.
Thus, when a commercial property investor defaults, the initial source of recovery is the value of the property itself, which changes based on ever-evolving market factors. The mortgage originator gambles that the future value of the property will be sufficient to cover any future default, even during a foreseeable recession when property values decline.
Editor’s note — A secondary source of recovery on the default of a commercial loan is the person who signed the note, as well as any persons who signed guarantees assuring payment. Unlike homebuyer-occupants, investors are not protected by California’s anti-deficiency laws except when the mortgage holder complete a trustee’s foreclosure sale.
Therefore, a thorough analysis of the income property is required by the prudent commercial mortgage lender, and their DRE licensed agent, to ensure an appropriate value has been assigned to the property securing the mortgage.
In contrast, appraisers and their consumer mortgage lenders are evaluating property for purchase by buyer- or owner-occupants and are never really “on the hook” for the valuations, since the mortgage lender recovers under government guarantees.
To avoid an investor’s over-optimistic valuation of property they seek to buy, the MLB packaging a mortgage to fund the purchase needs to order or (much better) be trained and prepare a price evaluation themselves, called a broker price analysis (BPA).
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Astute readers will note that BPAs have historically been called broker price opinions (BPOs), as though an opinion of value. But legislation has clarified the meaning of words in the mortgage world. A BPA for mortgage originations is a comparative pricing analysis, an analysis of market data on sales, not an opinion.
The MLB develops a BPA by first downloading a property profile — title condition — on the property and a printout of recent sales in the surrounding area from a title company website.
A broker’s BPA is documented by preparing a comparative market analysis (CMA). The CMA is a worksheet used when establishing a property’s value based on prices recently paid for comparable properties. The CMA reflects observations on a visual inspection of the comparable properties, noting in each property’s column for itemized features distinguishable from the subject property the dollar adjustment needed to correct for its greater or lesser value than the subject property. [See RPI Form 318]
In contrast, a BPA without supporting data has no CMA documentation and is merely an uneducated guess. Thus, it is a “no docs,” dishonest analysis with no basis for being accurate.
A BPA developed by preparation of a CMA will confirm:
- how ownership is vested and who has authority to employ management;
- the liens on the property and their foreclosure status;
- property taxes and their payment status;
- any use governed by covenants, conditions and restrictions (CC&Rs) affecting use by occupants including any HOA policies;
- comparable sales figures in the area; and
- price adjustments for:
- zoning;
- easements;
- location;
- landscaping;
- improvements;
- livable space; and
- amenities. [See RPI Form 318]
The completed BPA will confirm an appropriate valuation of the investment property to be funded.
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High-interest mortgages, a teaser in a recession
The amount of interest — annual earnings — a private, non-exempt lender can charge is regulated by statute and the California Constitution. Collectively, these are referred to as usury laws. [Calif. Constitution, Article XV; Calif. Civil Code §1916-1 through 1916-5]
Here, a DRE-licensed broker has an edge on the commercial loan market during periods of high risk of mortgage defaults, and thus high rates of interest to cover the losses on a lender’s mortgage portfolio. That rate of interest when negotiated by a broker can exceed limits on annual earnings — interest, etc. — a private “hard money” lender may charge and collect when a broker is not involved.
The goal of usury laws is the prevention of loan sharking by private lenders, all other lenders being exempt. Loan sharking is the act of charging exorbitant interest at a higher rate than the allowable ceiling-rate established by the usury laws. These mortgages are categorized as usurious. [CC §1916.3(b)]
However, as we are now entering a period of rising mortgage interest rates, earnings by lenders originating commercial mortgages will exceed the usury rate ceiling — presently set at 10% in California and subject to change annually. [Calif. Const. Art. XV §1]
Types of lenders exempt from usury law restrictions when funding a mortgage include:
- DRE-licensed brokers;
- savings and loan associations (S&Ls);
- state and national banks;
- industrial mortgage companies;
- credit unions and pawnbrokers;
- agricultural cooperatives;
- corporate insurance companies; and
- personal property brokers. [Cal. Const. Art. VX]
A huge advantage of the DRE licensee with an MLO endorsement is that the mortgage originated at an interest rate exceeding the 10% usury rate ceiling requires a licensed broker to arrange (negotiate) the otherwise usurious commercial mortgage lending situation to qualify the mortgage as exempt from the state’s usury law.
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Two basic distinctions for private mortgage lending exist, based solely on whether a DRE-licensed broker is involved:
- brokered real estate mortgages; or
- restricted or non-brokered real estate mortgages.
When a DRE-licensed broker is involved in “arranging or making” a real estate mortgage, the transaction is exempt from usury restrictions and falls into one of two categories:
- mortgages funded by a licensed real estate broker acting as a principal — the lender — for their own account; or
- mortgages arranged by a DRE-licensed broker acting as an agent negotiating the mortgage origination on behalf of another for compensation.
Restricted real estate mortgages are all mortgages made by private party or hard money lenders which are neither made nor arranged by a broker.
Private lenders include corporations, LLCs, partnerships and individuals. These entities are controlled by usury limitations on annual earnings unless operating under an exempt classification, such as a personal property broker or real estate broker.
The most common restricted mortgage involves hard money lenders, unlicensed by the DRE and unassisted by a DRE-licensed broker, who make loans secured or unsecured by a mortgage.
Friends and acquaintances fall victim to this usury law when helping themselves by helping a friend. The purpose is genuine, usually to avoid a foreclosure on the friend’s home. Often the documentation is a grant deed/leaseback with option or some other security device other than a trust deed to secure the debt, evidenced by a note. Nonetheless, it is a mortgage and usurious when earnings on the funds exceeds the annual ceiling — no broker was involved as a principal making or as an agent arranging the mortgage.
Editor’s note — Carryback notes executed by the buyer in favor of the seller are not loans of money. They are credit sales, also called installment sales. A seller may carry back a note at an interest rate in excess of the usury threshold rate. The rate exceeding the usury law threshold is enforceable since the debt resulted from a sale, not the advance of money to fund the purchase.
Hard money lending
Hard money lenders, also known as private lenders, are lenders who make short-term mortgages from their own funds, called a hard money mortgage. Private lenders are not institutional lenders. [See RPI e-book Mortgage Loan Lending, Chapter 40]
A hard money mortgage, commonly referred to as a bridge loan, is typically a short-term business-purpose mortgage secured by real estate that has a mortgage term of three years or less, often one year.
These short-term mortgages generally have higher interest rates and upfront costs in the form of origination or discount points. The borrower pays the MLB fee, not the lender. But the fee most often is the discount amount or points the borrower pays. Further, the reasons for lending are not usually based on traditional credit guidelines as are loans by institutional lenders but rely solely on the value the property might have in a foreclosure scenario.
Hard money mortgages are commonly used to fund real estate purchases by investors who rehabilitate property for resale, called flipping, when they or the property does not qualify for conventional financing.
Sometimes, homeowners want to buy a replacement home, upgrading before they have a buyer ready to close a purchase on the sale of their home — a recession period experience.
Typically, these homeowners agree to buy a replacement home contingent on the sale of their present home. When the resale of their home either falls out or they do not have a buyer ready to close a purchase escrow, the homeowner seeks, via their agent, a bridge loan — a second trust deed mortgage against the equity in the property they are selling.
The proceeds from the bridge loan fund the closings of the replacement home. Now the owner has two homes, with time to sell the old home and pay off the “private money” bridge loan.
Often, hard money mortgages are evidenced by a straight note. A straight note does not call for the property owner to make periodic payments while completing repairs and the property is marketed for sale or refinancing is located to retain long-term ownership. When due, all principal plus accrued interest is paid in a single lump-sum payment. [See RPI Form 423]
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Working with hard money lenders with or without an MLO endorsement
Hard money lending opens doors for MLO-endorsed DRE licensees. It’s also an opportunity for DRE licensees who do not have an MLO endorsement. Commercial mortgages arranged by DRE licensees may encumber any type of property from owner-occupied SFRs to land, from income property to a tenant’s leasehold interest, and even a lien on a trust deed note the borrower assigns as collateral. No MLO endorsement required.
It is the borrower’s purpose for their use of the funds that distinguishes a consumer mortgage from all other mortgages. The purpose of a consumer mortgage origination is to fund a buyer’s purchase of an SFR to fourplex for use as their home or to refinance a consumer mortgage on the home they occupy. The MLB needs to confirm in writing the borrower’s intended use of the net proceeds from a business mortgage. [See RPI Form 202-2]
Consider an MLB who enters into a listing agreement, employed to arrange a loan secured by the borrower’s income producing real estate. [See RPI Form 104]
The MLB prepares a loan package and solicits a hard money lender who agrees to fund the mortgage sought by the borrower. The lender receives the borrower’s note as evidence of the debt and a trust deed lien on real estate as security for repayment in the event of default on the note.
The hard money lender handles the collection of payments on the note. Later, the lender wants to sell the trust deed note and contacts the MLB.
The MLB knows trust deed investors willing to purchase the lender’s trust deed note. The MLB, acting as authorized by their DRE license as a trust deed broker, negotiates the sale of the trust deed note.
The originating lender receives cash and the trust deed investor is assigned the note and trust deed. Further, the MLB enters into a loan servicing agreement with the investor to handle collection on the trust deed note — for a fee. [See RPI Form 237]
The owner of the real estate securing the mortgage is notified of the assignment of the trust deed note to the new mortgage holder. The property owner is also advised to make future payments to the broker under the loan servicing agreement. [Calif. Civil Code §2937(a); Calif. Commercial Code §9318(3); see RPI Form 238]
A trust deed dealer is in the business of buying and selling trust deed notes and land sales contracts for their own account, sometimes called flipping paper.
Unlike a trust deed broker, a trust deed dealer acts solely as a principal. A trust deed dealer buying and selling trust deed notes is required to hold a DRE broker license when they buy, sell or exchange eight or more trust deed notes during a calendar year without retaining a broker to negotiate the assignments. [Bus & P C §10131.1]
Here, the dealer is required to also hold a broker license even though they do not act as an agent for anyone.
Conversely, an individual is not a trust deed dealer and need not be a licensed DRE broker when they:
- resell trust deeds to the public through a DRE-licensed broker; [Bus & P C 10131.1(b)(1)(B)] or
- hold the paper they buy as a long-term investment. [Bus & P C 10131.1(b)(1)(A)]
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Expand your real estate practice, pivot with the market
firsttuesday forecasts mortgage industry employment to precipitously decline roughly 50% in 2023-2024 from the 2021 level.
MLOs who continue applying the same approach to earning income developed during the recovery, expansion and pandemic distortions since the 2008 recession will be first in line for a rapid career exit.
In other words, leaning on home refinancing and single family residence (SFR) purchase-assist mortgage originations, i.e., federally controlled consumer mortgages, will quickly leave an MLO with empty pockets in the new paradigm.
To survive the decline, MLOs holding a DRE license need to expand and adapt their practice to work with:
- REO properties;
- sellers-in-foreclosures for mortgage workouts and short sales;
- non-traditional consumer mortgage originations; and
- commercial mortgages made by hard-money private mortgage lenders to fund income property owners and buyers.
DRE licensees without an MLO endorsement also need to take note of these survival strategies. Brokers and agents still have time to pivot and cater to recession period demands of homebuyers and income property investors and capture a chunk of their fast-developing market.
As we head into 2023, the property market recession is just getting started. Stay up to date on the latest market updates by subscribing to firsttuesday’s weekly newsletter, Quilix.
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