A real estate loan primarily provides additional capital sought by buyers and owners of real estate. As financing, a real estate secured loan does not affect any condition or aspect of the real estate it encumbers, except to appear as a lien on the ownership of that property. What a real estate loan does affect is the owner’s rate of return on invested funds (excluding the capital provided by the loan), net spendable income from the property, income tax reporting, and risk of losing his property.
The alternative to a real estate loan is seller financing. A note carried back by the seller extends credit on the purchase price. Similar to the real estate loan, the property itself is not affected by the carryback note, as it is only a lien on ownership. As with any lien, it decreases the owner’s solvency and increases the risk he will either lose the property (his investment) or increase the return on his investment, a concept called leveraging.
Loans made to finance real estate transactions are classified as either: Fixed rate mortgages (FRMs) and adjustable rate mortgages (ARMs). FRMs provide stable long-term financing since the rate of interest is fixed for the life of the loan. The fixed rate is based on 10-year treasury note rate at the time the FRM loan is originated, with the addition of a mortgage risk and servicing margin. Historically, the margin has been 1.4%. Presently, the margin is double the historical margin, and likely to remain above the historical margin until 10-year bond rates rise above 4.5 % and the Federal Reserve steps into the secondary bond market for mortgages.
An FRM allows the owner to retain the hedge against future inflation, the hallmark of long-term ownership in real estate. Further, FRMs provide stability for future ownership since the monthly payments are constant and the loans are fully amortized. Any due date disrupts stability and increases the risk of loss.
ARMs on the other hand do not have the elements fundamental to a real estate loan. ARMs are based on short-term rates designed for financing consumer products. The degree of instability an ARM places on the ownership is reflected in the range of periodic adjustments in the note rate and monthly payments agreed to in the note. While amortized, the amount of the monthly payment is reset constantly based on fluctuations in short-term interest rates, a most volatile and unpredictable variable affecting all future monthly payments. The risk of loss associated with an ARM loan is unacceptable except for the most sophisticated of investors, and far too great a risk to be placed on homeowners.
Short-term rates used to set the note rate in an ARM are harnessed by the Federal Reserve to fight inflation (and deflation). By forcing the rate up (or down), the Fed makes it more (or less) costly for consumers to buy goods and services. However, the ARM uses these short-term rates to set the cost of continued ownership of real estate it encumbers. The natural consequence of coupling real estate ownership to short-terms rates has always been higher foreclosure rates for ARM loans than for FRM loans.
Further, an ARM shifts the inflation hedge of long-term ownership from the owner to the lender. The shift in wealth occurs as inflation occurs since short-term rates rise to fight inflation and at the same time drive up the amount due monthly to the ARM lender. Thus, the lender presently reaps the benefits of any future inflationary increases in the value of the secured property since the short-term rate controlling the ARM increases the monthly payments as inflation is occurring. The amount of this present shift in wealth to the ARM lender represents the present value of any later inflationary increase in the value of the property.
The primary beneficiaries of ARM loans are the speculators in real estate, exemplified exclusively by the buy-and-sell crowd of flippers. An ARM fits their needs perfectly. Initially, and for a short period of time, ARMs are low-cost loans. Monthly payments are based on teaser rates set at Federal Reserve interbank rates. In addition, the speculator typically has the option of continued low payments which produce negative amortization which builds up the principal balance on the loan, in lieu of out-of-pocket cash expenditures.
Speculators are unconcerned with future inflation. They seek instant profit on a flip of the property based solely on a rapid immediate appreciation in prices and the lowest possible carrying costs. The ensuing loan adjustments will never affect them, unless the property does not flip and the speculator retains ownership. At some point, the speculator will rationally stop making payments to cut his losses. Short-term interest rates during periods of low rates of inflation are only good for short-term objectives, the antithesis of real estate ownership.
Since the earnings of these gatekeepers who police entry into the real estate market are based on the dollar size of the property and not the services rendered, brokers, builders and lenders want buyers to have access to ARM financing. ARMs put more money into the hands of a buyer than he is qualified to repay. Excess funds mean more and larger properties can be sold at ever increasing prices and earnings. Thus, there is a great need to provide long-term stability to real estate transactions by regulating the types of loans available to buyers and owners.
The minimal guidelines now existing for these loans must be restructured if the real estate market is to avoid future exploitation of buyers and owners who are undercapitalized and uneducated in the economics of ownership. In part, appraisers are collaborators in the pricing scheme since they nearly always agree with the buyer who deceptively insists the price set in the purchase agreement is the property’s true value.
Appraisers routinely ignore fundamental real estate valuation principles which dictate that the lesser value calculated based on comparable properties, cost of replacement, or the actual or implicit rental income approaches controls the ceiling on a property’s fair market value (FMV), and consequently, the loan amount that should be funded. Instead, appraisers faithfully follow the lender’s employment instructions which include the value needed to close the loan.
Historically, brokers and their agents made judgment calls on the total amount of the loan a buyer would be able to qualify for. They simply quadrupled the buyer’s gross annual income to get an approximation of the loan amount a buyer could afford. If the loan was conventional, the lender would require a 20% down payment or allow the seller to carry 10% of the price in a second with a 10% down payment, called 80-10-10 financing.
Armed with this simple loan-to-income ratio, the agent knew that a buyer making $50,000 gross annually as a wage earner could qualify for a $200,000 loan, and at 80% of value would need $50,000 in cash for a down payment on a home priced at $250,000. At 6.6% interest, the payment would be 31% of the buyer’s gross income, the figure Congress used in 2008 for monthly payments on a loan cramdown. Congress is now talking about raising the ceiling to 38% of gross income to allow buyers to qualify for higher loan amounts on a loan cramdown and thus permitting higher valuations of the property they occupy.
Government oversight after the Wall Street bailout will be intense. Congress will need to assure the public that the lenders the government has backed are making loans only to individuals who will repay. Agents and brokers working with buyers will need to present their prospective buyers to a mortgage banker by applying for a written approval stating the specific maximum loan amount they will lend to the buyer. A loan approval fee may be required along with a deposit of the costs the lender will incur to process the paperwork and make the written commitment. The buyer will need to have verifiable funds equal to the down payment to qualify for a loan; 3% for FHA insured financing, 20% for conventional financing. Since 1990, the annual savings rate of potential home buyers has decreased every year, and is presently zero.
A ding on a buyer’s credit history due to a foreclosure will most likely be excused as being caused by the recent mortgage lending financial crisis and resulting massive devaluation of real estate since these events have undermined the use of credit scoring. The conduct of the Troubled Asset Relief Program (TARP), if it is funded as congress intended with the $700 billion bail out, is also likely to be a cover for an employed buyer with a 20% cash down payment since TARP will most likely delay the resolving of cramdowns and foreclosures on over-encumbered property.
When the buyer locates a property and contracts to buy it, the property must qualify as adequate security for the loan amount. An appraisal to set the fair market value must be the result of strict guidelines which real estate appraisers must be required to follow. The appraiser’s connection with the lender will be broken, the independence of the appraiser will be established, and the method of developing the current market value of the property will be legislated to respect the lesser evaluation generated by the different methods for setting a property’s Fair Market Value (FMV).
Listing brokers and sellers will not be happy with the initial results since the buyer’s price and terms of purchase will no longer be the standard for setting the property’s value or acceptable condition of that property. The history of comparable sales, costs of replacement by construction, and current rental values will keep property values from drifting upward quickly enough to attract speculators. Appraisals are reflective of past events; they are not forward-looking. An inflationary factor based on the current rate of inflation may well be allowed as the only increase in value over the value set by the appraiser.
Carryback financing might be allowed to fill the gap between the appraiser’s FMV determination and the price agreed to by the buyer and seller. The buyer and any carryback seller can then decide whether the anticipated future appreciation in the value of the property will, in their minds, justify the price. These carryback conditions for financing were common place prior to 1985.