Rated securitizations may whet Wall Street appetite for house flipping loans
Plans to begin rating securitizations backed by fix-and-flip mortgages may help lenders create new capacity and satisfy growing demand for short-term financing of house flipping projects.
While the majority of house flippers still use cash, the share of projects that are financed has hovered around 40% since the second quarter of 2017. That's up from a low of 21.4% in the first quarter of 2011, but well below the peak of 67.7% in the third quarter of 2005, according to Attom Data Solutions.
The securitization market for fix-and-flip loans is still relatively small. But rated securitizations could change that by injecting fresh capital from institutional investors that won't buy bonds without a third-party assessment of their risk. Morningstar Credit Ratings, for one, is currently developing criteria to rate fix-and-flip securitizations in anticipation of the opportunity.
"These deals might become more commonplace, as investors and issuers become more aware of these securitizations," the ratings agency said in a recent report.
There are a number of factors behind this trend. As the price to acquire properties continues to rise, house flippers are increasingly turning to financing to fund their projects. Lenders are more willing to offer fix-and-flip financing as a way to offset mortgage volume lost to rising interest rates. And that drop in originations also has investors in search of new ways to deploy capital.
But ultimately, Wall Street's willingness to invest in securitizations backed by fix-and-flip loans will drive the niche product's growth prospects in 2019.
Fix-and-flip loans are secured by a lien on the property, similar to a traditional mortgage, but with lower loan-to-value ratios than owner-occupied financing. In most cases, fix-and-flip financing have a draw feature like construction loans and consist of interest-only balloon loans, with terms typically no longer than three years.
"I think it's pretty interesting because you can lend on something with reasonable interest rates with a 50% LTV," said Michael Nierenberg, CEO of New Residential Investment Corp. "We really haven't done a lot of volume there. We're starting to offer the product through our mortgage company, but there really hasn't been a lot of volume."
New Residential does cleanup calls on the nonagency residential mortgage-backed securities it services. As a result, it acquires nonperforming loans and foreclosed properties.
"It would be great to offer consumers and fix-and-flip buyers mortgages that would go along in parallel with the properties that we're offering," Nierenberg said.
Its recently acquired mortgage origination subsidiary NewRez, formerly New Penn, is "now beginning to offer some products, out in conjunction with some of the folks that are purchasing REO," he said. "But in general, there's been very little done by us."
Having a securitization outlet for the product only enhances New Residential's interest. Nierenberg compared its potential to the growth of lending outside qualified mortgage requirements and other private-label securitizations in the post-crisis era.
"I think down the road you'll see some rated deals, similar in nature to how the non-QM market started," he said. "Initially, very quiet and now we're starting to see a little bit more activity."
Marketplace lender and single-family bridge loan specialist LendingHome did six securitizations of fix-and-flip loans from 2016 to 2017, totaling nearly $183 million, but none were rated. While LendingHome did not do any securitizations in 2018, there was an unrated transaction from Angel Oak issued in March and another from Civic Financial Services in May.
"This asset class has come out of the 'mom and pops' and out of the country clubs, so to speak, and into the mainstream," said Josh Stech, a senior vice president at LendingHome. "When something comes from Main Street to Wall Street, it comes with a tremendous amount of oversight and sophistication," Stech said.
In California alone, the percentage of flips purchased with financing was 48% in 2017, compared to 36.5% in 2014, according to a LendingHome report based on data from the lender and Attom. During 2017, 48,020 homes were purchased in the state to be flipped, compared with 28,646 in 2014.
The current growth in financing is a result of diminished returns for investors. Because of leverage, they can make more when they sell a property where they financed the purchase versus one that they used their own money, according to an Attom report for the second quarter of 2018.
Lenders price fix-and-flip loans better than construction loans because of the shorter duration, which reduces risk, said Builders Capital CEO Curt Altig. There is much less risk in rehabbing an existing property compared to a brand-new construction project.
Builders Capital's primary business is construction lending. But in its primary market in the Puget Sound area in Washington state, there is a limited amount of available land to build new homes.
"What we began to notice was our builders were having to source different types of properties," like redeveloping existing homes to keep their pipeline going, Altig said, adding the fix-and-flip loans are very similar to construction loans, but with just one or two draws.
While 75% of its business is in the Puget Sound market, it also lends in the Portland, Ore.-Vancouver Wash., area along with the Colorado Springs and Denver markets.
"We have ambition to grow outside of [those areas]," as it looks to take advantage of this burgeoning market, Altig said.
Securitization will lead to enhanced liquidity and investor interest in these loans, something which has been happening over the past few years. But fix-and-flip financing also comes with unique credit risks that make it more difficult to rate securitizations back by the loans.
"The credit risks as we view them include abandonment of the properties because of lower-than-expected profits owing to a miscalculation of the rehab costs, property valuation, or a decline in the demand, which would require the properties to be sold for a longer period of time or at a lower price," said Youriy Koudinov, a Morningstar senior vice president and analyst who wrote its recent report.
At the Structured Finance Industry Group's February 2017 conference in Las Vegas, 35% to 40% of Morningstar's meetings were about fix-and-flip loans and the possibility of doing securitizations, said Managing Director Kevin Dwyer. "Now that the unrated deals have been done in the market, we think there is a higher chance of rated deals coming," he added.
So far, none of the other rating agencies are developing their own criteria at this time. "We do not have a methodology to rate fix-and-flip loans," said Jack Kahan, managing director, RMBS for Kroll Bond Rating Agency. "However, we're always evaluating new opportunities and we have been active in discussions with a number of market participants in the space."
Likewise, Moody's Investors Service and Fitch Ratings have not created specific methodology or rated any fix-and-flip securitizations.
"The biggest obstacle for us is the lack of historical performance data of the product through an economic stress," said Grant Bailey, who heads the U.S. RMBS team at Fitch. "The low LTVs are a big mitigating factor. However, there's some uncertainty about how the take-out of the fix-and-flip loan would hold up in a stress environment where both buyers and lenders are pulling back."
Despite the optimism, it's possible the demand for fix-and-flip lending has already peaked. Taking the opposite view for fix-and-flip lending's prospects is Hunton Andrews Kurth, a law firm whose practice includes structured finance. The firm was the issuer's counsel for a fix-and-flip securitization in 2018, as well as the asset manager's counsel for a different transaction.
Fix-and-flip lending and securitizations will slow, given the downturn in the housing market along with higher borrowing costs and low property inventory in many regions, the firm wrote in a recent market outlook report.
"Secondary market whole loan sales will most likely continue to be the preferred takeout option for originators and lenders," Hunton said in the outlook.