Originally published in the August issue of Think Realty Magazine, DLP Lending explored the impacts of COVID-19, and how lenders are not only reacting to shifts in the market, but adapting and paving the way to recovery.
It is undeniable that COVID-19 heavily impacted the real estate industry, creating a high degree of fear and uncertainty. The pandemic and accompanying shutdown hit the lending market hard, with mortgage delinquencies surging by 1.6 million in April to peak at 6.45 percent.
While it now seems like we are on the path to recovery, we cannot forget that uncertainty remains. The worst may be behind us, but we’ve yet to see everything from COVID-19 and the residual fallout within real estate and lending.
As we continue our return to normalcy, there’s one thing that is certain in real estate investing and lending: a cautious and conservative approach will help mitigate the risk of uncertainty and pave the way for a stable, steady recovery and a healthy market in the future.
Housing trends in the COVID-19 era
While we’re not out of the woods yet, we have reasons for optimism. As the economy further recovers, it’s expected retail sales will climb and commercial real estate will improve. We saw increases in mortgage applications near the end of the second quarter, which is a good sign for residential and multi-family.
Still, uncertainty remains. The after-effects of the Great Shutdown make it tough to predict the future housing landscape. Additionally, there is always the threat of re-emergence of the virus until we have a vaccine. For example, many health experts have predicted a surge in cases in the fall, with a peak in December.
How lenders have reacted to the ever-changing landscape
The economic shifts stemming from COVID-19 have been strong and swift. In response, lenders have become more conservative to mitigate risk.
First, many large institutional banks and REITs basically stopped deploying capital once the pandemic hit American shores. As Douglas M. Weill, founder of a global real estate capital advisory firm, notes, “Institutional investors are defensively looking at their own portfolios.” During the pandemic, lenders and institutional banks mainly focused on their asset management and loan portfolio servicing. They tightened the purse strings because of changes in financial markets, declines in other asset values, and uncertainty surrounding the market.
So, how has this impacted lenders and investors?
Well, many lenders are structurally tied to other capital sources. Traditionally, lenders originate loans and sell those loans to Wall Street at a 2-3 percent premium. During the pandemic, Wall Street wouldn’t pay that premium due to market uncertainty.
As a result, many lenders have reduced their loan programs or stopped funding loans to real estate investors. We do anticipate capital markets to continue to come back with tighter pricing and looser guidelines, but this will happen over time. Moreover, pricing from the secondary and capital markets will likely not be at the same levels as pre-COVID for quite some time, if ever.
When the pandemic peaked, only those self-reliant, balance sheet lenders were active. Now that the capital markets have re-emerged, more types of lenders have begun providing financing again.
DLP Lending, for example, doesn’t rely on institutional investors. We raise money through a fund structure and balance sheet all our loans. This has enabled us to still provide loans directly to real estate investors throughout the Coronavirus pandemic.
Even for lenders who haven’t been as impacted, uncertainty clouds the market. This has led to big changes in the way they structure the loans.
The new norm for lenders post-lockdown
Uncertainty has necessitated that lenders mitigate risk with a more conservative approach. Some have chosen to fund loans more carefully by making changes to their credit box. Others have chosen to sit on the sidelines.
Lenders also have greater concerns about borrowers’ ability to execute. They are more actively asking:
- Given the current situation, can borrowers make payments?
- Can investors continue with their projects? How quickly and efficiently can investors complete their renovation products? Construction was deemed non-essential in many states, like New Jersey and Washington. Will there be continued delays in construction timelines due to the supply chain and labor force?
- How will valuations change? Housing prices are rising now because of pent-up demand and low supply, but that could change later in 2020.
The last question about valuations is important. While the housing market has momentum now, what happens when stimulus support measures fade? The continued effects of unemployment could lead to a rise in distressed inventory at the end of 2020 and into the beginning of 2021. And that may force more home sales.
Considering all the uncertainty, and potential for asset value declines, lenders have been forced to become more conservative. Investors should not expect the same conditions and terms as before COVID-19. And it is hard to tell when we will return to the way it was (if ever).
Listed below are ways lenders have updated their funding process and parameters. If you are a real estate investor and entrepreneur, understand the new conservative approach from lenders. And embrace it as the new norm.
- Lenders have reduced leverage by 5 Percent to 15 percent
Reducing leverage lowers risk for lenders. That is because borrowers have more skin in the game when they are putting in more of their own money. Less leverage also insulates lenders from declining values. If an asset declines in value, they won’t be overleveraged. For example, if a lender gives an investor a loan with a 70 percent LTV, and then the market declines 5 percent, the lender won’t be overleveraged.
The investor approach: Expect lower leverage. Prepare more cash out of pocket, but also stay conservative with your deals and give yourself options.
- Lenders have increased rates by approximately 0.5 Percent
Lenders have done this for two reasons. One, higher rates offset heightened risk. And two, the cost of capital has increased, and that cost has been passed on to borrowers in the form of higher rates.The investor approach: Expect higher rates and a higher cost of capital. And adjust accordingly when calculating deals. Take this into account when analyzing the profitability of your deal.
- Lenders are requiring reserves
Lenders want a guarantee of payments for their future portfolios. This ensures they have money for long-term payment plans to their investors. Requiring a deposit of payments from the borrower enables that. It also allows borrowers to not worry about debt payments.The investor approach: Expect to have more cash in reserves, enough to cover 6-12 months of future payments for principal, interest, taxes, and insurance. Before COVID-19, investors were expected to only have a few months of reserves, with many hard money lenders not requiring reserves at all. Given the amount of reserves you need, this will require more upfront capital and may limit you from doing as many deals at the same time. If that’s the case, you’ll need to tighten your buy box so that you only do deals with maximum profits.
- Lenders are tightening their borrower qualification requirements
Due to the uncertain environment, lenders have mitigated risk through overlay guidelines that necessitate:
- Higher FICO scores and tighter credit requirements
- A reduction in cash-out loans
- More experience (which shows proof of execution)
The investor approach: First, expect conservative underwriting and there may be longer times to process loans. Lenders want to see proof of execution, so be prepared with a track record document that outlines all the real estate investment deals you have completed. You also need to be prepared to show more liquidity and capital in your accounts. Finally, understand it’s more important than ever to pay close attention to your credit score, especially if it is in the 600s. Know that if you don’t have the experience, having things like more reserves and better credit can help, but it’s not always a 1-to-1 comparison.
The road ahead in real estate lending
From higher experience to greater reserves to lower leverage, investors must embrace the new reality. Yes, lending terms may appear ‘worse’ than pre-COVID, but it’s a much healthier, more stable place for the industry to be in.
Also, what led us to this recession differs from the Great Financial Crisis. In 2008, a lack of lending diligence helped lead to the real estate market crash. The credit industry learned from this event, and the fundamentals are much more sound now. Lending won’t be the reason for a real estate market crash this time. Proof of this is already there in how adjustments have been made to mitigate risk and ensure lending fundamentals remain sound.
Sure, uncertainty remains for lenders and investors today. And we could encounter a tough stretch in the future. However, opportunities abound, especially in areas like new construction where there is an incredible need. Those that learn how to navigate the new lending landscape through a conservative approach and identify new opportunities stand to gain the most.
Don’t think of the present lending landscape as an obstacle. The new lending terms align better with the norms of the past decade. This is good news for the housing market. It will set the stage for a strong recovery and long, steady growth—much like what we saw following the Great Recession. Growth will be driven by a strengthening economy, sound lending fundamentals, and strategic investors that know how to execute. For those who take a conservative yet savvy approach, the 2020s will be another decade of opportunity.