Hey folks, 👋 Mo here!

Welcome to another jam-packed issue of the newsletter. Strap in, because today we're tackling some core concepts that every homebuyer needs to know.

• Mortgages

• Status of 2023 mortgages

• What happens during defaults?

Mortgages

First up - mortgages. I know, about as spicy as plain oatmeal, right? But having a solid grasp of how mortgages work means you can shop around like a pro when it's time to get your own loan.

This means you can negotiate $ on fees, timelines, and make millions if you know how to play the game.

Let's break it down...

Demystifying Mortgages

If you're looking to finance a purchase, you'll need to get something called a mortgage. Simply put, a mortgage is a loan that uses the property as collateral for the borrowed amount.

Let's unpack some key concepts:

The Principal vs Interest

The principal is the amount you originally borrow from the lender. This money goes towards buying your investment property.

Interest is the fee you pay for borrowing the money, typically shown as an annual percentage rate (APR). The higher the interest rate, the more you'll end up paying over the full loan term.

Your monthly mortgage payment goes towards both the principal and interest. In the early years, most of your payment goes to interest. As you pay down the loan, more goes towards principal.

Fixed vs. Adjustable Rates

With a fixed rate mortgage, your interest rate stays the same for the entire loan term (usually 15-30 years). This offers predictability, since your payment won't fluctuate.

Adjustable rate mortgages (ARMs) start with a lower introductory rate that can change over time. After the intro period, the rate adjusts periodically based on market conditions. Your payment goes up and down too.

ARMs offer lower initial payments, but the risk is uncertainty. Fixed rates mean your payment and interest costs are stable. But if rates fall, ARMs could end up costing less overall.

Loan To Value

Two key metrics lenders look at when approving mortgages are loan to value ratio (LTV) and debt service coverage ratio (DSCR).

The loan to value ratio (LTV) compares the amount borrowed to the total appraised value of the home.

A higher LTV means more risk for lenders.

Example – a $1mm loan on a $2mm property is 50% LTV. Loan is $1m and property is $2m or 50%.

Debt service coverage ratio (DCSR) measures the borrower's ability to cover mortgage payments based on their income.

It compares monthly debts like loans to monthly income.

Example – a property makes $10k a month in net rental income a month. Net means after operating expenses. The debt on the property is about $8k a month.

The DSCR is $10k/$8k or 1.25.

Most lenders want to see above 1.25. If it doesn’t cover 1.25, then the amount of leverage needs to be lowered.

A higher ratio indicates greater ability to afford loan payments. Lenders want to see a reasonable LTV and high DSCR when approving borrowers, to ensure they aren't over-leveraged and can comfortably make payments.

These metrics help assess risk and are crucial parts of the mortgage approval process.

Down Payments and PMI

The down payment is the amount you pay upfront when purchasing a home. Conventional loans typically require at least 20% down to avoid private mortgage insurance (PMI).

PMI is an added premium for borrowers who put down less than 20%. You pay this monthly until you reach 20% equity in the home through appreciation or extra payments.

While PMI increases costs, it allows buyers to purchase with a smaller down payment. FHA and VA loans also let you buy with little to no money down, but have mortgage insurance built in.

Commercial loans usually require 30% down minimum.

Loan Terms and Payoff Timelines

Standard residential mortgage terms are usually 15 or 30 years. The longer the term, the lower the payment but more interest paid over time. A 15-year loan costs more per month but builds equity faster with less interest.

Many factors affect your payoff timeline for a mortgage:

- Loan term - Amount of terms Shorter terms mean faster payoff

- Interest rate - Lower rates save money over the life of the loan

- Payment amounts - Extra or higher payments pay off principal faster

- Home appreciation - Rising home value builds equity

Recourse vs Nonrecourse Debt

Within commercial real estate, there is recourse and non-recourse debt.

In a nutshell, recourse debt means the borrower is personally liable if they default. With nonrecourse debt, the lender can only seize the collateral - i.e. the property but your personal assets are in good shape.

So if times get tough and you default, with nonrecourse loans the lender can take the building but that's it.

Recourse debt opens you up to much greater personal risk. Your other assets could be fair game beyond just the property used as collateral.

Non-recourse lending is more common in commercial real estate since it somewhat limits lenders' exposure. But for riskier projects, lenders often want the option to go after the borrower's personal assets.

The rule of thumb is non-recourse debt starts at loan sizes of $1mm (or property purchases above $1.3mm).

Context:

The reason why so many commercial borrowers are in hot water and you see article about the impending CRE bust is due to adjustable rates hiking up at least 400 basis points (4%).

In fact, the Fed has raised rates to 5.5%, the highest it’s been in 22 years.

How does this affect borrowers?

Wall of Maturities

In the next year, nearly $430 billion in commercial real estate debt will mature. That's a huge chunk of loans coming due all at once! These are across all asset classes but recently, there’s been a lot of multifamily sponsors that have been getting into hot water.

Tides Equities calling for more funds to inject into properties

Applesway Investment Group foreclosed on 3,000 units

Multifamily Syndicators face debt exposure

This massive wave of maturing debt is nicknamed the "wall of maturities." Catchy, right?

When these loans originated years ago, credit was flowing freely and aggressively. Loans were done with minimal money down on risky projects. Not the most prudent lending, in hindsight.

The Fed was printing. That was back in the days when Jerome Powell was referred to as “Daddy Powell”.

With rising interest rates and depressed rents, refinancing to pay off maturing debt will be difficult.

Many properties are worth less now than when their loans were originated. Plus lenders today have higher standards including DSCR and LTV.

This scenario is especially troubling for older Class B/C malls and office buildings. Their values have declined and finding financing will be tough.

If property owners can't refinance and pay off their matured loans, lenders may take back the buildings. We could start to see an uptick in foreclosures.

Recently, some of the largest office owners have started to hand keys back to the owners.

While the Fed keeps aggressively hiking rates, borrowing costs will remain high. Loans will be harder to come by for distressed commercial assets.

So in short - a massive lump of dicey commercial loans made over a decade ago are now coming due. It'll be an interesting year ahead as owners scramble to refinance.

What happens during a default?

If someone defaults, what are possible avenues that can happen?

Banks are not in the property management business, they’re the lending business.

Usually, one of three things can happen:

• Refinancing

• Loan modifications

• Foreclosures

Refinancing

- With loans maturing, the ideal scenario is for borrowers to refinance and pay off the old debt.

- Interest rates are much higher now compared to 10+ years ago when deals were originated. Plus lenders have stricter standards with DSCR and LTV.

- Many properties declined in value or rents dropped. Owners may not meet loan-to-value ratios for refinancing.

- Not all loans will qualify for refinancing. Borrowers unable to refi will need to pursue other options like selling or handing back keys.

Loan Modifications

- If refinancing isn't feasible, owners may try negotiating loan modifications with their lender.

- This involves changing the terms of the current loan to make it more affordable or extend the maturity date.

- Lenders may be open to modifications to avoid foreclosing and taking on a non-paying asset.

- But modifications require lenders to acknowledge losses on their books, so approval isn't guaranteed.

Foreclosures

- If owners can't refinance or modify, lenders may initiate foreclosure proceedings to take back the property.

- With foreclosure, the owner loses the asset and the lender tries selling it to recoup losses.

- We'll likely see an uptick in foreclosures as loans mature and borrowers struggle to get new financing.

- Foreclosing isn't ideal for lenders either as it means recognizing losses and marketing distressed assets.

The commercial real estate crisis will test owners and lenders alike. Those unable to refinance or modify loans may face foreclosure. It will be a painful reckoning after years of loose lending practices.

I hope you’ve enjoyed reading this. If you enjoyed this article, please email me with any topics and consider downloading the ebook!

Until next time,

Mo