Mortgages in 2023 & Capitalizing on them

Hey guys – It's Mo again.

We’ve done a few deep dives on mortgages - from how loans work to what happens when owners default.

I know mortgages can seem dry as a concept and we’ve spent the last 2 weeks covering them. But in 2023, it’s quite imperative to know how they work.

Demystifying Mortgages: How Loans Work

If you plan to purchase real estate, chances are you'll need a mortgage - the ubiquitous financing tool that lets you borrow against a property's value.

But how exactly do mortgages work under the hood?

In a mortgage, the amount you borrow from the lender is called the principal. This capital goes towards buying your property. The interest is the fee you pay for borrowing, shown as an annual percentage rate (APR).

Your monthly payment covers both principal and interest.

In the early years, most goes to interest since your balance is high. As you pay down the loan, more goes to reducing principal.

You'll also choose between a fixed or adjustable rate mortgage (ARM). Fixed rates remain constant for the full loan term, typically 15-30 years. ARMs have lower teaser rates that fluctuate in later years.

Lenders look at metrics like your loan-to-value ratio and debt-service coverage ratio when approving borrowers. These help assess if you are over-leveraged or can comfortably afford payments.

Down payments are also crucial. Conventional loans require 20% down to avoid private mortgage insurance (PMI). FHA and VA loans allow less. The longer your mortgage term and lower your rate, the less you'll pay overall.

Now you've got a handle on how basic mortgage mechanics work! Let's turn to the context shaping loans today...

The 2023 Mortgage Landscape

Mortgages are on a wild ride in 2023 as rising rates lead to dramatic shifts in borrowing costs. Here's what's unfolding:

-In recent years, we’ve had next to 0% risk-free Fed funds rate. Banks borrow at what’s called “SOFR” and tack on a 150-200 basis points (bps) surcharge.

- The Federal Reserve boosted interest rates over 5.25% for the first time since 2007. Mortgage rates followed, hitting 7% for a typical 30-year fixed loan.

- Higher rates killed the refinancing boom and cooled the scorching housing market as buyers got priced out. Home prices are softening in many areas.

- Stricter lending standards make financing challenging. Lenders want higher credit scores, income levels, and down payments compared to recent years.

- An enormous $430 billion wall of commercial debt maturity looms in 2023. Most of these loans originated over a decade ago when credit flowed freely.

With values down and rates up, refinancing to pay off old loans will be difficult. Distressed assets like malls and offices face the biggest headaches.

The value of these assets is significantly underwater comparatively to the balance of the loan, causing a lot of stress that’s going to happen.

The Fed's aggressive monetary tightening means challenging conditions for real estate financing are here to stay until 2025.

Savvy investors will need to adapt to succeed in this new landscape of high rates and skittish lenders.

What Happens When Owners Default

Rising rates also lead more owners to default on loans as payments become unaffordable.

But what happens after default occurs and what are some possible possibilities?

- The ideal outcome is refinancing to pay off the old debt. But higher rates and stricter standards make this elusive for distressed assets.

- Owners may negotiate loan modifications with lenders, changing terms like interest rates or maturity dates. But modifications mean losses for banks.

- If owners can't refi or modify, foreclosure looms. The lender may seize the property and tries recouping losses through sale.

- Lenders don't want foreclosed assets on their books. Lenders are not operators. Refinancing challenges will force more foreclosures, especially on over-leveraged commercial properties.

Prepare for market ripple effects as waves of loan defaults and foreclosures destabilize real estate markets. Only the most nimble owners and prudent lenders will stay afloat in the turbulent conditions ahead.

What should you do?

So… if you’re reading this and trying to figure out what to do, have no fear.

I think the next 2-3 years are going to have significant discounts for great assets in great location. Leasing up and adding value to those assets is a challenge in their own right, but I think everything has the “right cost basis” aka the right purchase price.

What am I doing?

I am talking to everybody who may have cash shored up via savings or refi’d when rates were <4%.

Any offers I’m putting out have significant down payments (above 35%) to reduce LTV (from last week’s newsletter) and DSCR.

Alternatively, you could look for loan assumptions, where you can assume the underlying loan and not have to get a new loan. This may require being underwritten by the current bank, but it’s one way of making deals pencil if the current investors have to exit.

Another strategy I’m seeing in the marketplace is people buying debt (notes) positions and foreclosing if the borrowers don’t make payments. I am seeing a lot more distressed debt funds pop up to capitalize on the opportunity.

Conclusion

The mantra “survive til 2025” holds true especially right now. We had a slew of low leverage loans in the last 12 years when the Federal funds rate was close to 0%. Now, it’s shot up significantly to 5.25% and lenders are figuring out what to do…

It’s a very risky time in CRE and fortune favors the bold. There’s no guarantee that the prices are going to reach their peak valuations. Conversely, there’s no guarantee that prices will go down even further.

Tread carefully and best of luck.

Let me know what real estate topics you want to see in future newsletters! Until next time...

PS: I wrote an eBook last year. I’m currently illustrating it and it should be available for sale via Amazon in the next month or two. Let me know if you’d like a copy.

Thanks,

Mo