BREAKING BANKS: HOW INTEREST RATE HIKES RESHAPED REAL ESTATE FINANCING

From the Emergence of DSCR to Bank Failures: Navigating the Tides of Real Estate Financing

As the Fed embarked on a year-long journey of hiking interest rates, Wall Street's famous saying, "The Fed tightens until something breaks," couldn't have rung truer than during the bank failures of March 2023.

The first casualty was Silicon Valley Bank (SVB), crumbling on March 12. Just three days later, Credit Suisse, a banking giant with a storied history, found itself in the embrace of UBS. Not long after, Republic Bank joined the somber parade in May.

These bank failures mirrored the grim specter of 2008, both in terms of the assets involved and the support needed from the Federal Reserve. The question that naturally arises is, how did we find ourselves in this déjà vu?

The answer, as eerily familiar as it was in 2008, can be traced back to the interplay of interest rates and mortgage-backed securities.

Silicon Valley Bank's Downfall

The unraveling of SVB commenced with their decision to sell mortgage-backed securities to raise capital. (These securities are essentially bundles of multiple home loans packaged together for investors.)

Unfortunately for SVB, this move resulted in substantial losses on their financial books. This triggered a panic among depositors who began doubting the bank's ability to cover its liabilities.

To understand why SVB ventured down this treacherous path, we need to delve into why regional banks like SVB initially ventured into the realm of mortgage securities.

Bank Deposits as Liabilities

When we deposit money in our neighborhood bank, it essentially becomes a liability on the bank's balance sheet. These deposits can be withdrawn at any time, and historically, banks had to pay very little when interest rates remained low.

During the peak of the Covid-19 pandemic, these deposits became a cost-effective source of funding, thanks to the Federal Reserve's cash infusion and interest rate cuts to near-zero levels. Interest rates on deposits plummeted to historic lows, while the volume of cash deposits skyrocketed.

SVB, in particular, catered to venture capital firms, who poured millions into the bank. These deposits adorned SVB's balance sheet as low-cost liabilities and a lucrative source of funding.

In SVB's case, the bank invested its capital in mortgage-backed securities with returns of around 3%, creating a favorable spread between their returns and the cheap source of capital from deposits.

The Fatal Flaw – Asset-Liability Mismatch

SVB, along with several other banks, utilized short-term deposit capital to purchase long-term bonds and mortgage-backed loans intended to be held for years. This risky practice, known as an asset-liability duration mismatch, goes against the fundamental wisdom of finance, which warns, "Don't Do This, It May Kill You."

When a bank lends out customer deposits for a long period, they expose themselves to the risk of being unable to produce those deposits if customers demand them earlier. In such cases, the bank is forced to sell assets to repay the deposits, potentially at a loss if interest rates have risen in the interim.

The temptation of easy gains proved irresistible. Bank executives rolled the dice, and as interest rates climbed, they found themselves compelled to offload mortgage-backed securities at a loss. These losses sent shockwaves through the public, sparking bank runs, and ultimately, culminating in bank failures.

A Glimpse into Real Estate Securitization

Let's take a brief detour into the history of residential real estate securitization.

Before institutional involvement, residential real estate was primarily a playground for individual investors, offering high risk-adjusted returns in a fragmented market.

Wall Street's Entry

In the wake of the 2008 financial crisis, housing prices plummeted, creating an abundance of inventory for a good reason. Real estate assets were valued at mere fractions of their former worth, leading commercial banks to foreclose on properties between 2010 and 2012. With surplus inventory, banks became eager sellers.

However, the only financing available for purchasing these properties came from the very banks desperate to offload their bloated inventory. Commercial banks had no interest in extending loans on assets they were desperate to shed. Consequently, asset prices plummeted to levels that offered attractive unleveraged returns.

As a result, Wall Street, led by private equity groups like Blackstone, entered the residential real estate game with a vengeance. They initiated the securitization of residential mortgages, bundling them into bonds that attracted investors and raised more capital.

This marked the onset of institutional capital pouring into residential real estate.

Competing with Local Banks

Following Wall Street's success in financing real estate for institutions, companies such as B2R Finance, First Key, and eventually, Corevest, emerged to provide long-term financing for retail real estate investors.

This marked a significant shift where Wall Street financiers began challenging local banks and traditional funding sources. Corevest, for instance, introduced non-recourse products, offering lenders limited recourse beyond the collateral (typically, the property itself) if borrowers defaulted on their loans.

Around 2017-2018, companies like Verus revolutionized the market. They introduced real estate debt products that primarily considered the debt service coverage ratio (DSCR) of the underlying collateral. They educated bond buyers and rating agencies about these innovations, tapping into an underserved market. Their goal: to reduce rates and compete directly with banks.

And thus, DSCR loans were born.

Understanding DSCR Loans

DSCR loans are secured by investment properties and offer an alternative to traditional bank loans that require personal income verification. A popular variant of these loans offers a 30-year term with a fixed interest rate and a 30-year amortization schedule.

Rather than scrutinizing paystubs and income from tax returns, these "no-income" loans focus on a property's debt service coverage ratio. DSCR compares the property's annual gross rental income against its annual mortgage debt, including principal, interest, property taxes, and insurance.

In essence, lenders evaluate a property's rental income potential instead of the borrower's income to determine loan viability. While credit scores still matter, and there are limits on the maximum loan-to-value ratio, borrowers aren't required to submit tax returns.

DSCR loans find favor among real estate investors who:

• Don't qualify for agency-backed investment property mortgages.

• Have legitimate business deductions that reduce their income.

• Prefer not to rely on their own income to cover a mortgage.

The DSCR Revolution

Historically, real estate investors faced limited borrowing options to expand their rental portfolios, primarily relying on local banks.

However, following the path blazed by companies like Verus and with the backing of Wall Street investors, DSCR loans gained wider acceptance, offering competitive terms without the hassles of traditional bank loans.

Expanding the Reach

Initially, DSCR loans were costlier than regular bank loans, with mortgage brokers being the primary distribution channel catering to self-employed borrowers.

Then came the disruptive impact of Covid-

19 in 2020. For the first time, DSCR products offered cheaper rates and better terms than local banks. The distribution network expanded to include private and hard money lenders, complementing their bridge loan offerings.

The product exploded in popularity. Although banks have traditionally been a major source of capital for small businesses, their prospects started dimming.

The Fed Steps In

In 2022, the landscape shifted again as the Federal Reserve aggressively tackled inflation by raising interest rates.

During the early stages of the Covid-19 pandemic, banks accumulated substantial cash from deposits, rendering them less reliant on borrowing from the Fed. However, as deposit levels began declining in the third quarter of 2022, banks went from being flush with cash to competing fiercely for depositors. This competition extended throughout the banking system: depositors sought better rates, and banks scrambled to retain deposits by offering higher rates.

Unfortunately, as deposit levels dwindled, banks found their low-cost funding vanishing, resulting in skewed loan-to-deposit ratios. Regulators prefer these ratios to be low, as it signifies a larger cushion of deposits to protect against deposit runoff.

Bank Loan Competitiveness Wanes

When a bank's loan-to-deposit ratio undergoes a shift, banks have two options: reduce their loan portfolio or increase deposits. Typically, this led to fewer loans being offered at higher interest rates. Bank profit margins a

lso took a hit due to increased interest rates paid on deposits.

Consequently, over the past six months, bank loan terms underwent significant changes as banks aimed to reduce the number of loans. They tightened credit standards for loan qualification and increased interest rates to maintain profitability. Investors began seeking better alternatives, and DSCR loans made a resurgence by offering similar costs but superior terms and service.

The Future of Commercial Banking

One overarching concern revolves around the role of the commercial banking industry in financing Main Street single-family real estate. Without access to very low-cost deposits, banks face challenges in keeping pace with other financing sources.

The Lurking Credit Challenge

Another looming issue pertains to the status of commercial property values. In major markets across the nation, such as Los Angeles, Chicago, and Austin, commercial real estate grapples with alarmingly high vacancy rates, sometimes exceeding 40%. Banks that financed these office buildings now grapple with substantial but often hidden losses on their balance sheets.

The Fed's Influence

The Federal Reserve has also contemplated keeping interest rates elevated for an extended period to combat inflation, further escalating funding costs for banks. The convergence of a potential commercial real estate credit problem and rising interest rates suggests that banks might face increased challenges in the long run.

Continued Banking Consolidation

Historically, after banking crises, regulators tend to respond by tightening regulations, placing greater burdens on small banks. Following the Dodd-Frank Act, we witnessed a decade marked by increased mergers and acquisitions. Local banks evolved into regional players, and regional banks merged with or were absorbed by larger institutions.

Since 2008, around 3,500 community banks have vanished nationwide, leaving just 5,000 in existence. The recent banking crises, coupled with the impact of Covid-19, could potentially halve this number in the coming decade. Consequently, we stand at the precipice of more banking transformations that could usher in consolidation, diminished service quality, and a stronger bond between Wall Street and Main Street.

Staying Informed Amidst Shifting Tides

In the wake of these bank failures and persistently high interest rates, DSCR loans continue to reshape the industry. Private lenders embracing DSCR loans have expanded the distribution network, making them a convenient core financing option for real estate investors.

The deepening connection between Wall Street and Main Street, combined with macroeconomic shifts, is redefining the real estate industry's landscape. Securitization and private lending are emerging as vital financing tools. In this dynamic environment, staying attuned to macro trends and incorporating them into your business strategy is more crucial than ever.

If you're seeking competitive long-term rates and top-notch service, consider exploring CMG's DSCR loans.