Last week CoreLogic, a leading real estate research firm, reported that in December distressed sales (REO and Short Sales) fell to 12.8 percent of all sales. The company also recently reported that cash transactions—the common barometer used for real estate investment sales—made up 35 percent of all home sales, down from 38.5 percent in 2013.
This seems to confirm what we are seeing with our clients and what we are hearing at industry conferences. And that is, the SFR market is changing from both a property and a strategy perspective. REO and short sales, which had been a big factor in the market, are rapidly giving way to non-distressed, MLS listed sales and even new homes, which are being purchased from builders as rentals.
At the same time, many of our clients are increasingly using leverage – read mortgages —in their purchase strategies, as opposed to all cash.
Our CFO, CP Pal, has created relationships with lenders who help our clients secure financing and he says that although most of the loans our clients are applying for are still coming through agencies, like Freddie Mac and Fannie Mae that permit investors to buy up to 10 properties with mortgages (including their own home), increasingly investors are looking for new options. The new, non-agency lenders are more flexible to provide additional liquidity to the market.
“There are advantages and disadvantages to each option,” says Pal. “the agencies often have the best rates, and long term (30 year) loans but they are limited in who they can serve. The new lenders can be more flexible and can serve international investors, LLCs and investors with portfolios that exceed 10 properties but their costs will be higher and in many cases the loan terms will be for 5 or 10 years with a 30 year amortization.”
What the new lenders are focusing on is the quality of the property. They put the ability of the property to generate cash flow and maintain its value as the key attributes to qualifying for a loan. For some lenders, this is even more important than an investor’s ability to repay. This is where the new lenders, some of whom were the main distressed property buyers a couple of years ago, are becoming a factor in the market—lending based on the ability of a property to generate enough cash to service a loan, also known as non recourse loans.
And why is leverage such a powerful tool for investors? First, with more money, investors can purchase more rental homes increasing their returns and creating a geographically diverse portfolio. It also allows investors to build wealth as the loans are paid off. Here’s how that works: An investor buys a $100,000 house with a $25,000 investment and a $75,000 loan. During the course of the 30 years, assuming that it’s an agency loan, the investor can use the monthly rental payments to make loan payments and pay for property maintenance and the principal on the loan and the costs of property management are tax deductible, offsetting much of the rental income.
As the loan amortizes, the investor builds equity. After the 30 years, assuming there is no change in the house price, the investor has turned a $25,000 investment into a wholly-owned free and clear property worth $100,000— quadrupling his original investment and making a healthy cash flow every year. Any capital gains is icing on the cake. And much of the return was tax-free as the investor can claim deduction of mortgage interest and depreciation for investment properties from his taxable income.
However, there are risks associated with leveraging, which the investors should be aware of. If the property is vacant for longer than anticipated or there are larger than estimated repair costs, the net rental income from the property may not be sufficient for paying the mortgages, which the investor has to pay from his other sources of income. Also, if there’s a dip in the value of the prices, the investor may be upside down on his/her mortgage. Hence it becomes extremely important for both the investor and the lender to conduct proper due diligence on the property.
This type of value investing is why the market has switched from bottom feeding to seeking quality properties that can maintain value and generate cash. So real estate investment sales may be slowing down, but the new capital available to investors will ensure that the market remains healthy.