From the Emergence of DSCR to Bank Failures: Navigating the Tides of Real Estate Financing
As the Fed embarked on hiking interest rates over the past year, the Wall Street saying: “The Fed tightens until something breaks” proved especially accurate during the March 2023 bank failures.
The first was Silicon Valley Bank (SVB), which failed on March 12. Three days later, Credit Suisse – one of the largest and oldest banks in the world – was bought by UBS. They were followed by Republic Bank in May.
Together, these bank failures matched those of 2008 in terms of assets purchased and Fed support required. So, how did we get here, again?
The answer, as in 2008, has to do with interest rates and mortgage-backed securities.
Silicon Valley Bank Failure Trigger Point
The trigger for SVB’s failure began with the sale of mortgage-backed securities to raise cash. (Mortgage-backed securities bundle multiple home loans into a single, securitized package that bond investors can purchase.)
Unfortunately for SVB, these sales resulted in substantial losses on their balance sheets. That sparked a run on the bank, as depositors feared that the bank didn’t have the capital to meet all its liabilities.
To understand why we reached this point, let’s explore why regional firms like SVB bought mortgage securities in the first place.
Deposits as Liabilities on Bank Balance Sheets
When you deposit money in your local bank, your money funds bank activities and sits on the bank’s balance sheet as a liability. Depositors can ask for their money back at any time and may receive interest in a savings account. Historically, the bank has to pay very little when interest rates are low.
During the height of Covid-19, deposits were a low-cost source of funding as the Fed flooded the economy with cash and slashed interest rates to zero. Interest rates paid on deposits plunged to all-time lows, while the amount of cash deposits spiked to all-time highs.
SVB catered to venture capital firms raising millions of dollars, which they would deposit into the bank. These deposits sat on SVB balance sheets as liabilities and a very cheap source of funding.
In SVB’s case, the bank invested its capital into mortgage-backed securities at ~3%, making a spread between that return and their low cost of capital from deposits.
The Original Sin – Asset Liability Duration Mismatch
SVB (among other banks) deployed their short term deposit capital into buying long-term bonds and mortgage-backed loans they expected to own for years. Borrowing short and investing long in this manner is known as an asset-liability duration mismatch – and in Finance 101 you’re taught “Don’t Do This, It May Kill You.”
If a bank lends out customer deposits for a term of five years, they risk not being able to produce them if the customer asks for their deposits back earlier. If that happens, the bank will be forced to sell assets in order to repay the customer’s deposit. However, if interest rates have risen in the meantime, the assets that the bank wants to sell may not be worth the original price, leading to a loss for the bank.
The temptation for easy money was too great. The C-suite at these banks gambled… and lost. As interest rates rose, they had to sell mortgage bank securities at a loss. These losses spooked the public, triggered bank runs and, ultimately, led to bank failures.
A History of Real Estate Securitization
Let’s take a step back into the history of residential real estate securitization for a moment.
Before institutions got involved, residential real estate used to be one of the greatest mom-and-pop investments – a completely fragmented market but with incredible risk-adjusted returns.
Wall Street Enters the Industry
In the wake of the 2008 Great Recession, housing prices and inventory levels hit extremes – for good reason.
Real estate assets were valued at pennies on the dollar, and commercial banks were foreclosing and taking these assets between 2010 and 2012. With all the inventory, banks became forced sellers en masse.
On the other hand, the only place to get a mortgage to buy these assets was from the same banks trying offload their bloated inventory. Commercial banks had no interest in financing debt on the assets they were so desperate to shed, and these asset prices plunged to levels that generated an attractive unlevered return.
As large inventory became available in residential real estate for the first time ever, Wall Street entered the business in a major way.
Private equity groups like Blackstone through Invitation Homes moved in first, buying undervalued properties aggressively. Once Wall Street private equity started investing, they called their debt financiers over at Deutsche Bank, who were happy to get involved with fees to be made. Deutsche helped them securitize residential mortgages, grouping mortgages together into bonds that would allow investors to raise more capital.
This was the beginning of the wave of institutional capital buying into residential real estate.
Competing with local banks
After Wall Street had success financing real estate debt for institutions, companies like B2R Finance, First Key, and a company that eventually became Corevest decided to open up long-term financing for retail real estate investors.
This was a key shift where Wall Street financiers began to compete with local banks or friends & family funding sources. Corevest provided non-recourse products – if a borrower defaults on a non-recourse loan, the lender can not pursue anything beyond the collateral, which would be the home.
Around 2017-2018, companies like Verus changed the market forever. They minted real estate debt that based the underwriting principally on the debt service coverage ratio (DSCR) of the underlying real estate collateral. They also familiarized and educated bond buyers and rating agencies with these new products.
In the process, they tapped into a huge, underserved market, knowing that if they could educate and interest bond buyers, they could drive down rates and compete directly with banks.
As a result, DSCR loans were born.
What are DSCR Loans?
DSCR loans are secured by investment propertied and provide an alternative to traditional bank loans requiring personal income verification. A popular version of the loan offers a 30yr term with a fixed rate of interest and 30yr amortization schedule.
Instead of considering paystubs and income calculated from tax returns, these “no income” loans look at a property’s debt service coverage ratio. DSCR pits the property’s annual gross rental income against its annual mortgage debt, including principal, , interest, property taxes, and insurance.
In other words, lenders consider a property’s rental income potential instead of the borrower’s income as the source for loan payments. Generally, they don’t require investors to submit their tax returns, though they still consider credit scores and limit the maximum loan-to-value ratio.
DSCR loans are often used by real estate investors who:
- Won’t qualify for an agency backed investment property mortgage
- Have legitimate business deductions that lower their income
- Don’t want to rely on their own paycheck to cover a mortgage
How DSCR Revolutionized the Industry
Real estate investors have historically had limited borrowing options to grow their rental portfolios – mainly from local banks.
After companies like Verus paved the way with Wall Street investors, DSCR loans became more accepted and competed with bank loans more directly. Borrowers no longer had to navigate the slow, complex, bank loan process to obtain financing.
Expansion of the Distribution Network
Initially, DSCR loans were more expensive than regular bank loans and the distribution network was limited to mortgage brokers offering them to self-employed borrowers.
Then, Covid-19’s effects hit financial markets in 2020, and that changed everything.
For the first time, DSCR products offered cheaper rates and better terms than local banks. The distribution network expanded to private and hard money lenders to complement their bridge loan offerings.
The product exploded – and though banks have been a significant source of capital for small businesses, their ongoing prospects seem to be dimming.
Fed Hikes Rates
2022 saw the markets change again as the Fed took a sledgehammer to inflation in the form of interest rate hikes.
Early in Covid-19, banks stored so much cash from deposits that they didn’t need to borrow from the Fed. It was not until deposit levels began trending down in the 3rd quarter of 2022 that banks went from being flush with cash to competing for depositors. That applied competitive pressure system-wide: depositors withdrew cash in pursuit of better rates, and banks strived to keep deposits by paying better rates.
Unfortunately, as deposit levels dropped, banks saw their low-cost funding disappear, and their loan-to-deposit ratios grew lopsided. A low ratio means a larger capital cushion of deposits against its loans to protect against deposit runoff, while a higher ratio shows exposure to this issue. Regulators prefer loan-to-deposit ratios to be low.
Bank Loan Competitiveness Declines
When a bank’s loan-to-deposit ratio moves, banks can take two steps: decrease their loans or increase their deposits. Typically, that meant making fewer loans at higher interest rates. Meanwhile, bank profit margins took a hit due to having to pay higher rates of interest on deposits.
As a result, in the past six months, bank loan terms have changed materially as banks try to decrease the number of loans. They’ve tightened credit standards for loan qualification and hiked interest rates to stay profitable. Investors have started hunting for better deals again – DSCR loans have returned to popularity by providing similar costs but better terms and significantly better service.
We’re generally concerned about the role of the commercial banking industry in Main Street single-family real estate on an ongoing basis. Without very low cost deposits, its hard to see how banks will keep continue to keep up with other sources of financing.
The Looming Credit Issue
Another issue affecting banks is the status of commercial property values.
In major markets around the country – LA, Chicago, Austin – commercial real estate now faces extremely high vacancy rates, sometimes north of 40%. The banks financing these office buildings now have substantial (though often not realized) embedded losses on their balance sheets.
The Fed has also discussed keeping interest rates higher for longer to battle inflation, which increases bank funding costs.
The combination of a potential commercial real estate credit issue and increasing interest rates means that banks could be materially less competitive on an ongoing basis.
Ongoing Banking Consolidation
After bank crises, regulators tend to compensate by over-regulating, increasing the burdens placed on small banks. Post-Dodd Frank, we saw ten years of increased mergers and acquisitions. Local banks became regional banks, and regional banks bought each other out or were absorbed into larger institutions.
Since 2008, about 3,500 community banks nationwide have disappeared, leaving just 5,000 remaining. Following Covid-19 and the most recent banking crisis, that number may very well halve in the next decade. Ultimately, we’re poised for more banking changes that could lead to consolidation, worsening service, and a stronger connection between Wall Street and Main Street.
Stay Tuned to Macro Shifts: The New Norm
In the aftermath of the bank failures and continued high rates, DSCR loans continue to revolutionize the industry. The widespread adoption by private lenders of DSCR loans has expanded the distribution network, providing a convenient core financing product for real estate investors.
The deepening bond between Wall Street and Main Street, coupled with macroeconomic dynamics, is reshaping the landscape of the real estate industry. For example, securitization and private lending are emerging as important financing tools. Staying in touch with macro shifts and incorporating those ideas into business planning is now more important than ever.
Looking for competitive long-term rates and high quality service? Check out Dominion Financial’s DSCR loans.
Want to know more about how the news headlines will impact your real estate investing business? Tune into the Real Investor Radio Podcast hosted by Dominion Financial’s very own Jack BeVier.
Published September 5, 2023