The Dirty Secret About Subprime Mortgages And How They Affect Commercial Deals

In recent days, the Dow Jones Industrial Average closes several percent below it’s high of 14,000.00 less than a month ago. It’s been a slap in the face to Wall Street. What’s happening?

Giving a person who can’t afford the home they own when their note skyrockets, three years later, sounds like a recipe for disaster. It is. When houses started to double in value over the last five years, subprime mortgage companies expected some defaults, but figured even if some of the borrowers did default, the home would be worth at least the amount of the loan or considerably higher. There would be no problem flipping those homes and keeping their portfolio profitable. In addition, subprime mortgages were being bundled with hundreds of other home loans and sold to Wall Street investors who sold securities based off the revenue from the loan payments. That means the originators of the loan weren’t responsible for the loan after it was sold. That was Wall Street’s problem. Many institutional investors had purchased portfolios of subprime to eek out a few more basis points in their portfolio and give stellar returns. After all, pension funds, hedge funds, and foreign banks liked their returns and continued to demand more.
Most people, even the ones who saw the writing on the wall, figured with equity built up, they’ll only be asking for half of what the home was worth to refinance and they’ll surely get a great low rate. Everybody wanted to get out of the boat at the same time and so the boat tipped and many people got wet because they couldn’t dump their house off. When it’s saving the earth, none of us move in unison. However, give people the opportunity to make a quick buck, and we all march like lemmings to our demise. The dot.com bubble apparently didn’t teach us much about anything.

Because interest rates jumped higher to cool off the economy to a steady trot, investors demanded a higher return on investment that also put pressure on mortgage companies to sell higher interest rate loans. After all, why deal with any of this when you can park your money in c.d. for 5%? Hence, nobody can refinance at the rate they thought they could sneak by with. Additionally, banks needed to charge higher rates because their borrowing rate from the Federal Reserve was higher.
So now that the defaults are on the rise, some companies are going bankrupt and making some profitable investment portfolios look meager and dropping the value. So who has to save their necks?

You? Yes, you! If you are looking for commercial money, you’re going find it difficult to get that sweet interest rate that you wanted. Why? First, companies that buy loans from originators are needing a higher return on investment to cover their losses. Banks are pulling back because as housing values plummet, their good credit borrowers are seeing their equity shrink as well and it puts the bank in a less favorable position. By the way, the definition of good credit was also diluted over the years because of the abundant availability of funds. Banks are particularly weary of defaulting loans because for every non performing asset in their portfolio, they have to hold a reserve to cover it. In English, that means if you default on your $300,000 loan, the bank has to sit with that loan that’s not getting paid back, plus has to leave an additional $300,000 to cover that asset. That’s money that they can’t lend out, but still pay interest in terms of savings accounts and c.d.

Because commercial deals are done by big money entities such as investment banks and private equity firms, if they have a hard time getting cheap money, you’re going to have a hard time getting cheap money. Everything works off a spread. You establish yourself as having a lot of liquidity, low risk, and you borrow from banks and pension funds and other institutional investors, and give out loans to developers at a few percent above what you paid for it. I need to own an investment bank someday! Again, if their pension fund company had a slice of the forbidden pie, they are going to ask for higher interest to the investment bank, and will in turn charge you a higher interest.

If you have a deal in the works, expect longer delays in underwriting as lenders will watch every dollar they lend out to make sure they are mitigating risk. It’s not saying commercial deals can’t be done and that world will end, but it will take longer to get financing and you may not get the interest rate and leverage you would like. Plan for it now and you should be fine. Having a back up plan may allow you have better negotiating power with the lender. If you’re looking for 90% financing on construction financing for an apartment complex, arrange to have 20% equity on hand. Consider taking on a partner. If the lenders refuse your loan, you’ll know that you can still get the deal done. Sure, it’s more expensive and lower returns, but it sure beats having to worry to death that your deal will fall through and you’ll be sitting on a piece of dirt. Just having that backup plan may give you the confidence and time to get a lender to come at the leverage you want. After all, lenders like to give money to people who don’t need it.

Ameet Chagan is a licensed commercial real estate broker with first hand experience in owning income producing assets. He specializes in helping motivated entreprenuers get commercial loans for their real estate acquisitions.

His website is http://www.lionheartfinance.com You are welcome to share this article, unedited, in it’s entirety with anyone. You may not remove this text. © 2007 Lionheart Commercial Finance & Real Estate.

Tags: commercial financing, credit crunch, subprime