Why the Alt A Residential Market Exists — and Why Investors Should Care

Experienced investors consider Alt A residential mortgages a great secured product, offering a higher return than Canada Mortgage Bonds and traditional first residential mortgages. Yet to the uninitiated, the Alt A residential mortgage market is just another real estate investment offering. We’ll explain what it’s all about.

Key Points

  • The risk in the residential non-conforming mortgage market is tradeable with the risk in the conforming market. The real difference between the two is that borrowers in the non-conforming market come with stories — they are “storied mortgages.”
  • Canada’s residential mortgage market can be divided into two segments: “conforming” residential mortgages and “non-conforming” residential mortgages.
  • Conforming mortgages have the benefit of mortgage insurance, but most non-conforming mortgages do not qualify for insurance.
  • Changes in the regulatory environment have resulted in a much stronger borrower entering the private mortgage market.

Canada’s residential mortgage market can be divided into two segments: “conforming” residential mortgages and “non-conforming” residential mortgages.

An overview of Canada’s residential mortgage markets

Canada’s residential mortgage market can be divided into two segments: “conforming” residential mortgages and “non-conforming” residential mortgages.

A conforming mortgage is either fully insured by one of the mortgage insurance companies, or which is a non-insured conventional mortgage with loan-to-value of 80% or less. Borrowers with these mortgages have strong credit histories and files that are fully documented in terms of income verification and other important aspects of the loan applications. Conforming mortgages often receive the best interest rates from mortgage lenders. Our Schedule A banks dominate the conforming mortgage market.

Conforming mortgages that have the benefit of mortgage insurance make up the backbone of what are Canada Mortgage Bonds. Our big banks don’t just sit on their mortgages. To generate further income for themselves, lenders originate mortgages, pool them, then sell the pool as mortgage backed securities (MBS) to the government. To pay for the MBS, the government sells Canada Mortgage Bonds (CMBs) to investors (think pension funds, insurance companies and the banks themselves).

If the borrower is using mortgage financing for the purchase of a recreational property or housing for a family member, or the borrower is purchasing a residence for investment purposes, then the mortgage issued the borrower would be described as “non-conforming.” If the borrower has not yet established a credit history generated in Canada, that borrower will generally only qualify for “non-conforming” mortgage financing, i.e., the Alt A mortgage market.

Conforming mortgages have the benefit of mortgage insurance, but most non-conforming mortgages do not qualify for insurance.

What is the Alt A mortgage market?

Historically, there was a divide in the residential mortgage market. The mortgage was either “A” or it wasn’t. To be an “A” residential mortgage, the borrower had to meet a very rigid criteria set by the Schedule A banks which at minimum required a three-year employment history with the same employer, income verification, three years of clear Income Tax Notices of Assessments, and a credit score 700+.

The principal reason for the rigidity was to ensure the residential mortgage would qualify for mortgage insurance. The borrower had to fit within the “box.” Any borrower that did not fit within the box would have to seek out “alternative” mortgage financing. As time passed, folks who did not fit within the box, yet had good credit, came to make up what we call today the alternative or “Alt A” mortgage market.

The risk in the residential non-conforming mortgage market is tradeable with the risk in the conforming market. The real difference between the two is that borrowers in the non-conforming market come with stories — they are “storied mortgages.”

Who invests in the Alt A mortgage market?

The Alt A market, which caters to non-conforming mortgages, has proven to be an appealing mortgage investment opportunity for a variety of people, including:

  • Contractors, entrepreneurs, and small business owners who have volatile income and have a difficult time retaining traditional bank financing
  • Borrowers with challenging credit history
  • Asset accumulators who invest heavily in rental properties and have ‘too much debt’ on paper, making them riskier to schedule A banks
  • Investors purchasing income properties or second properties for family/recreational use
  • Those acquiring certain rural and agricultural properties that have residential components
  • “New to Canada” immigrants who are likely to find jobs, form households, and buy homes, but do not have credit history in Canada yet

The Modern Day Playbook For Super Successful Investing

How can a smart, modern investor get in on the real estate investing action, especially since going on your own may require prohibitive amounts of capital? Most people do not have the requisite knowledge or expertise to invest in real estate on their own.

Who borrows in the Alt A mortgage market?

The people most likely to use Alt A mortgages are what we call “New to Canada.” They’re immigrants who are sought after under Federal and Provincial immigration programs designed specifically to attract those persons who possess a specific skill or trade. They are the immigrants most likely to find jobs, form households and, ultimately, buy homes. But they do not have credit history in Canada, thus the name “New to Canada.”

Other borrowers in the the non-conforming residential first mortgage market are generally persons with a challenging credit history, investors purchasing income properties, and persons purchasing second properties for family or recreational properties. The acquisition of certain rural and agricultural properties that have residential components also fit in this category.

What are the risks of investing in the Alt A mortgage market?

Most non-conforming mortgages in the Alt A mortgage market do not qualify for insurance. Therefore, pools of nonconforming mortgages cannot be collaterialized for the purposes of issuing MBSs. Because non-conforming mortgages are typically riskier and more difficult to handle, the lender will charge the borrower more. Further, as the non-conforming mortgage does not have to comply with any restrictive guidelines, the lender may allow a higher loan-to-value than if it was a conforming mortgage. The lender may also entertain borrowers with less than ideal credit history and loosen any income verification practices it employs, especially with respect to borrowers that may be self-employed or have alternative sources of income rather than traditional employment income.

Yet, apart from these differences, the underlying real property security for non-conforming mortgages may be at least the same as for conforming mortgages in that they may be located in desirable marketable areas and well maintained at the date of underwriting. Non-conforming mortgages may also carry many of the same characteristics as conforming mortgages in that the security may be the same; they may have the same payment frequency; and the loans may be amortized resulting in a recapture of capital for the lender throughout the mortgage term.

Changes in the regulatory environment have resulted in a much stronger borrower entering the private mortgage market.

Changes in Alt A mortgage regulation through the years

15 years ago, a borrower’s mortgage could qualify for mortgage insurance at a 95% Loan-to-Value (“LTV”) and an amortization period of 40 years. Employment income used to qualify for a Mortgage did not always have to be fully confirmed and/or documented and credit scores could be as low as 580. That’s no longer the case.

Regulation has evolved. LTVs are lowered and amortization periods have been shortened. In July of 2020, CMHC increased the credit score requirements of borrowers with less than 20% down payment from 600 to 680. That knocked out a huge fraction of the borrowing populace. With a sub 680 score and no insurance, that band of borrowers will have extraordinarily difficult time retaining traditional bank financing. Now, that group looks to the alternative mortgage market.

Private lending can be quite lucrative for both lenders and their investors. And in the Alt A or “non-conforming” residential first mortgage market, it can be reasonably safe as well.

The future of the Alt A mortgage market

As the rules have become much more stringent (and the types of properties insurers are willing to cover have narrowed), borrowers are looking for alternatives. Alternative lenders are desperately trying to fill this void created by regulation. Today, they can offer their investors secure long term returns of 6% to 8% (and sometimes more) simply because there are so few options for persons forced out of the traditional mortgage markets by regulation.

Canada enjoys one of the strongest real estate markets in the world. Whether the borrower is “new to Canada” or is simply the square peg that doesn’t fit Big Bank’s round hole, the Alt A mortgage market has proven to be an appealing mortgage investment opportunity for adventuresome investors who like good stories.

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An Inside Look: How Financing a Real Estate Project Works

Real estate investors often wonder why a developer might choose to pay what seems to be an unusually high rate of mortgage interest when compared to prevailing rates. Well, the truth is that sometimes it’s in their long term interest to do so and raise equity capital instead. This article explains the whys and why not’s from an insider’s perspective.

Key Points

  • There are three ways to fund a real estate project: debt, equity, or a combination.
  • The amount of money required for a project from different sources is called the “cost of capital” and is vital to determining a developer’s “optimal capital structure.” It all hinges on the concept of ROE (Return on Equity) which very much takes into account leverage.
  • The choice of debt, equity, or combination financing is exceedingly complex and will depend on the circumstances and metrics of each project. At the very least, you may now have a better understanding of why sometimes a real estate developer will take on a high-interest first or second mortgage, bearing say 10% or 12% where going rates for standard mortgages or lines of credit are a lot less.

How does a developer fund a real estate project?

A developer needs capital to fund land acquisition, construction, and all soft and hard costs associated with a real estate project. In the absence of an unlimited bank account, they have three options: debt financing, equity financing, or a combination.

Debt financing is accomplished through borrowing. Usually, this: (i) means a higher ratio of investment via debt capital as opposed to equity capital; (ii) allows for tax-deductible interest (i.e., the interest paid on debt is a business expense and is deductible); and (iii) maximizes leverage.

Leverage is using borrowed money (debt) to amplify or increase potential returns from a project. It allows a developer to multiply buying power in the marketplace. So, for example, if the project costs $100, the developer could get 10 investors to chip in $10 each.  They each own one tenth of the project.  When finished, let’s presume the project will be worth 133.00.  Now, each investor’s share is worth 13.30! Well the developer knows banks are in the business of lending money so the developer (and his investors!) know the bank will come in for $60 of the cost of the project! Whoo – woo! The investors only have to put in $40! So, for $40 the equity investors have $100 of brick and mortar.  But once the building is finished those $40 investors will have building worth $133.00! That’s not bad.  If we were to increase the amount of indebtedness by another $20, the investors would only have to put up $20! Now for $20 you get a building worth $133.  That’s how leverage works! The more debt you “lever” into a project, the less equity you need; the smaller the equity requirement, the greater the return on that equity!

Equity financing refers to selling part of the project to investors. Given more risk to an investor, the cost of equity for the developer is generally higher — except in the case where the developer is able to keep equity for itself and benefit from owning more rather than less. The only time a developer has to share ownership of a project is when the developer needs more equity.   

There are three ways to fund a real estate project: debt, equity, or a combination.

Choosing between debt financing and equity financing

The “cost of capital” is the amount of money required to complete a project and is vital to determining a developer’s “optimal capital structure.” It all hinges on the concept of ROE (Return on Equity) which very much takes into account leverage. The actual calculation of ROE is “net income” of the business (i.e., income after expenses (including debt repayment!) and taxes) divided by the shareholder equity. As debt is subtracted from the calculation, the ROE increases. In fact, if the ROE appears too high, it may be a warning sign that there is too much debt in the enterprise.  Generally, an ROE equal or less than 10% would be considered poor. 

Typically, equity financing returns deliver a higher IRR (Internal Rate of Return) over the life of the project than debt financing which is reasonable when you think about. Debt financing is generally secured.  If something goes wrong, the secured lender can step in, seize the assets and repay themselves.  Equity is full “at risk”; it’s not secured. If something goes wrong, the equity investor is out of luck! They potentially lose everything.  Therefore an equity investor will demand more in return than a debt investor. In real estate it is not unusual at all that an equity investor will look for a return of 20% or  more on its investment.  And because they are an owner, they expect that forever!  If the need for additional equity could be satisfied with high interest rate debt, then that becomes a credible alternative for the developer.  If high rate debt is 14%, but the developer anticipates being able to pay it all back in 3 years, debt makes a lot of sense.  A developer with an eye on maximizing ultimate profit will be understandably jealous of keeping as much equity as feasible and therefore may prefer to pay a risk premium for mortgage financing.

There’s also “bridge financing” (which really has nothing to do with bridges), which is a type of mortgage financing that is a premium when compared to the risk free rate of return, but a discount if you compare it to the cost of equity. It’s often used by developers to temporarily finance the cash flow for a short period of time (ergo, the “bridge”). Instead of injecting additional equity, they will need to fund the financing gap and bridge the project until it reaches the next stage of development or a subsequent financing stage. Generally, bridge loans are short term (12-36 months), pay interest only so it is non-amortizing, and have a well-defined exit strategy.

Here’s what a typical project lifestyle looks like and what kind of financing is utilized during different project development stages.

A developer may also choose a combination of debt financing and equity financing, coming up with an “optimal capital structure” that balances both and keeps in mind the cash requirements of the project at its various stages.

What are cost of debt and cost of equity?

If you need financial capital to construct an asset and then sell the asset, the interest expense for borrowing the capital is the cost of debt. Equity also has a cost, in the form of profit-sharing, and this is the cost of equity or the expected rate of return a fellow owner would expect for a similar risk profile investment. The weighted average of a project’s cost of debt and cost of equity is generally the cost of capital. The lower your overall average cost of capital, the more profit you can keep for yourself as the owner.

Consider a small project where the developer is planning to do a build and flip, with the below Pro-forma budget. This model below assumes a duration of 12-18 months:In the No Leverage scenario, the developer maximizes the cash profit. However, they have to inject 2.146M of their own equity. For every dollar the developer invests, i.e. their equity injection, they will earn a 19% return or 19 cents for every dollar of equity. When a party invests for an ownership interest, then they have an equitable interest, or equity, and have a beneficial interest in the profits from the project. Put another way, an equity investor will likely expect or require a 19% return on their invested equity capital (the “expected return” or equity’s “cost of capital”).

Whereas if someone were to invest and own the debt or mortgage of a property, then they become a debtholder entitled to a return defined by a predetermined interest rate. As a debtholder, you will get paid first, but that’s why your return is fixed. As an equity holder, you may get paid last, but you keep the rest of the upside.

What is leverage?

As stated above, leverage is using borrowed money (debt) to amplify or increase potential returns from a project. In some scenarios, for every dollar a developer invests, they can earn more per dollar by investing less equity. Consider this example:

By taking on additional debt and actually reducing the nominal dollar profitability, the developer achieves a few strategic objectives. It frees up over $550K of the developer’s capital, which they can deploy to another site, thereby diversifying their portfolio and helping them line up additional sites (a pipeline) for future work. It adds additional liquidity into the project. And financially, it increases the rate of return or ROE for every dollar the developer invests. Instead of earning $0.19 for every dollar invested, the equity owner earns a projected $0.238!

Borrowing from a private lender vs bringing on additional equity partners

We’re going on a math tangent now — stay with us! Even if you don’t speak equations, seeing real-life examples is a helpful way to better understand investing concepts.

The weighted average cost of capital (WACC) is calculated by the formula:

(Proportion of Equity Capital %) * (Cost of Equity) + (Proportion of Debt Capital %) * (Cost of Debt) = [100% * 19% + 0% * 12% ] = 19%

Your debt holders only demand 12%, but equity partners will want their 19% return. From a project point of view, the cost of that capital is going to be 19%! It’s the expected return your equity holders expect to receive by investing in the project. If you took on debt even at 12%, the math would work out to be 13.8%. So, overall, you can pay $0.138, or pay $0.19 for every dollar invested.

Ask yourself: Which project has a lower cost of capital? As the principal owner of the project, you want to drive down your cost of capital as much as possible. That way, you can take on projects of varying profitability and be competitive with how much you can pay for the residual value of the land at the time of acquisition.

The choice of debt financing, equity financing, or combination financing depends on the circumstances and metrics of each project.

How to get started

Funding a real estate project is a complex subject. We hope you now have a better understanding of why sometimes a real estate developer will take on a high-interest first or second mortgage when going rates for standard mortgages or lines of credit are a lot less.

Still have questions? Fundscraper is here to help its community wade through these kinds of considerations which are key to analyzing the underpinnings of its project offerings. We aim to provide our clients with the ability to make informed decisions and deliver a transparent investing process. Contact us today to learn more about your real estate investment options.

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How to Read Loan-to-Value Like a Pro

Loan-to-value (LTV) is likely the most discussed ratio in real estate lending and mortgage investment circles. Conceptually, it’s a fairly simple concept: the ratio of a loan to the value of an asset purchased with the proceeds of the loan. The ratio is the value of a debt that has been secured against a present value of an asset that has been offered by a borrower as collateral. If in the event the debt has not been repaid, the lender can seize the asset and sell it to satisfy the debt owed.

LTV correlates with the security an investment provides. The general rule of thumb is the higher the interest rate, the higher is the perceived risk of the mortgage investment. Thus, studying the LTV is a common way to assess risk. Let’s walk through how to read LTV like a pro.

Key Points

  • Borrowers often insist that their property is worth much more than a lender is willing to accept.
  • A lender always approaches a transaction with the conservative view that the potential borrower will default. It’s not a statement about the borrower; it’s simply how lenders assess debt transactions.
  • Values are always changing, and the underlying LTV calculations change with them. As the LTV ratio changes, so too does the risk profile of the mortgage investment. Lenders constantly monitor their original LTV calculations against actual LTV values as markets undulate forwards and backwards.

 

When Is Loan-to-Value Determined?

The LTV ratio is determined at the time the loan is advanced, meaning it’s fixed for the purpose of the loan. As time passes, the actual value of the securitized asset can go up or down. Once the loan is out the door, the value of the lender’s security is subject to the whims of the market. Regardless of which way the value goes, the lender is owed the same amount.

Borrowers often insist that their property is worth much more than a lender is willing to accept.

How Is the Loan-to-Value Determined?

The LTV ratio is the loan amount against the value of the asset. What the “value” of the asset is can sometimes be a difficult matter to determine and have parties agree upon. The borrower will want the asset to have the highest value possible, while the lender will want a conservative value—one that can be easily realizable in the event the lender is forced to sell the asset to pay off the loan.

Borrowers often insist that their property is worth much more than a lender is willing to accept. Lenders complain that borrowers are too greedy and fail to appreciate that the value of their property might not be worth as much as they think if a sale of the property is forced to repay the debt. This problem is most often satisfied by hiring an independent third party appraiser to assess the value of the asset being offered as collateral.

Realization (n): The amount received, in excess or loss, of the adjusted basis of the property.

What Is the Cost of Realization?

All lenders price with a mind to realization. A lender always approaches a transaction with the conservative view that the potential borrower will default. It’s not a statement about the borrower; it’s simply how lenders assess debt transactions.

How easy it is to sell the underlying asset goes directly to the cost of borrowing and will be reflected in the LTV. It may be wonderful to have a debt security on a property that is 40% LTV, but if you can’t sell the property, then it’s kind of meaningless.

The general rule of thumb is the higher the interest rate, the higher the risk of the mortgage investment.

How Is Loan-to-Value Related to Interest Rate?

A high interest rate can mean anything. Interest rates do not rise proportionally to the percentage LTV. The rate is generally determined by the market based on liquidity, the actual LTV as discussed, and the desperation of the borrower. A high rate of interest usually signals a high LTV ratio. However, LTV is a strictly relative value particular to a given market. What’s considered a very good LTV in one market may be horrible in the next.

Can Loan-to-Value Change?

The LTV calculation is generally done only once, at the outset of the transaction. It’s a thorough process that requires time, expense, and expertise. Yet, nothing stands still – markets rise, fall, and are subject to unexpected events. What one may have thought a very conservative investment may suddenly become a very risky investment given events beyond the lender’s/investor’s control.

Values are always changing, and the underlying LTV calculations change with them. As the LTV ratio changes, so too does the risk profile of the mortgage investment. Lenders constantly monitor their original LTV calculations against actual LTV values as markets undulate forwards and backwards.

We invite everyone to share in the opportunities that we create with our borrower clients.

How Do I Get Started?

Loan-to-value might seem like a simple concept to grasp, yet many investors have lost very large sums of money by investing in highly leveraged properties. Don’t let that happen to you! Before you invest in real estate, speak to a qualified advisor who’s an expert in mortgages.

At Fundscraper we review residential and commercial real estate transactions all the time — it’s our “day” job! We work closely with our borrower clients to make sense of the value propositions they advance and do the homework necessary to insure the LTV we determine based on the evidence in front of us is an accurate and safe assessment against which we are willing to risk our money. We can help you invest smarter. Contact us today to learn how mortgages and private real estate can be great investments.

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