With average coupons twice the rate of agency MBS, residential transition loans (RTLs) are a hot product. Any time a whole loan buyer can invest in a product that potentially brings double the yield of traditional residential whole loans, you’re going to get a lineup of capital evaluating the opportunity. It is important to keep in mind that RTLs, also known as fix-and-flip loans, have some inherent risks.
The typical RT loan has a 12-month balloon with actual average maturities of 15 to 16 months. But RTL servicing is more than just a sped-up version of homogenous plain vanilla home loan servicing. It’s a real specialty that includes cradle-to-grave asset management in a compressed timeline.
Mitigating the unique challenges associated with this type of lending requires a specialized menu of processes not typically found in the traditional residential mortgage servicer’s toolkit. These specialized procedures can reduce overall portfolio losses by between 20 to 30 percent by shortening foreclosure timeframes, preventing or limiting title defects, and maximizing underlying real estate value on projects/loans that go bad, thus raising total portfolio returns.
Critical Fix-and-Flip Special Servicing Tasks
To make a true difference in total returns, a special servicer has to tackle at least five critical tasks:
- Appraisal oversight;
- Periodic property inspection (both draw release and unannounced non-draw release);
- Controlling project time frame creep;
- Offering foreclosure alternatives; and
- Effective real estate marketing, including stepping in to take failed projects to completion.
Let’s take a look at how and why each of those tasks influences profitability.
The appraisal process in RTL servicing must accurately estimate current and as-complete values with careful attention to market conditions. Every property rehab is unique, but they all share a common goal of putting in a dollar of renovations in the expectation of getting far more than a dollar of return.
RTL appraisals are challenging because they’re moving targets. While renovations happen, underlying real estate market conditions change. The appraiser has to predict not just the value of upgrades, but also where the project will fit into next year’s local real estate market, estimating the influence of population changes, job markets, new housing and existing home sales. It’s critical to use specialized appraisers who have proven RTL valuation experience and focused tools to review the appraisals before loans close.
Proactively evaluating the progress of the rehab to manage the draw process sounds easy, but there’s more involved than just checking for completion. Inspectors have to evaluate construction quality, understand the permit process and make judgements about plan changes that inevitably arise during construction. Periodic inspections not tied to a draw release are also invaluable in keeping tabs on rehab timelines and as an early warning signal that loans are at risk of default.
Flippers, especially new flippers, often underestimate the effort required to keep a project within its timeline. To service RTLs effectively, the special servicer must make the right legal maneuvers to minimize stall tactics and time frame creep. Monitoring issues such as property code violations and mechanics liens provides additional early indication of emerging problem loans.
Pursuing foreclosure, particularly in judicial states such as New York, New Jersey and Florida, can be a lengthy and therefore expensive option. Best practices involve an experienced asset manager who can resolve loan defaults via negotiation versus judicial foreclosure.
It is also important to select attorneys who have commercial foreclosure experience and can deploy legal tactics including involuntary bankruptcy, negotiating down subordinate liens and judgments, executing effective deed-in-lieus (DILs) and pursuing personal guarantees on loan defaults.
When a borrower defaults, and the special servicer takes control of the deed via DIL or foreclosure sale, the special servicer offers RTL investors three alternatives:
- Market the property “as is” via conventional listing. This option has its benefits, but there are risks of “agent steering.” These risks are mitigated by focused diligence on the appraisal and the real estate agent’s marketing efforts.
- Market the property “as is” via auction sale. Auctions tend to attract more investors than traditional homebuyers, but the competitive market for rehab opportunities and the open outcry nature of the sale all but eliminates the “steering risk.”
- Bring in a construction manager, complete the project and market the property. This is a skill set that provides significant lift to the RTL investor, as full retail value can be realized once the project is completed.
One other thing is worthwhile to consider when selecting an RTL special servicer is reporting. A servicer with a data warehouse that consolidates all pertinent loan-level data can send daily data files and reports on draw activity, project status changes, early warnings, and workout activity. That information will deliver critical portfolio insight to the investor.
RTL lending promises to deliver attractive returns to investors who lend intelligently. Having a special servicer capable of appraisal oversight, property inspection, time frame creep, foreclosure alternatives, and stepping in to take failed projects to completion can help ensure the promise of high returns materializes.
James DePalma is executive vice president of private client services for Planet Management Group, a Rochester, N.Y.-based portfolio manager and special servicer for private investors, including REITs, investment banks, hedge funds, private equity firms and independent mortgage bankers.