Mortgage-backed securities aren’t anything new. They were at the heart of the 2007 financial crisis that saw investment giants like Lehman Brothers fall from grace and shift the world’s financial markets to a point that recovery took nearly a decade.
However, John Warren has recently seen potential in the mortgage-backed securities, or MBS market that he believes is a sure-fire success.
His idea: develop an investment that is backed by small-balance mortgages made on non-owner occupied rental homes. It’s a securitization of those small-balance, multi-borrower mortgages on one to four family investment properties.
“It’s a niche, but it’s a pretty big niche overall,” Warren said. “If you look at the fix-n-flip market, we think it’s a $50 billion market in terms of the number of homes sold last year and we’ll finance flips and we will also finance rentals and multi-family.”
So, what is it?
The advent of the non-qualified mortgages — a jumbo loan of over $470,000 — has allowed Lima One to enter into the non-owner occupied mortgages, an arena traditional large mortgage lenders like Freddie Mac and Sallie Mae tend to take on a marginal scale, only buying up to four investment property loans per investor, regardless of who the investor is or what their credit looks like.
“What has happened is a lot of the traditional home lenders have gotten out of the non-QM, especially for the non-owner occupied investment properties,” Warren said. “That has opened up a lot of opportunities for different types of capital to come in, partner with an operator and that operator originates the loans.
“What happens, especially with the long-term rental loans, is that no one wants to keep them on their books, so the securitization is the best option once you’ve pooled enough loans that you can securitize.”
For this new investment, Warren said the minimum value of these non-owner occupied mortgages to securitize is $114 million. He said that was the amount that “made the most sense” considering outside fees like legal, rating agency and the costs involved with underwriting.
Thomas Springer, professor of finance and real estate at Clemson University’s College of Business, said the new offering was “risky” but has potential for solid yield.
“They found a niche lending market,” Springer said. “They are making the capital available, then packaging them up and selling them to investors. That takes the risk away from Lima One.”
Lima One is backed by Evanston, Ill.-based Magnatar Capital, a hedge fund with approximately $13.7 billion in assets under management according to its website. Warren said Lima One will either originate loans and sell them to a different capital partner who will, in turn, securitize them, or Lima One will pool the loans together with a large bank line of $100 million to $200 million from a Wall Street bank then the loans go through the securitization process.
Risk and reward
With these kinds of MBS products, there is going to be risk.
“Ultimately, if these loans don’t perform it kills our reputation and we don’t make money and investors lose a lot of money,” Warren said. “It ruins your reputation for future deals.”
He said the security — called RCO 2016-SFR1 — has a “AAA” rating on senior bonds. Those senior bonds are 56.5% of the total principal balance. The “AAA” rating by Morningstar has also been affirmed on 83.35% of the total principal balance. Warren added the loan portfolio within the securitization has a performance record of 99.5%. Underwriting was done by the Nomora Group based in Tokyo, Japan.
These are 30-year loans that are fully amortized, similar to a traditional mortgage, the difference being these loans are for non-owner occupied and the loans are considered commercial loans. Warren said Lima One will look at the borrower’s credit score as well as the income generated from the rental home.
Warren said while there is risk in any kind of investment, he is confident in the potential rewards from this new product. He said the three criteria used in making loan decisions — credit score, income produced from all the loans and the loan-to-value — mitigate a lot of the risk. Additionally, he said the average credit score of someone getting one of these loans is around 723.
“In no way are we a sub-prime lender,” Warren said. “We’re just a non-QM lender.”
Because this product has launched nationally and because Lima One Capital is based in Greenville, with no other offices, there is a challenge.
“If you are going to be a national lender, you can do it over the internet, but you really want someone on the ground locally to assess property,” Springer said. “If you don’t, you are taking certain chances. You can look at the property on the internet, but there is a risk.”
It’s a potential pitfall that Warren said he hasn’t overlooked. He said the underwriting includes both the person taking out the loan and the property itself.
Underwriting the borrower is easy and can be done from anywhere. It’s the property that’s the challenge.
“We realized we needed a scalable model to where we could underwrite the property in Greenville the exact same way we underwrite property in Miami; the exact same way we underwrite property in Los Angeles and New York,” Warren said.
That brought about the creation of what Warren called “on-site operational teams,” or groups of sub-contracted appraisers and inspectors as well as local attorneys that are based in certain markets.
“We build these teams and they are really our expert eyes to understand what the market conditions are, because real estate is very local and streets in certain neighborhoods matter,” Warren said.
He said, historically, the appraisals done on property are within 3% of the actually resale of the property.
With some investments, the longevity is short, but Warren said Lima One’s new investment does have staying power.
“This is not a trade, this is a totally sustainable specialty finance company,” Warren said. “There will be certain trends for certain markets. Flips might be better in certain markets, multi-family may be better investments at times, rental properties may be better for investors at times.
“Because we are diversified in our products now, we are not dependent on just one real estate plan for execution.”