Sunday, April 4, 2021

ARMs: A Quick Look

Adjustable-Rate Mortgages (ARMs) are a viable financing option for both single, multifamily and owner-occupied commercial property owners. Ever since their formal establishment by Title VII of the Garn–St Germain Depository Institutions Act of 1982, ARMs have offered the opportunity to link mortgage payments to marketplace activity. Coupled with the rate collars, ceilings and floors, these financial instruments have the potential to lock in the conditions of a favorable interest rate market, at interest rates that are typically lower than a fixed-rate mortgage. In the world of retail real estate, lower rates can translate into increased purchasing power. For the real estate investor, however, rate fluctuations and potential for sustained above market-rates usually tends to also lead to an early refinance. With the January 3, 2022 deadline for ARMs to decouple from the LIBOR index imposed by Fannie and Freddie, now is an opportune time to take a look at ARMs and their role in the mortgage market.

ARMs: A Definition

Adjustable rate mortgages are mortgages with monthly payments that track a chosen index. These payments can adjust monthly, yearly or after a couple of years, with the most frequent adjustment period being annually. Although it is possible for an ARM to adjust after the first month or year, in which case it is a traditional ARM, most ARMs are hybrids. Hybrid ARMs have an initial period during which the rate is fixed, after which the mortgage converts into an adjustable mortgage with fluctuating payments. Hybrid ARMs are popular, because they come with an initial “teaser rate” during the fixed period that is typically lower than the prevailing rate for fixed mortgages. This lower rate allows the borrower a period of adjustment that could result in either refinance, liquidation or increased preparation for the impending larger payments. There are also Interest-Only (I/O) ARMs, which have an initial period during which only the interest of the mortgage is paid before the adjustment period begins, and Payment Option or Option ARMs, which allow the borrower to pick a fixed payment during the initial period of the mortgage, before the adjustment period begins. Both of these products, however, fell out of favor after the mortgage crisis of 2009 due to concerns around retail consumer suitability.

Below is a list from of the most popular hybrid ARM products:

1-month ARM: First adjustment after one month, then adjusts monthly
6-month ARM: First adjustment after six months, then adjusts every six months
1-year ARM: First adjustment after one year, then adjusts annually
2/2 ARM: First adjustment after two years, then adjusts every two years
3/1 ARM: First adjustment after three years, then adjusts annually
5/1 ARM: First adjustment after five years, then adjusts annually
3/3 ARM: First adjustment after three years, then adjusts every three years
3/5 ARM: First adjustment after three years, then adjusts every five years
5/5 ARM: First adjustment after five years, then adjusts every five years
5/6 ARM: First adjustment after five years, then adjusts every six months
7/1 ARM: First adjustment after seven years, then adjusts annually
10/1 ARM: First adjustment after 10 years, then adjusts annually
15/15 ARM: First and only adjustment after 15 years

As is apparent, there is a variety in the length of both the fixed rates and the adjustment periods offered amongst hybrid mortgages.

ARM Indices 

All ARMs, be they hybrid or traditional, are tied to an index that regulates payment fluctuations during their adjustment periods. Below is a list of the most popular list of indices to which most ARMs are attached, along with an explanation of their functions:

T-Bill: The yield resulting from the weekly auctions of one-year Treasury-Bills held by the US Treasury.

Prime: The rate set by the Federal Reserve that most commercial banks charge their creditworthy customers for lending products.

Constant Maturity Treasury (CMT): The derived yield of a mix of Treasury securities, with various maturities, including T-bills, T-notes, T-bonds and off the run securities, adjusted to a one-year term.

Monthly Treasury Average (MTA): The average of the last 12 values of the CMT, adjusted for lag effect.

The 11th District Cost Of Funds Index (COFI): The rate savings institutions pay depositors for checking and savings accounts in the 11th Federal Home Loan Bank District. This district includes banks in Arizona, California and Nevada.

London Interbank Offered Rate (LIBOR): The interest rate charged among London-based banks for borrowing transactions between them. This rate is set by a panel of global banks and is based on their global currency trading estimates.

Secured Overnight Financing Rate (SOFR): The volume-weighted median of transactions taking place in the overnight U.S. Treasury repo market.

Each of these indices has their strengths and weaknesses, with the T-bill being one of the more volatile, due to its dependence on weekly auctions, Prime being the most expensive and the COFI being more stable, but less popular after the housing bubble of the late 2000’s. One thing is for certain--after prolonged concerns of overreliance and clear instances of manipulation, LIBOR is no longer the index of choice for mortgages in particular and dollar-based securities in general. Going forward, SOFR will replace LIBOR as the most frequently used index for ARMs. Although SOFR is a secured rate and more inherently volatile than LIBOR, as it relies on the availability of collateral, it offers two characteristics that LIBOR does not: it is based on markets that use the American dollar and it is not tied to the general creditworthiness of the interbank market. All GSE’s are preparing for the transition to this practice change, which should be completed by January 3rd of next year.

ARM Metrics

When evaluating the performance of any ARM, a number of factors must be taken into consideration. Below is a short list of terms and definitions that are helpful to evaluating ARM yields:

Index Value: The mortgage rate, based on the market index.

Initial Coupon/Teaser Rate: The first rate paid by the borrower until the first adjustment period.

Gross Margin: The amount above the index value paid by the borrower during the adjustable term of the mortgage.

Net Margin: The spread paid to the investor after deducting the servicing and guarantee fees or credit enhancements.

Servicing Fees: The rate charged by servicer to service the loan.

Guarantee Fees: The rate charged by MBS servicer to ensure that payments from the mortgage will be supplemented in case of default.

Credit Enhancements: Collateral posted to offset any credit risk from the mortgage.

Reset Frequency: The amount of time between reset periods.

Periodic Rate Collar: The maximum allowable adjustment to the rate paid by the borrower during any one adjustment period.

Gross Life Cap: The maximum allowable rate paid by the borrower during the life of the loan.

Gross Life Floor: The minimum allowable rate paid by the borrower during the life of the loan.

To find the rate of an ARM during its adjustment period, one need only take the initial coupon and add the index value and gross margin, limiting this value by the lesser of the periodic rate collar and gross life cap. If the rate later decreases at some point, the negative index value is added to the gross margin and limited by the greater of the gross life floor or periodic rate collar.

The gross life cap and floor are also helpful in calculating a best and worst case scenario for performance during the life of the loan. Running a maturity value calculation that results from the sum of the fixed period calculation, graduated payment escalations from the teaser rate to the gross life cap, bounded in each period by the rate collar and the adjustment period, assuming that the rate will remain at the gross life cap for the duration of the loan will yield a max value. Performing a similar calculation, graduating the payments down by the rate collar until the loan reaches its teaser rate and then assuming that the loan stays at the teaser rate for the duration of the loan, will yield a worse case scenario. Either one of these calculations can be weighted by the historical performance of the index to which the ARM is tied for a risked-weighted calculation.

Finally prepayments can be assumed to have a 100 PSA, in the absence of any other prepayment data. The PSA or Public Securities Association’s Standard Benchmark is a method calculating prepayments based on a derived prepayment curve. A more in-depth discussion of the PSA can be found here

As the mortgage market continues to move away from LIBOR, a shift in underwriting for ARMs may follow. Understanding the factors that drive mortgage returns, however, gives any investor an advantage when it comes to financing.

That is my take on Adjustable Rate Mortgages. Please feel free to leave your thoughts below.

Sunday, March 21, 2021

How to Navigate Legal Structures in Real Estate

As the real estate market attempts to move past the COVID-19 pandemic and progress toward a “New Normal,” federal moratoriums have become a way of life in real estate. Navigating the legal landscape of a local market has always been part of creating wealth in real estate. Every real estate marketplace is subject to its own local laws, as well as its state law and federal law. At the highest level, real estate investment and development is a game of understanding the rules—the applicable laws, ordinances, building codes, etc., and knowing when you can bend them in your favor through variances, court cases and lobbying. Although much of this may seem a little nefarious, it need not be, as our legal system was designed to establish a certain set of default rules for real estate, with a mechanism to allow for change in the event that either some rules are inapplicable generally or inadequate for a given situation. That stated, below are some ways to capitalize, navigate or at least survive the laws of any real estate market:

1. Choose Your Market Wisely

The most effective way to navigate any real estate investment is by carefully choosing the market in which to invest. Location, location, location once again proves to be a sage cliché. Being aware of legal risks and rewards is just as important to the analysis of any property as its income numbers and  property condition. The location of a property will not only determine the set of laws that an investor must navigate, but it will also determine the prevailing legal sentiment around the property. This sentiment will effect the laws passed in a given market and have a bearing on how local courts will view real estate disputes like waste, nuisance, foreclosures, evictions, etc. Understanding the local view of these issues will allow investors to accurately estimate the legal costs and make an informed investment decision as a result.

2. Know The Laws That Affect The Property

Understanding the applicable laws influencing property can be the difference between a profitable investment and a poor acquisition. Legal frameworks like rent control, affordable housing zoning and industrial tax credits will all effect the viability of an investment. This is especially true with real estate development, as many jurisdictions have detailed, idiosyncratic new development requirements that protect the rights of both the developer and the community. These requirements may affect zoning, construction ordinances, restrictions on selling and transfer of the property and even property taxes. An intimate knowledge of these regulations is essential, even if the purchased property is not newly constructed, as an acquisition that is economic in some jurisdictions can be rendered uneconomic by the prevailing local new development requirements. Please also keep in mind that recently renovated buildings can be considered “newly developed” in some jurisdictions and subject to new development laws.

In addition to new development regulations, investors must be aware of other laws that could affect properties. Building ordinances, for example, affect all properties, not just those that are undergoing construction and renovation. These ordinances are also present at every level of legislation from the federal American Disabilities Act and FHA guidelines all the way down to the village building code. Properties that are not compliant with the requirements of the local building code are subject to fines and violations, both of which eat into investment profits. Much of the same can be said for zoning ordinances. In most jurisdictions, there is a mechanism to apply for a variance or appeal for both zoning laws and the building codes. Variances to zoning are more frequent than building code appeals, as building codes are driven by use and public safety concerns, whereas zoning is primarily driven by municipal planning and use. Understanding local building codes and zoning laws is essential to real estate profitability. To do avoid doing so is to raise the risk of an investment by exposing it to additional risk that can be easily mitigated. Attorneys, expeditors and knowledgeable contractors are effective allies in mitigating this area of legal exposure.

3. Understand The City/Town/Village Plan

Every municipality publishes a plan of development for its area. Much has been stated and written about the importance of the local plan. This document outlines the areas that the local government wishes to develop and the incentives that it will provide to stimulate such development. Often times unviable projects become realities, because they are either moved to or fortuitously located in a development zone. Understanding the presence of incentives is essential to obtaining an accurate estimation of value for a property. The local municipal planning document will assist with such a determination.

4. Hire Great Professionals

This point is mentioned in numerous articles on this blog and above, so it won’t be expanded in much detail here. If legal analysis and/or real estate planning is not a strength, it is important to hire professionals to ensure that the necessary information is readily available.

5. Remember That It’s Not Personal

Laws reflect the dominant ideology of an area. Every area has its own context, demographic and history, which leads to a prevailing sentiment of how real estate should be managed by default. In other words, real estate laws are a collection of the most popular ideas of how real estate should be run in an area. Most people aren’t anti-investment, nor are they against wealth per-se. Most voters, however, will vote to protect their interests and this takes different forms in different locales. In most instances, with notable exceptions, real estate laws are not enacted for personal reasons and, in the absence of extreme lobby power, there isn’t much any one investor can do to change the laws. The most viable course of action for most investors is to be aware of the legal scheme that affects a property, earnestly consider if the local laws work for the investor’s criteria and find viable ways to navigate the relevant laws.

So, this is my take on how to navigate legal structures affecting a property. This a high-level view of this topic. This post definitely could have been substantially longer, but I am happy to discuss your comments below.

Saturday, February 27, 2021