Remember the wild days of the real estate boom when you could buy a house with nothing down? You still can. Well, maybe you can’t, but a very select group of wealthy buyers can.
The strategy is called cross-collateralization. It uses the house as collateral for a conventional loan and, in lieu of a down payment, pledges the borrower’s investment portfolio (at least 20 percent of the purchase price), preventing the need for private mortgage insurance.
The average homebuyer wouldn’t be able to swing it. Even among the wealthy, not every homebuyer should try. But for those who have the bucks and the nerves, it’s a way to get the keys to luxurious quarters with nary a penny out of pocket.
The strategy might seem counter-intuitive at first. Someone wealthy enough to have the investments could easily turn some into cash for a big down payment or to buy a property outright. But cashing out isn’t always a wise financial move.
A CEO or a prominent board member might want to hold onto company stock, says James Hooper, vice president of Capital Line Funding Group, a mortgage broker in San Diego. Selling stock might also trigger capital gains taxation. So, borrowing against it not only means keeping the portfolio intact and avoiding the tax hit, but it also generates a larger mortgage deduction.
“They don’t need to borrow; they borrow because it makes more sense to borrow,” says Erin Gorman, managing director of national mortgage sales for Bank of New York Mellon. “Especially now, in this low interest rate environment, it makes more sense to use someone else’s money to pursue your investment strategy.”
The tactic does come with some drawbacks, however. Think of what would have happened to someone who tried this kind of financing in, say, 2006. First, the value of real estate started sliding, meaning the homeowner would need to pledge more investments to cover the difference. Then, the stock market fell sharply, resulting in decreased assets.
That’s why the people who go for cross-collateralization typically have enough assets to weather such a squeeze.
“Oftentimes, the real estate may be a fraction of the size of the portfolio,” says David Schauer, chief investment officer at Hanson McClain Advisors in Sacramento. That could be a $10 million portfolio pledged against a $2 million house. “Even if it went down by 20 or 30 percent, it is not putting anything in jeopardy,” he says.
The borrower should also have good cash flow to cover the mortgage payments. Cross-collateralization is not designed for someone with a volatile income stream, such as someone who depends entirely on commissions, Schauer says.
On the other hand, doctors, dentists and veterinarians are popular targets for lenders, says Hooper.
“Physicians are going to be fairly resistant to recessions, and their income is going to be fairly stable,” he says. Plus, offering them 100 percent financing is a good way to get the rest of their banking business.
Cross-collateralization doesn’t have to pair with a standard 30-year mortgage, either. It can work for bridge financing, too, Gorman says. The borrower might finance the new house at 100 percent while waiting for the old house to sell. When it does, the proceeds can pay down the new mortgage and free up the investment portfolio.
Gorman did a deal in which a father used cash to buy a $675,000 house for his daughter, then turned to 100-percent financing to put the cash back in his pocket. She’s also seen the strategy used for second homes, especially in Florida.
And, though it might seem odd, it can be easier to use cross-collateralization for investment real estate than for a place to live.
Suppose you bought a beat-up $100,000 house and rehabbed it. Now it’s worth $250,000, and you are renting it out for $1,250 a month.
“But then up comes another one, and you have cash tied up. I would say, ‘Let’s cross-collateralize,’” says Bill Watson, president of The Money Brokers Inc., a mortgage lender in Sacramento.
The equity in the first house might fully finance the second. It could even be pre-approved, allowing you to shop for the right property.
Watson has worked with flippers who own five or six properties, pulling $50,000 in equity from one, $30,000 from another, and so on until there’s enough to buy one more house for nothing down.
“I have it happen maybe 10 percent of the time,” Watson says. “It can be sort of a credit line for someone.”
He saw some borrowers get squeezed in 2009, but calls the start of that recession a “500-year storm.”
“Equity will cure most situations — if you have real equity, not bubble equity,” he says. “What I am seeing is not equity that people have been building up on paper. This is equity that is born from cash-down and making real-dollar improvements. Lending against that is much different than lending against the equity we had in the bubble. I just really don’t see another 70-percent loss in equity.”
But he won’t touch owner-occupied deals. The rules for collecting and servicing the loans are too onerous, and it’s too hard to foreclose when a loan goes sour, he says.
Which brings up the fact that even most lenders who do specialize in owner-occupied mortgages don’t want to mess with cross-collateralization. That father who bought a $675,000 house for his daughter? He already had $16 million under management at BNY Mellon, Gorman says, so the bank could easily keep a close eye on fluctuations in value.
In fact, it’s the wealth management relationships that often spark the discussion about cross-collateralization, Gorman says. A client calls in with an order to liquidate some stocks, and the bank can offer 100 percent financing as an alternative.
“When we get into conversations with these clients, it’s kind of an ‘aha’ moment,” she says.
It also can be a means of moving the wealth management into her bank from somewhere else. When the bank doesn’t also manage the securities, cross-collateralization is a tougher sell.
“Let’s say we are doing the money management, and the risk officer that is reviewing this type of loan is reviewing what we have,” says Schauer of Hansen McClain. “They are usually extremely strict about securities changing. You can’t just go in and manage those dollars the way you want.”
At the very least, it means an extra layer of paperwork, and more likely a lack of interest in doing the deal at all.
Hooper of Capital Line Funding Group calls cross-collateralization a very thin slice of the pie.
“We do not see a lot of these, to be honest. Even wealthy people who have this much money want to put some money down and have some equity,” he says.
Sacramento, with its moderate real estate prices and few eight-figure investment portfolios, doesn’t see many of these deals. Schauer could recall only one, up around Lake Tahoe.
But for those who are earning, say, 8 percent on a portfolio big enough to back a mortgage at 4 percent, it’s a hard deal to beat.
Financing for the Average Joe
The lending climate for middle-class homebuyers in the Capital Region is improving, and rates are continuing to decline. Thirty-year, fixed-rate loans have been hovering around 3.5 percent all year, while adjustable loans have been well below 3 percent.
As recently as three years ago, a 5–percent loan was considered pretty good. So, today’s rates mean the same monthly payment today can cover a mortgage about one-third larger.
On the other hand, the loan process can be painfully slow. Banks want to see documentation on every aspect of a borrower’s creditworthiness. Put it together, and loan demand is on a moderate but unspectacular rise. This past April, the Federal Reserve’s San Francisco District said, “Ramped-up mortgage and automobile lending continued to spur growth in overall loan demand.”
There’s no question that real estate deals are getting done. The Sacramento Association of Realtors tracked a 43- percent jump in the number of closed escrows in the first quarter of this year from the same period in 2012. The median value was up almost exactly as much. Meanwhile, the number of short sales and sales of bank repossessions has dropped sharply.
But those stats don’t necessarily mean lenders will relax.
“I think the housing market is way overinflated right now,” says Steve Zeller of Zeller Kern Wealth Management in Gold River. Homes are getting sold, but the buyers include large investment organizations such as The Blackstone Group, which is sprucing up distressed houses and then renting them out. That sucks up the supply and artificially drives up prices, he says.
“It’s not your typically sustainable value within the housing market,” he says.
Loan demand is up a bit at El Dorado Savings Bank in Placerville, according to CEO Tom Meuser, but most of that is from existing homeowners refinancing to take advantage of this year’s lower rates. The average balance has been about $150,000, he says.
— Robert Celaschi
This year could provide some of the first expansions in bank lending since 2008. So is the market back up to speed? No. But banks are slowly and smartly increasing their appetites for commercial lending, and the Capital Region will see its share of transactions.
Walk into any coffee shop and it’s obvious that the place we call “the office” has changed. Many of the people sitting at tables are likely mixing laptops with lattes as they browse email and write reports. Some may be pitching a sale over coffee.