Feeding the Demand for SFR Loans: Q&A
- Apr 28, 2021
Toorak Capital Partners has recently bolstered its long-term rental investor loan program with a $500 million capital commitment.
“The market for single-family rental home financing is underserved and it is growing rapidly,” remarked John Beacham, CEO of Toorak.
In the discussion below, Beacham shares Toorak’s approach to the rapidly growing single-family investment market, as it focuses on small balance loans of $50,000 to $6.5 million, and the importance of single-family rentals as an affordable housing type.
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What were the decisive factors behind Toorak increasing its position in this market segment?
Beacham: Toorak is in the business of providing capital to lenders by acquiring newly originated loans. One of our products is a bridge loan that allows borrowers to improve properties in need of rehab. We saw that many of our bridge loan borrowers decided to rent out their properties after completion, so we needed to develop a product to meet their needs for efficient long-term financing that our origination partners could offer.
The market for single-family rental home financing is underserved and it is growing rapidly. Families are looking for quality housing options, and suburban housing options have proven to be especially attractive throughout the pandemic.
What are some of the main differences between Toorak Capital’s above-mentioned program and the financing options provided by the GSEs regarding single-family investor loans?
Beacham: Toorak takes into account the rental income of the underlying property, while the GSE program places a larger emphasis on the personal income of the borrower. There are a number of differences in the programs.
First, the loan is underwritten based on the cash flow of the property, rather than the borrower’s personal income. In this way, we are taking an approach that is similar to commercial real estate loans.
Second, the borrower can purchase properties through an LLC or other legal entity, which many property investors prefer to do rather than owning the property in their personal name where they are exposed to liability claims.
Finally, the loan documents incorporate commercial real estate concepts, including rent direction letters and property management replacement agreements stipulating that, if the borrower stops paying the mortgage, they can no longer continue to collect rent.
Toorak is further able to fulfill a critical financing need because of the recent news that government-sponsored enterprises like Fannie Mae are tightening their portfolio limits for second homes and investment properties.
When it comes to evaluating borrower credit (for single-family investor loans), Toorak Capital utilizes debt-service-coverage ratio vs. debt-to-income. Why is this your preferred approach?
Beacham: The DSCR is a better predictor of loan performance for rental properties than debt-to-income because it measures the actual rent coming from the property relative to the mortgage payment. Thereby, properties that provide excess income are more likely to support continued borrowers’ commitments to keeping the loan performing.
For example, if a borrower has an investment property with a mortgage payment of $1,000, which generates $2,000 in rental income (DSCR = 2.0x), then that borrower is less likely to default on this loan and thereby lose the excess income stream.
Alternatively, the approach that relies on the borrower’s personal income to qualify for a loan, allows for loans on properties where the rent does not cover the mortgage and the borrowers’ commitment to keeping such an underwater property afloat in hard times becomes less likely.
How do private lenders (that you work with) regard this type of financing solution?
Beacham: Our lending partners are very supportive of the DSCR underwriting model as this is not a loan category currently offered by GSEs like Fannie Mae and Freddie Mac. We are filling a niche that is having a necessary and positive impact on the housing supply and is supportive of entrepreneurial endeavors.
It also makes sense for private lenders like Toorak to offer DSCR-based products because our borrowers are heavily engaged in the rehab loan space. It’s a natural transition for these borrowers to move from rehabs to a long-term rental model.
In addition to evaluating the DSCR of the property, Toorak is also focused on the FICO, liquidity and background of the borrowers.
What role can single-family rentals play in alleviating the affordable housing shortage?
Beacham: The pandemic has demonstrated the importance and value of housing, as well as the fact that there is not enough housing supply to keep up with demand from the U.S. population. Single-family rentals comprise a majority of rental housing stock. We have seen the percentage of SFR relative to total housing stock increase over the past decade and expect it to continue to increase.
SFRs provide an attractive option for families who wish to live in single-family homes with more space and in more suburban/distanced areas than multifamily rentals. These locations are and will continue to be in high demand because of access to quality school districts, employers’ increased willingness to embrace flexible work-from-home policies and the changing nature of what a house means to people.
It is no longer just a place to live and eat, but a place to work as well, which requires more space and different configurations. SFRs are also attractive to families because there’s more anonymity in renter status than with multifamily, and renters can enjoy the same high quality of life as neighbors who own their homes.
Since 75 percent of Toorak Capital funds are used toward affordable housing development or renovation, what are some other financial solutions and initiatives that could address the scarcity of affordable housing?
Beacham: The way I view it, there are three common-sense initiatives that could immediately enable the industry to better address the scarcity of affordable housing.
First, we need to standardize and digitize the regulatory infrastructure the entire industry relies upon. Currently, the real estate industry works in an antiquated system dependent on a patchwork of manual review processes that create unnecessary market frictions and increase transaction costs. A public, searchable system of digital property records can serve to lower these costs and improve outcomes for all market participants.
Second, zoning regulation and approval should be administered at the state, rather than the local level, preventing local zoning boards from artificially inflating property values by limiting new housing. This way, long-term policies could also be developed to specifically target the areas hardest hit by the affordable housing crisis. Zoning is critical because, simply put, we cannot create more land, so we need to increase housing density to solve our housing shortage.
Finally, we need to renovate our existing housing stock by harnessing the entrepreneurial spirit of our industry and incentivize small contractors, property owners and developers to renovate, rehab and repurpose existing housing to better reflect the changing demographics and preferences of the housing market.