As an investor in real estate home loans, you stand to gain interest income like banks have done for decades. By replacing them as the lender you put your money to work for You, not the bank.
Here is how investing in mortgages works: when a home buyer gets a mortgage, the bank provides the full loan amount at an agree upon interest rate, as a lender you receive this interest income from the homeowner (less a ~1% servicing fee) every month until the mortgage is refinanced (historically the majority of borrowers refinance every 4 years) or until it’s paid in full (mortgage terms range from 3–5year arms and 15–30year fixed loans). When the homeowner makes timely payments the mortgage is called a performing mortgage. A performing mortgage becomes a non-performing mortgage when the borrower misses 6 consecutive payments. This occurs during difficult situations when the homeowner may have unexpected costs or job loss, but a majority of borrowers rebound and continue payments. Unwilling to “workout” non-performing mortgages (loan workout is the process by which a vast majority of non-performing loans become re-performing again), banks are often willing to sell them at a deep discount, this creates an opportunity to gain that discount as capital return in addition to interest income on re-performing loans, yielding 10–40% returns in 1–4 years.
Upside of Re-performing Mortgage Investments
Investing effectively in non-performing mortgages requires analyzing conditions that inform the likelihood of the mortgage becoming a re-performing mortgage — when the borrower continues to pay. Criteria include real estate demand, housing pricing, asset conditions, loan to value ratio (LTV) as well as borrower financial and employment criteria. Mortgages backed by the primary home of a borrower are the least risky because their home is a necessity — unlike a loan backed by a car or second/vacation home a borrower is more likely to default on first.
You may be asking: Can’t banks make this analysis themselves and keep mortgages most likely to repay? The answer is no, banks are not in the business of investing in re-performing mortgages. Bank employees are paid for originating new mortgages, collecting an origination fee upfront, and collecting interest. Banks are so conservative, many are happy collecting an origination fee then selling even performing mortgages to a secondary mortgage market investor (FannieMae, Freddy Mac, hedge funds, or securitized MBS’s, the latter is a pool of mortgages offered on stock exchanges for a premium) who pays the full principal amount and a small discount/premium (typically ~1% depending on the value of future revenues, ie net present value). This creates one investment opportunity, but one that requires more capital to compete with institutional investors, with stable but returns around the interest rate (currently 4–5% for conservative mortgages).
Say the bank kept the mortgage, but it then stops performing because the borrower was laid off. The bank will then act according to their policy reflecting the return expectations of their conservative investors — put in place by a finance executive who will never see individual mortgage files nor meet the struggling borrower. Because a bank can have millions or billions of dollars in mortgages they will rarely conduct a workout, instead will leave it up to a 3rd party servicer to collect payments without digging into the borrower’s circumstances, and in as little as 6 months may sell the mortgage at a discount. This creates an investment opportunity.
Re-performing Mortgage Investment Example
Let’s use an example to illustrate the investment opportunity a non-performing loan presents. Say the following mortgage was issued to John:
Borrower: John Wells
Date issued: January 2015
Original Home Value: $600,000
Mortgage Original amount: $480,000 [originated January 2015]
LTV (Loan-to-Value): 80%
Mortgage Interest Rate: 4.5%
Principle and Interest Payments: $2,000 per month
Location: Houston, Tx
Mortgage type: Fixed-rate, Primary Home
John purchased the home in January 2015 for $600,000, putting down 20% cash and borrowing $480,000, which means his LTV (Loan-to-Value) ratio was 80% ($480,000/$600,000=80%) — a typical LTV for home purchases.
John has unfortunately lost his job and has stopped paying his loan for 6 months, the bank is ready to sell it at a loss in order to get capital to make new loans while not expecting those 6 months to be repaid. In order to decide if this is a good investment, we calculate the current market price for the home and likelihood of John continuing payments.
Based on local housing market data we are confident his home value has modestly increased to $620,000. He has also paid down his principal outstanding balance to $400,000, yielding an LTV of 65% ($400,000/$620,000=65%), much more attractive than the original LTV and far below what is considered a risky LTV for the Houston market according to our data.
There are a lot of criteria that go into accessing the likelihood of John repaying his loan, let’s discuss a few. In this instance say we learned his profession is a high-in-demand electrical installation project manager who has reserves in his bank account. We also know that his mortgage payment makes up 15% of his expected salary for target jobs in the Houston area. Lastly from a credit report, we can see his overall debts are low, with total debts including his mortgage payment (P&I) totaling only 20% of his income, also known as his DTI (Debt-to-Income) ratio.
We decide there is a high probability of the loan becoming re-performing or being able to re-sell the home within 6months (workout with John the first step, foreclosure last resort). To be conservative we may estimate John will be able to resume payments in 12 months, not 6, so we calculate an additional loss of 12 months worth of payments $2,000 x 12 = $24,000. In reality we would calculate a probability ratio and apply that to the discount (BitCasas achieves this through an underwriting algorithm validated by the community), as well as the time it takes to start getting returns, but let’s keep it simple and say we want a $50,000 discount for possible losses and our time and effort. We offer the bank only $350,000 for the mortgage that could eventually pay off $400,000. The bank accepts. Our deal looks like this:
Home Value at Acquisition: $620,000
Mortgage Outstanding principle: $400,000
LTV (Loan-to-Value): 65%
John’s DTI (Debt-to-Income): 20%
Our Investment: $350,000
John finds a job and begins to repay his mortgage 6 months later; we have now made $38,000 in capital gains plus income of $2,000 per month providing a total cash-on-cash return of 11.43% in month 6 passed on to you as the investor ($40,000/$350,000=11.43%).
If John refinanced his loan within 24months of our purchase we would receive $391,000 ($400,000-$9,000 principal payments=$391,000), more than we paid for the loan for a return IRR of 39.10% for investing our capital for 24 months.
Like any other investment, diversification is key to gaining additional protection by lowering risk. In stock investments, diversification means spreading your money across various companies and industries such as tech, healthcare, consumer goods, etc., so that if one industry is down or a company goes bankrupt you don’t lose all your money/returns. When investing in mortgages we can achieve diversification investing in a portfolio of both performing and re-performing mortgages as well as different geographies, employment hubs, and credit ratios (LTV, DTI among others).
BitCasas built an algorithm housing years of investment acumen (during up and down markets) used to rate mortgages based on their risk and return profile. Data and feedback from industry veterans (our blockchain community governance) are key components incorporated into our underwriting allowing our investors to enter the best non-performing mortgage deals faster versus secondary mortgage market players (FannieMae, hedge funds, Mortgage Backed Securities). Every day we are building on top of our relationships to gain access to larger pools of mortgages across the US.
How Can You Become A Mortgage Investor?
Capital and relationships are key to become a mortgage investor because unfortunately, it’s not easy to obtain access to investment opportunities like that highlighted above. By joining BitCasas, you pool your investment alongside other investors to gain access to a portfolio of performing and non-performing mortgages yielding steady income and capital appreciation.
Become an investor and support the American dreams for families by making mortgages part of your investment portfolio, join Bitcasas.io.