Real Estate Financing and Investing/Sources of Funds
Since such a small percentage of the purchase price of real estate is normally provided from the savings of the purchaser, available sources of funds need to be known to anyone desiring to purchase real estate. For purposes of discussion, the more common financial sources have been divided into four groups: (1) primary sources, (2) financial middlemen, (3) other sources and (4) the secondary mortgage market.
Savings and Loan Associations
While savings and loan associations (S&Ls) are not the largest financial intermediary in terms of total assets, they are the most important source of funds in terms of dollars made available for financing real estate. S&Ls have sustained large asset growth in recent years, and currently the total assets of the 3,900 associations is second only to commercial banks. Traditionally, they have been the largest supplier of single-family owner-occupied residential permanent financing, although S&Ls are not limited solely to this type of financing. Savings and loan associations also make home-improvement loans and loans to investors for apartments, industrial property and commercial real estate. Recently, primarily as a result of the restructuring of lending activities through deregulation, the average S&Ls assets invested in mortgages has continued to decrease. As recently as 1980, on the average over 80% of an association`s assets were invested in loans on real estate. By late 1983, that percentage had dropped to below 60%.
An S&L is either federally or state charted. Approximately 40% of the S&Ls are federally chartered. If federal, the association must be a member of the Federal Home Loan Bank System (FHLBS), and its funds must be insured by the Federal Savings and Loan Insurance Corporation (FSLIC). All federally chartered S&Ls are mutually owned (owned by depositors) and the word `federal` must appear in their title. State chartered S&Ls can be either mutually owned or stock associations. (In a stock association, individuals buy stock which provides the equity capital.) They have optional membership in both the FHLBS and the FSLIC. In some states, these lenders are known as building and loan associations or cooperative banks.
While lending policies vary from association to association, most S&Ls are involved in the same type of activities and with the same basic lending requirements. The following are common lending policies:
- The bulk of their mortgages are in conventional loans for single-family residential real estate.
- Most S&Ls provide both FHA and VA financing, although these loans typically comprise a small percentage of total assets.
- The majority of loans are made locally. Funds are typically not available to faraway geographic areas. However, recently some of the larger associations have been engaged in lending funds to users in other states through service corporations and correspondent accounts.
- Residential loans are usually for 25- or 30-year periods calling for periodic (monthly) full amortization. The current average maturity for conventional mortgages on new homes is approximately 28 years.
- While conventional loans can be made for up to 95% of a property`s value, the average loan-to-price ratio on new conventional mortgages on new homes is between 75 and 80%.
- Any S&L handling VA mortgages is subject to interest rate ceilings set by the federal government, regardless of who issued the association`s charter.
- All S&Ls are expanding the type of services they offer in terms of more consumer loans, checking accounts and services, heretofore, limited to commercial banks.
In terms of total assets, the more than 14,500 commercial banks are the largest financial intermediaries directly involved in the financing of real estate. Commercial banks act as lenders for a multitude of loans. While they occasionally provide financing for permanent residential purchases, commercial banks` primary real estate activity involves short-term loans, particularly construction loans (typically six months to three years) and to a lesser extent home-improvement loans. Most large commercial banks have a real estate loan department; their involvement in real estate is through this department. Some of the largest commercial banks are also directly involved in real estate financing through their trust departments, mortgage-banking operations and real estate investment trusts.
All commercial banks are either federally (nationally) chartered or state chartered. National banks are chartered and supervised by the U.S. Comptroller of the Currency. The word `national` appears in their title, and they are members of the Federal Reserve System (FRS). However, only one-third of all commercial banks are members of the FRS, even though the member banks control the majority of total bank assets. Nationally chartered banks are also required to maintain membership in the Federal Deposit Insurance Corporation (FDIC). Federally chartered banks can make real estate residential loans up to 90% of the appraised value with a maturity of not more than 30 years. However, any government insured or guaranteed loans are exempt from these limitations.
State chartered banks are regulated by various agencies in their particular state, and membership in both the FDIC and the FRS is optional. Banks not members of the FDIC are normally required to maintain membership in a state insurance corporation.
Life Insurance Companies
Insurance companies play an important role as providers of capital for real estate from an equity (owner) standpoint. Unlike the savings and loan association or the bank, which normally deals directly with the borrower, the 1,800 insurance companies typically do their lending through local correspondents, either mortgage brokers or mortgage bankers. Insurance companies normally specialize in large-scale projects and mortgage packages. Historically, between 25 and 30% of their assets have been invested in mortgages.
Insurance companies receive their money through the payment of premiums by their policyholders and since both the inflow of premiums and the outflow of claim payments can be predicted with reasonable accuracy, insurance companies are able to invest in those assets yielding higher returns but less liquidity than is available to either banks or associations. For their real estate investments, this normally means long-term commercial and industrial financing. While insurance companies have historically invested in residential mortgages, this form of investment has continued to become a smaller and smaller percentage of their portfolio. Few insurance companies presently originate residential mortgages.
All insurance companies are state chartered since there is no federal agency which issues charters. The result is less regulation in most states than is true for either S&Ls or banks. Less regulation generally results in liberal lending patterns which leads to the funding of a wide variety of real estate projects. Over 90% of the insurance companies are stock companies; however, the majority of the industry`s assets are held by mutual companies.
Mutual Savings Banks
Located primarily in northeastern states, the 500 mutual savings banks are an important supplier of real estate financing. As their name indicates, these banks are owned by their depositors. who receive interest on their deposits.
All mutual savings banks are state chartered and typically are less regulated than their closest financing relative, the savings and loan association. The percentage of their assets invested in real estate mortgages is less than the average S&L, although a higher percentage of their total mortgage portfolio is FHA and VA loans. Most mutual banks have a relatively larger percentage of their mortgage. Mutual banks also make personal loans which can result in capital being moved from surplus areas to deficit areas. Over two-thirds of the mutual banks maintain membership in the FDIC. The remaining ones are insured by state savings insurance agencies. These state agencies exercise authority over both the type of investments and the amount of their assets invested in particular types of real estate.
Mortgage brokers are not direct or primary suppliers of capital. However, they do play an important and necessary role in the financing process. A mortgage broker is a person who serves to bring together the user of capital(borrower or mortgagor)and the provider of capital (lender or Mortgagee). For this service, a finder`s fee equal to one percent or so of the amount borrowed is normally paid by the borrower. The financial success of the mortgage brokerage firm depends upon the ability to locate available funds and to match these funds with creditworthy borrowers.
Certain sources of funds, particularly insurance companies and the secondary sources discussed below, do not always deal directly with the person looking for capital; rather, they work through a mortgage broker. Thus, if you wish to borrow from certain lenders you would need to go through a mortgage broker. Normally, the mortgage broker is not involved in servicing the loan once it is made and the transaction is closed.
The mortgage banker is also a financial middleman; however, the services offered include more than simply bringing borrowers and investors together. Mortgage bankers normally make mortgage loans, package these loans and then sell these packages to both primary lenders and secondary investors. Financial help is often sought from a lender, typically a commercial bank. The bank becomes a warehouse for mortgage money, and the mortgage banker draws on these mortgage funds until payment is received from the investors. Usually the mortgage banker continues to service the loan (collect debt service, pay property taxes, handle delinquent accounts, etc.) even after the loan has been packaged and sold.
For this management service a small percentage of the amount collected is retained before forwarding the balance to the investor. Obviously, the success of the mortgage banker depends upon the ability to generate new loans. In some geographic areas, mortgage bankers are the primary source for financing real estate. All mortgage bankers try to stay in constant touch with investors and are aware of changing market conditions and lender requirements. Quite often the loan origination fee or finder`s fee charged the borrower is more than offset by a lower interest rate from a lender not directly accessible to the borrower. Mortgage bankers are involved in both commercial and residential financing and also carry out related activities such as writing hazard insurance policies, appraising and investment counseling. As with mortgage brokers, mortgage bankers are regulated by state law.
Besides the four primary sources of funds, a number of other sources are available and each plays an important role in financing real estate. Most of these sources rely on mortgage brokers and mortgage bankers to assemble loan packages for them since they normally do not provide funds directly to the ultimate user.
Pension funds are one of the newer sources available for financing real estate. Whereas these funds historically were invested in stocks and bonds, the recent growth of pension funds has meant new outlets had to be found for their investments. This growth, plus the favorable yield available through real estate investments, has resulted in active participation in financing real estate projects. Besides making mortgage loans, pension funds also own real estate. The majority of all their real estate activity is done through mortgage bankers and mortgage brokers.
Traditionally, finance companies have provided consumer loans for the purchase of both durable and nondurable goods. However, as commercial banks have become more and more involved in personal loans, finance companies have turned to other forms of investment including real estate mortgages. In residential real estate, finance companies are actively engaged in second mortgages. This type of mortgage is usually made at an interest rate four or more percentage points above the rate on first mortgages and is amortized over a much shorter time period. Some of the larger finance companies such as those owned by the automobile manufacturers finance land development, provide commercial gap financing, acquire land leaseback and enter into joint ventures with real estate developers.
Real Estate Investment Trusts (REITS)
Federal legislation passed in 1961 created Real Estate Investment Trusts (REITs). REITs pool the money of many investors for the purchase of real estate, much as mutual funds do with stocks and bonds. There are three types of REITs. An equity trust invests their assets in acquiring ownership in real estate. Their income is mainly derived from rental on the property. A mortgage trust invests in acquiring short term or long term mortgages. Their income is derived from the interest they obtain from their investment portfolio. A combination trust combines the features of both the equity trust and the mortgage trust. Their income comes from rentals, interest, and loan placement fees. For more on REITs, visit National Association of Real Estate Investment Trusts
While the majority of loans made by credit unions are consumer loans some of the more than 22,000 credit unions provide mortgage money for both residential and nonresidential financing. In addition to permanent loans, credit unions also make home improvement loans directly to depositors. Credit unions normally use mortgage brokers to locate real estate investments for their portfolios.
There are a number of large investors located throughout the United States who constantly lend money on real estate. These investors include individuals with available funds, groups of investors seeking mortgage ownership and large investment companies desiring to hold a diversified portfolio. They deal both direct and through mortgage brokers. Additionally, many of these investors seek to take an equity position in real estate. It is thus possible to raise equity capital through syndication instead of relying solely on mortgage funds.
Over the past decade, a substantial sum of foreign capital has flowed into the United States and much of it has taken the form of real estate equity capital. The relatively high return offered through real estate ownership in this country coupled with a stable economic system means a financially attractive alternative for foreign investors.
Farmers Home Administration (FMHA)
The Farmers Home Administration is an agency of the U.S. Department of Agriculture. Currently, FmHA administers two loan programs for rural housing: (1) a direct loan program and (2) a guaranteed loan program. Properties securing such loans may not be located in urban areas and , like FHA and VA, FmHA requires that the property meet certain minimum requirements. Although there is no statutory loan limit for such loans, the property must appraise for the contract sales price. Information on both loan programs is available from any office of the Farmers Home Administration.
State Finance Programs
Numerous states have enacted home financing programs that provide direct loans at preferred interest rate to citizens of that state who, for various reasons, have been unable to obtain financing from private institutions. Applicants must be residents of the state for a specified period of time and under most programs may not own other real property. In recent years, cities and countries have also established mortgage funds in order to meet the needs of the housing market in their political jurisdictions.
The Secondary Mortgage Market
The availability of funds for financing real estate is affected by economic conditions, both local and national. The result is that at certain times or in certain geographic locations little or no capital is available for mortgages; consequently, few if any loans are made. From the viewpoint of the lender, another problem is that real estate loans can be highly illiquid; thus, the supplier of funds can have a difficult time converting loans into cash. For these reasons, the need exists for some means by which a lender can sell a loan prior to its maturity date.
The secondary mortgage market attempts to meet these needs. Capital can be made available during times of tight money and at capital deficit locations. By selling mortgages in the secondary mortgage market, a lender can convert existing mortgages into cash which can in turn be used to fund new mortgages. Likewise, an investor in the secondary market can buy existing mortgages, pay the seller a small servicing fee and avoid the time and expense of originating and servicing the loans.
Federal National Mortgage Association (Fannie Mae)
The largest and best known buyer of existing mortgages is the Federal National Mortgage Association (FNMA), known to many as "Fannie Mae." (www.fanniemae.com/index.jhtml). The FNMA was originally organized by the federal government in 1938 to purchase FHA insured mortgages. The association was reorganized in 1968 as a quasi private corporation whose entire ownership is private. Fannie Mae raises capital by issuing corporate stock which is actively traded on the New York Stock Exchange and by selling mortgages out of its portfolio to various investors. Over the past 20 years, Fannie Mae has purchased many times more than it has sold. At the end of 1983 current mortgage holdings exceeded $80 billion, the majority being FHA insured.
The mortgage purchase procedure used by FNMA is conducted through an auction process referred to as the Free Market System Auction. Periodically, the association accepts bids from approved lenders as to the amount, price and terms of existing mortgages that these lenders wish to sell Fannie Mae. Upon deciding how much money it will spend during a given time period, FNMA notifies the successful bidders (determined by those mortgages offered for sale that will generate the highest yield to FNMA), and these bidders have a certain time period in which they can choose to deliver the mortgages. Once the mortgage has been delivered to Fannie Mae, the originator of the mortgage continues to service the loan (collect monthly payments, escrow property taxes, etc.) and for this service the originator receives a servicing fee.
The Housing and Economic Recovery Act of 2008 changed Fannie Mae`s charter to expand the definition of a "conforming" loan. Effective with the November 2008 release of the conforming loan limits, two sets of limits are provided for first mortgages -- general conforming loan limits, and high-cost area conforming loan limits. The conforming loan limits apply to all conventional mortgages that are delivered to Fannie Mae on or after January 1, 2009. The high-cost areas are determined by the Federal Housing Finance Agency. The company may purchase loans up to $625,500 in designated high-cost areas.
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(*) The limit may be lower for a specific high-cost area; use the Loan Limit Look-Up Table above to see limits by location. (http://www.fanniemae.com/aboutfm/loanlimits.jhtml)
Government National Mortgage Association (Ginnie Mae)
When the Federal National Mortgage Association reorganized in 1968, the Government National Mortgage Association (GNMA) (www.ginniemae.gov/index.asp) was completely separated as a legal entity. Referred to as "Ginnie Mae," this participant in the secondary mortgage market is a wholly owned government corporation under the office of the U.S. Department of Housing and Urban Development (HUD). While FNMA is involved with the selling and purchasing of existing mortgage, Ginnie Mae is responsible for the liquidation and special assistance functions previously carried out by FNMA. GNMA receives its funds from U.S. Treasury and mortgage operations. Ginnie Mae is also involved with the mortgage securities pool plan and tandem plan. GNMA also makes financing available to certain urban renewal projects, elderly housing and other high risk mortgages.
Federal Home Loan Mortgage Corporation (Freddie Mac)
In 1970, under the Emergency Home Finance Act, the Federal Home Loan Mortgage Corporation (FHLMC) or "Freddie Mac" (www.freddiemac.com/) was created as a wholly owned subsidiary of the Federal Home Loan Bank System. Freddie Mac was established as a secondary mortgage market for savings and loan associations who are members of the FHLBS.
The creation of FHLMC was of added importance since S&Ls make such a high percentage of the total conventional residential mortgages and many of these lenders would like to roll over their mortgages. While Fannie Mae deals heavily in FHA and VA mortgages, the majority of mortgages in Freddie Mac`s portfolio are conventional. In recent years, this agency has referred to itself as The Mortgage Corporation. Funds to finance Freddie Mac operations and mortgage purchase programs come from: (1) participation certificates (mortgage backed securities) and (2) convertible subordinated debentures. The maximum loan to value ratio for an owner occupied residence under Freddie Mac typically is 95 percent. Log onto www.freddiemac.com/sell /factsheets/ltv_tltv.htm for an updated loan to value ratios under various programs.