Flipping Out: The Evolution of Residential Transition Loan Securitizations
Since the proliferation of residential transition loans (“RTLs,” also known as “fix-and-flip” loans or residential bridge loans) began in recent years, securitizations of these types of loans have become increasingly frequent. Loans intended for the purpose of financing speculative real estate construction have existed for many years, but in the residential space, these loans were typically originated by local “hard money” lenders. In the years following the global financial crisis, nationwide origination platforms have been developed to service this market. These large originators have naturally turned to the capital markets for securitization leverage.
The first large revolving RTL securitization was issued in 2018, and since then, the asset class has grown significantly. In 2022, it is estimated that total origination volumes in the United States approached $10 billion. Given the conditions of the housing market in the United States, it is no surprise that RTL origination volumes have increased so significantly. The demand for housing in the United States continues to outstrip supply. As the supply of new housing stock falls short of demand, homeowners will instead look to purchase legacy homes that have been modernized and refurbished. An entire industry of home flippers has emerged to satisfy this demand, and the credit markets have responded accordingly.
RTL securitizations have many characteristics that distinguish them from the securitization of more traditional mortgage loans secured by residential properties. Many of these differences arise from the features of the loans themselves, whereas others arise from the relatively recent emergence of this asset class.
This Legal Update first surveys the unique features of RTLs as compared to traditional, consumer-purpose residential mortgage loans. We then turn to the characteristics of RTL securitizations that are necessary to adapt to features of the underlying RTL assets. We conclude with observations about possible improvements on these transactions and speculations about further developments.
Residential Transition Loan Overview; Underwriting and Regulatory Policies
RTLs are a means by which real estate investors (“REIs”) may obtain financing for construction, repairs and other rehabilitation and renovation projects on a related mortgaged property. Each loan is generally secured by a first lien on the non-owner-occupied property and is usually of a short duration (up to 36 months) with interest-only payments until maturity. Principal on the loan is due in a balloon payment at maturity.
Given the commercial nature of RTLs, loan borrowers, who are often businesses or other non-natural persons, may not qualify for traditional agency, government or private label mortgage loans due to the rehabilitation or construction needs of the property, loan size, lower credit scores of the borrower or general business purpose of the loan. Because RTLs are business purpose loans, they are also not subject to certain consumer protection regulations such as the Consumer Financial Protection Bureau’s Ability-to-Repay/Qualified Mortgage Rule (“ATR/QM Rule”)1 and TILA-RESPA Integrated Disclosure Rule (“TRID Rule”).2
RTLs, therefore, have been developed by loan originators with a unique set of underwriting standards to accommodate the purpose of these loans but result in a product that is more costly for borrowers, in part due to the inherently increased risks and sometimes speculative nature of the underlying property improvement projects. On the other hand, these broader underwriting standards are typically more flexible than traditional standards for residential mortgage loans underwritten by government-sponsored enterprises (“GSEs”). RTLs are underwritten on the assumption that, after the completion of the related construction or rehabilitation projects, the borrower will either sell the mortgaged property or otherwise refinance to repay the RTL. The balloon principal payment compels borrowers to complete the related rehabilitation or construction project on schedule in order to realize any gains on the sale of the property.
Loans being made in anticipation of renovations or repairs to the related mortgaged property are often assigned an estimated after-repair value (“ARV”) by a third-party valuation provider to help determine the potential future value of the property after the planned projects have been completed. Because RTL loans generally involve some amount of construction, a portion of the principal balance of the loan is typically held back and not disbursed at origination (“Rehabilitation Holdback Amounts”). Rehabilitation Holdback Amounts are disbursed to the borrower only upon satisfactory completion of phased projected evaluations. Rehabilitation Holdback Amounts can either be fully funded at closing and held in an escrow account pending disbursement to the borrower, or they can be funded at the time of disbursement.
RTL Securitization Characteristics
RTL securitizations have developed to accommodate the unique features of RTLs. Due to the short-term nature of the RTLs, securitizations of this product are almost always revolving. During a securitization’s funding period (typically between one and three years), the sponsor of the securitization is permitted to sell or contribute new loans into the deal. These new loans are acquired using proceeds from the repayment of existing RTLs held by the securitization issuer. These new loans are subject to certain eligibility criteria and concentration limits. Operating within the scope of these limitations, however, sponsors are generally permitted to cause the securitization to acquire any loans chosen by the sponsor.
A revolving structure also presents greater flexibility in the timing of closing the securitization. For example, a sponsor might expect a significant volume of new originations in the near future. However, the sponsor desires to price and close a securitization now due to favorable market conditions. In this case, the sponsor might choose to close the securitization with a percentage of the proceeds of the sale of the bonds held in a pre-funding account to acquire new loans as they are originated.
Because RTLs generally have Rehabilitation Holdback Amounts, the securitizations need to be structured to fund these amounts. This is straightforward with respect to Rehabilitation Holdback Amounts that are held in escrow accounts. The securitization servicer can withdraw funds from the related escrow account when the Rehabilitation Holdback Amounts are required to be disbursed to the related underlying borrower. However, with respect to unfunded Rehabilitation Holdback Amounts, the securitization issuer will need a source of funds to either fund the Rehabilitation Holdback Amounts directly or reimburse the servicer for such amounts. Sources of funds could include proceeds from prepayments on the RTLs, a reserve account, or a funding commitment from the securitization sponsor. The securitization might also issue a variable funding note (either to the sponsor or to a third party) that can be drawn on to fund Rehabilitation Holdback Amounts. Regardless of the source of funds, being able to fund Rehabilitation Holdback Amounts as they are due is vital for the success of an RTL securitization. If the underlying borrowers do not receive expected Rehabilitation Holdback Amounts, it could lead to a failure to complete the related rehabilitation project in a timely manner. This in turn could cause the underlying borrower to be unable to sell the mortgaged property or refinance the RTL at maturity.
Servicing
The unique structural features of RTL securitizations give rise to servicing responsibilities that are not typically found in a standard residential mortgage loan securitization. For example, the servicer (sometimes working in conjunction with an asset manager or the securitization sponsor) is responsible for monitoring requests for disbursement of Rehabilitation Holdback Amounts. Rehabilitation Holdback Amounts are generally only disbursed upon satisfaction by the underlying borrower of certain construction benchmarks, and the servicer is responsible for confirming that these benchmarks have been met. In addition to traditional tax, insurance and other protective advances, a servicer of an RTL securitization might be obligated to advance Rehabilitation Holdback Amounts to the extent the securitization has insufficient funds to fund such amounts.
It is a fact of life that construction and rehabilitation projects are often delayed. Because of this, it is not unusual for underlying borrowers to request an extension of the RTL maturity date. The servicer (sometimes in consultation with an asset manager) is required to evaluate requests for maturity extension. The terms of the securitization might also limit a servicer’s discretion to grant such an extension.
Tax Considerations for Revolving Mortgage-Backed Securitizations
By their very nature, RTL securitizations present interesting tax challenges. As with any securitization of mortgage loans, RTL securitizations are potentially subject to the taxable mortgage pool (“TMP”) rules. Under the TMP rules, a pool of mortgage loans (other than a pool treated as Real Estate Mortgage Investment Conduit, a “REMIC”) that supports two or more classes of debt, the payments on which bear a relationship to collections on the mortgages, will generally be treated as a corporation for U.S. federal income tax purposes. These punitive rules were intended to encourage the use of REMICs by mortgage loan securitizers. REMICs, however, are generally not a suitable vehicle for revolving deals such as RTL securitizations because, typically, new assets cannot be contributed to a REMIC more than 90 days after its formation. As a result, RTL securitizations are generally structured without the necessary relationship between the timing and amount of mortgage loan collections and the timing and amount payments on issued securities (colloquially referred to as “breaking the relationship”). Often this is accomplished by structuring the deal so that subordinate tranches receive principal payments on a fixed date or series of fixed dates after the senior tranche is repaid. Additionally, RTL securitizations often include a significant interest rate step-up on the senior tranche if the tranche is not redeemed by the sponsor by a certain date. This feature can act as the effective repayment date of the senior tranche for tax purposes, allowing the fixed repayment dates of the subordinate tranches to be earlier in time.
Although these methods can be successful in achieving the desired tax treatment, they are often sub-optimal from a business perspective. More recent RTL securitizations have utilized a revolving REMIC structure, where a new REMIC election is made every 90 days, allowing the securitization vehicle to acquire additional RTL loans during the reinvestment period. This innovative, though complex, structure could prove increasingly attractive to RTL sponsors in the future because it allows sponsors to take advantage of the structuring flexibility of a REMIC while still being able to contribute new loans into the securitization more than 90 days after its inception, although it also introduces additional administrative burdens that are absent from other structures.
Conclusion
To date, no RTL securitization has been rated by a nationally recognized rating agency. The novelty of the asset class, combined with the challenges discussed above (such as the broad flexibility of the securitization to acquire new collateral and the need to fund Rehabilitation Holdback Amounts), have proved challenging for rating agencies. However, we expect that as the asset class matures and underwriting and servicing standards become increasingly uniform, an RTL securitization will eventually receive an investment grade rating from a rating agency. Once a set of rating agency criteria has been established, RTL securitizations should only continue to increase in volume in the coming years.
