Issues in Mortgage Underwriting for Mortgage Investors

Technical Discussion – Strata Ownership in BC

One of our brokers approached me the other day with a question about a self-managed strata corporation in Richmond –

“I have a client with a Strata Townhouse in Richmond who wants to take a mortgage. But they have one of those 'self-managed' strata committees, ran by all of the owners themselves. Is this insane? Is it legal?? There are strata minutes available, but no financial statements. There is also no contingency reserve. Dumb question - Is this safe for a private lender to lend against a building built in 1984 that has proper insurance but no contingency fund? How can they protect themselves? “

The broker obtained a legal opinion on the deal, after verbally discussing it with me, and this is what the lawyers said,

…Self-managed stratas are more common than I would like… As for the Contingency
fund (CRF), the Strata Property Act requires them to keep one, and for good reason. Insurance covers some catastrophic situations, but a myriad of others would leave the owners (and more importantly, the lenders) high and dry - from the basic replacement of pipes, to the building envelope issues we see so much of. Add to that that some lender, or owner might get antsy that there is no CRF and petition to court to appoint an administrator to run the strata, effectively putting control in the hand of a bureaucrat.I would strongly recommend against such a loan.[i]

This got me thinking more generally about issues related to strata corporations, and the implications for lenders, investors and underwriters. A recent report by the Vancouver Island Strata Owners Association (“VISOA”) raises a number of issues arising out of current legislative deficiencies, and proposes remedies in a new Act or Acts governing various aspects of the issues.

There are a large number of issues addressed by the VISAO report, and I’m not going to attempt to address all of them, especially since a number of the issues are primarily related to deficiencies in the Acts that relate to the owners of the strata units or bare lots, not all of which directly impinge on a mortgage interest. Unfortunately most of them do, as the legal interests of a lender are derivative, that is, they are derived from the rights of an owner established under the various acts.

Strata or condominium ownership has grown to 25% of taxable properties across British Columbia, with there now being 460,000 individual strata units. In several large urban areas, strata homes now account for 50% of all taxable properties. Growth in strata homeownership is expected to continue as land prices increase and efforts are made to reduce the “environmental footprint” of new housing.[ii]

In many urban areas such as the Lower Mainland and southern Vancouver Island strata ownership is becoming the de facto standard form of housing for most new homebuyers, indeed the vast majority of home ownership in the next twenty-five years will likely be strata titled property. Increasingly, for lenders, there will be little choice but to invest mortgage dollars into strata properties, as there will be few opportunities otherwise, especially for private mortgage lenders who tend to lend in situations where banks are unwilling to do so.

The Strata Property Act (SPA), the Real Estate Development Marketing Act (REDMA) and the Real Estate Services Act (RESA) affect strata homeownership. Although the RESA and the REDMA are relatively recent (2004) creations in response to concerns of the real estate industry, no public review of strata legislation to address homeowner concerns has occurred since 1998. In the meantime, other provinces have moved ahead with legislation to address emerging concerns in strata (or condo) homeownership. In 2003 the BC government recognized there were significant issues with the SPA and committed itself to a review. This review has not occurred.

VISOA has identified many deficiencies in transparency and accountability under current legislation and has categorized them under the topics of:

A. Strata Governance,
B. Strata Management Licensees,
C. Disclosure,
D. Strata Development Approvals,
E. Property Taxation,
and
F. Strata Fee Equity.

The areas which primarily are of immediate concern to lenders are: Strata Governance, Strata Management Licensees, and Disclosure. Although there are serious issues related to Property Taxation and Strata Fee Equity are also of some concern to ownership, they are of less relevance to the vast majority of mortgage lenders as they do not directly affect the quality of the security on a mortgage loan placed on a strata title.

Strata Governance

The complexities of shared ownership and mutual obligations among individual owners and their corporate body require relevant knowledge of the Strata Property Act and simple, direct and affordable access to due process for enforcing the Act and resolving disputes. Current legislation provides for only cumbersome, intimidating and expensive judicial, arbitration or mediation processes to administer the Act. It effectively indulges irresponsible actions and leaves disputes unresolved.

The main concern for a lender here is the derivative consequence of unresolved or irresolvable conflicts related to the maintenance and/or repair of common property held by a Strata Corp. Because there are requirements that a Strata Corporation must obtain 75% approval for any significant expenditure, including substantial maintenance or repairs, a council with reluctant participant with over 25% of the votes at an annual meeting may find itself unable to make corrective investments or even to repair serious damage to a building. The owners may have a remedy, by suing the corporation, to force necessary repairs, but there is no efficient mechanism by which an owner can enforce responsible conduct by a strata council, especially one where irresponsible members form a substantial minority of the votes (ie: over 25%).

The mortgage interest in a property can be seriously damaged if the quality of a building declines through deferred maintenance or damage that is not repaired. The lender has little or no leverage on the owner to force the strata to take action. To whatever degree the owner is handicapped in enforcing responsible behavior by a strata corporation, the lender is even more vulnerable in that the lender has even less in the way of access to due process than does the owner.

And while the law requires the strata corporation to maintain a contingency fund to pay for repairs and other liabilities of the strata corporation, in the event that a strata council doesn’t set fees high enough to ensure an adequate fund, there is little that an individual owner can do to force the council to do so.

This is one of the reasons that a lawyer would be doubly concerned about a self-managed strata corporation. In the absence of a professional management company there is very little way for an owner (or the lender) to even know that there is a problem regarding the strata council and its conduct in maintaining and protecting the ownership interest.

There is no requirement for audited annual financial statements from the strata corporation so there is no way to know how adequately they have been reported. The preparation of Form 9 disclosure statements by self managed strata corporation is necessarily a function of the elected executive of the strata council. There are no consequences of misreporting or under reporting of potential liabilities against a strata property. The law provides a form of disclosure that requires certain behavior but does little to enforce it.

Lenders (and their lawyers) are understandably nervous about disclosures from self managed strata corporations. Even when there is a professional management company responsible for the strata management, there can be no guarantee of fair, plain, and true disclosure necessary for the registration of a proper security interest. Strata corporations rank with governments in obtain position on title for any obligations of a unit holder to the corporation. Failure to fully disclose potential liabilities to a lender may open a manager to legal consequences for failure to disclose, but practical remedies that do not include suing third parties for negligence do not exist.

Lenders also have no way of knowing when a strata corporation is getting into trouble, either as a result of deficient property management practices and deferred maintenance, or as a result of structure problems, i.e.: leaky condo syndrome.

These problems, and others, which arise out of a fundamentally flawed set of legislative Acts, can ultimately only be resolved by legislation designed to address them. Lenders, on the other, can’t wait for a pie in the sky solution but rather have to take measures to protect themselves.
Which is one of the reasons why many lenders, including private lenders, are seeking independent inspections on all strata mortgages where the strata is self managed, as well as on any strata mortgage where there are any alarm bells at all arising out of an appraisal or an investor interview done at the time of loan approval prior to loan advance.

While issues related to deferred maintenance, structure deficiencies, environmental hazards are potentially present in all real estate transactions and therefore all mortgages, where title is more complicated and processes for resolutions of disputes more difficult, the risk is exacerbated.
Therefore it would be prudent to obtain a higher level of disclosure on Strata Titled properties during underwriting.

Conclusions and closing thoughts

In regards to private investors making direct or indirect investments in strata mortgages, it is important during the review of an investment opportunity to comfort yourself as to whether or not a strata is managed by a professional management team, or self managed; and, either way, that there is an adequate contingency fund as well as a well planned and self-evident maintenance program for the whole strata building. Look closely at the appraisal for any evidence of deferred maintenance or potential deficiencies arising out of the design or execution of the design of the building in the first place. Have your broker talk to the borrower, and see if they have any concerns about the property.

At the end of the day, if investors are going to invest in mortgages, which are still one of the safest and most secure investments available in the marketplace, it is important that investors be aware of any potential risks, and the scale of those risks.

In the case example given at the beginning of this blog, clearly the lawyer is correct. Not only is the property self managed (an alarm bell all by itself, not necessarily fatal, but still of concern) but in the minutes of the strata meeting the disclosure of no contingency fund and some deferred maintenance, combined with an unwillingness to increase strata fees to cover necessary repairs would disqualify this strata unit owner from obtaining a second mortgage. It may also prevent the unit owner from refinancing if these deficits are not remedied within a reasonable period.


[i] This initial quotation is a quotation from an email exchange between a broker and our office.
[ii] All other references in this blog are to a report - Ensuring Transparency and Accountability in BC Strata Developments May 2, 2008, Vancouver Island Strata Owners Association - http://www.visoa.bc.ca/static/VISOA%20Report%20on%20Strata%20Legislation%20Issues%20-%20May%202,.pdf

More Trends for BC Real Estate and Mortgages

Beyond obvious sales figures and average sales prices being obtained in any given marketplace over the short term there are a number of things to consider. Market trends pertaining to mortgage investments should also take into account some underlying trends such as:

1. Rental levels and vacancy rates in rentals
2. Absorbtion rates of new properties being released into the market
3. Net migration into market areas
4. Employment and unemployment statistics

On the first item, rental and vacancy rates, the news is pretty positive for owners of residential real estate, and for lenders in rental housing markets, especially in BC. The rental report from CMHC ending in June for the first half of 2008 indicates a powerful demand for rental housing that has kept vacancy rates below 1% in the major markets of Vancouver and Victoria, as well as in the secondary markets in the southern part of the Province.

If you own market housing in BC you can rent it for a pretty fair price as well, with rental prices rising steadily across all markets except for the northern areas of the province.

On the second item, absorbtion rates of new housing, the results aren't quite as clear cut, although it appears that urban rates are still extremely high, despite a lot of new product coming on the markets. If I were an owner of a presale unit in anywhere other than Vancouver or Victoria I would likely be considering trying to sell it without a gain, or hold it for rental. Any speculative increase in value is probably moot at this point.

Vacancies in new housing coming into the market are still at historic lows, and given the extreme shortage of rental housing in virtually all markets in BC except for logging towns in the north, any surplus presold vacant property will tend to be absorbed into the rental pool. Investors in presold properties should hope that they own units in buildings that permit rentals, as resales next year may be a little slow.

As far as net inmigration into the Lower Mainland and British Columbia is concerned it will likely continue for the foreseable future, given the historically low levels of unemployment and high levels of jobs available. Again, with the exception of the logging industry, job growth is strong throughout the province, but particularly in Vancouver area. No pressure here for any reduction in migrations to the area. Given falling employment in Ontario and Quebec as a result of declines in manufacturing, inmigration to BC may in fact increase in the next part of this economic cycle.

BC, especially urban BC, continues to be a place where you probably want to invest your money in real estate and mortgage investments. In addition to being one of the best places on earth to live, it also still continues to be one of the best places on earth to invest your money in real estate, especially if you always maintain a long term view.

Trends without a direction

I have been reading through my regular real estate and mortgage blogs this afternoon, trying to gain a perspective of opinions out there in the mortgage brokerage world, as well as in the larger real estate community.

Several things jump out at me.

1. Everybody is trying to figure out whether or not Vancouver is going to have a major price correction in the next few months, and if so, how deep, and if so, how long before it turns around.
2. People are worrying about changes in the mortgage environment as a result of (a) the US housing slump and mortgage crisis or (b) the government of Canada's reaction to (a) above, and whether those changes are going to be good or bad for the mortgage investor.

For example, a recent headline in a mortgage industry blog referred to a comment by the chief economist of the Export Board of Canada, where he refers to an excess of building stock and a potential for a collapse in the housing market because of a surplus of new housing.

I went to the read the report and discovered that the economist made a passing comment about this possibility while directing his main comments at declines in European and Asian housing, basically stating that while Canada isn't in the same condition Yet, it soon could be, if these early indicators are true.

The housing market is not as torrid as it has been, and selling properties now requires a little more common sense than it did at the peak of the markets a year ago. However, in the Lower Mainland prices are still up, and sales are still pretty strong.

I remember the 1990's when you couldn't sell something to save your soul in Vancouver, and the whole Province had the Asian flu. Stats Canada still says that net inmigration to the Lower Mainland will continue at a high level for the foreseable future. Unemployment rates continue to be excruciatingly low!

Boy! Things in BC are really going to Hell! Not.

So, be careful what you read or you could completely miss the boat in terms of making good investments.

Credit Scores - Arbitrary and Unfair

Recent changes in government policy have required major changes in how mortgage insurance is governed in Canada, with restrictive policies pertaining the minimum Beacon Score acceptable by a mortgage insurer for borrower to obtain an insured mortgage.

I have a number of problems with the new federal policy changes for mortgage insurance, but my biggest concerns is with the Harper government now deciding to make hard and fast rules on subjects previously open to discretion on the part of the insurance companies and the lenders.

To me it doesn't matter if the hard number for a Beacon score is set at 620, 580 or even 680. What matters is that the government has given over control of the mortgage insurance industry and insured lending to private companies, Equifax and TransUnion, that are only accountable to their own shareholders.

Credit Scores are an arbitrary and unfair tool to be used to determine eligibility for mortgage insurance, and therefore for prime mortgage loans.

I have many problems with these unaccountable private agencies who have godlike powers already, without seeing them gain even more influence in the credit granting marketplace.
One of my complaints is that a person's single largest debt, a mortgage, is generally NOT reported to the credit bureau, which means that the Credit Score is based on how a person deals with a minority of their personal debts - indeed even a perfect mortgage payment record is not referred to at all.

In fact, a person can have a flawless mortgage record and haveCredit Score at all, unless they have trade credit, ie: credit cards or installment loans of other kinds.

Errors or misfilings on consumer reports are also not corrected except by a persistent and determined consumer who can prove that they are NOT guilty of an offense. There is no presumption of innocence here... even any collection effort, justified or not, is a black mark on a person's credit score without reference to the merits of the collection case at all.

Even if someone wins relief from a collection, the collection report still is a negative on the Credit Bureau report reducing a consumer's credit score.

And the federal government has now given these organizations an absolute power to destroy an individual's ability to borrow money for a prime mortgage.

Opportunity Knocks - Private Investor Alert

One of the consequences of the meltdown of the US subprime mortgage business has been the collapse or withdrawl from the Canadian subprime marketplace by many lenders, especially lenders who depended on floating their mortgage backed securities in the now defunct mortgage bond market. This phenomena has been evident in the Canadian market since the disappearance of both Accredited and Exceed from the subprime markets in the past year.

What is new, however, is the imminent elimination from the government backed insured marketplace of the so-called ALT -A and ALT B markets. It means that a whole range of borrowers will now no longer qualify for insured mortgages, especially those who previously would have done so. Borrowers will a Beacon Score of between 580 and 620 previously would have qualifed for insured loans from a number of lenders under both Genworth and CMHC policies, with certain provisos.

For the immediate future, what this will mean to private lenders is a HUGE opportunity to improve the quality and yield on their mortgage investment portfolios, as well as a major opportunity for making investments in Mortgage Investment Corporations (MICs) on a highly profitable basis.

On a quick survey of Canadian MICs yesterday I determined that on the basis of my relatively unsophisticated and nonscientific survey, most Canadian MICs across Canada are performing pretty well already, with returns ranging between 7% (in Saskatchewan) and 13% (in British Columbia) per year for the past couple of years, with longer term results being in the average range of about 11% to 12%.

For most investors, even in equities, these returns should be startling! An investment in a MIC is similar to an investment in a mutual fund in the sense that it requires little or no hands-on management by the investors, but the advantage of the MIC investments is that there is little or no volatility in the capital value: a dollar invested is always a dollar redeemed except in the circumstance where the MIC actually loses money - a rare event in Canada, it turns out. The variability in the MIC investment marketplace is in the rate of return to be earned.

Even investing in the worst performing of the MICs I surveyed yesterday an investor would have earned 7% in the last year, not bad at a time when the equities markets are down 20% to 30% in both major and minor markets.

This mortgage crisis has relatively few silver linings for the average person, but it has created a significant improvement in mortgage investment returns, both Private and in MICs. Astute investors should be seeking opportunities to invest in this alternative marketplace, and move both RSP and non registered investments to a more stable and more profitable investment than currently available in any other part of the marketplace.

Broker or Bank - The Borrower's Dilemma

The differential advantage to a borrower for using a broker is NOT the fact that the broker sends a mortgage deal to a non bank lender, it is the goal that a broker will obtain the best available deal for the borrower, from a bank or a non bank lender.

Brokers should have no loyalty to a particular lender, although it would be disingenuous to suggest that bonusing arrangements have no impact on mortgage placements with different lenders.

Also, commission rates vary from one lender to another, and from one product to another, which means that some brokers measure their income from a deal before they figure out what the best deal for the borrower could be.

These things mean that brokers are inherently in a conflict of interest with a prime "A" borrower because the placement of the loan can have a huge impact on how much the A broker will earn.

In British Columbia the Financial Institutions Commission recognises the potential for conflict of interest, and requires brokers to sign a disclosure of the conflict of interest, as well as a disclosure form which details any fees paid by the borrower directly to the broker. However, fees paid by the lenders to a broker are not disclosed in any required forms in BC, something that probably should be remedied in due course.

This is not only an issue for mortgage brokers. All consultants who make their living by being paid for the placement of products or services to their clients are also generally in a conflict of interest, and are to some degree driven to sell products based on what they earn from doing so. So the main difference with mortgage brokers is that the service we sell is fundamentally different in that we represent vendors of the single largest expense in most of our clients' lives - their mortgage.

Undisclosed differences in payments by different vendors of loans drives some brokers to make recommendations based almost entirely on how much money they will make by placing the deal with one lender or another.

The thing that protects the public from being abused by the conflict of interest is that the mortgage brokerage industry is incredibly competitive - any broker who acted contrary to the client's best interest would probably soon find himself out of business with no clients.

It is one of the distinctions that separate private loan brokers from A lender brokers. When someone borrows money from a private lender through a broker there is no failure to disclose. All brokers fees, appraisals, inspections, etc. are paid for directly by the borrower and the borrower is fully aware of any and all out of pocket costs, which include all payments made to the brokers.

So while most "A" brokers tell you that you will pay no fees for their services, what they don't tell you is that the method by which they earn their fees may be inherently contrary to the borrower's best interest.

At the very least the rules of the industry should require that these fees be fully disclosed, so that the borrower may make a fully informed decision about the relative merit of the advice he or she is receiving.

As for the conflict of interest a borrower encounters by going directly to a bank - there is no conflict of interest: the bank employee represents the best interests of the bank, only the bank and always the bank.

So a borrower has to make the best of two choices, one with the potential for a conflict of interest (the broker) or the one with no conflict of interest (the banker) since the bank always acts in its own self interest.

I am attaching the following article from Merix completely because it provides a comprehensive explanation of how mortgage insurance actually works for most consumers.

Clearly, based on what Merix is saying, the changes to government policy regarding mortgage insurance may have a significant effect on mortgage investors, if they are relying on Home Lines of Credit secured by mortgage insurance, whether provided by CMHC or by a private insurer.

However, most mortgage and MIC investors who are using leveraged funds are not borrowing money under the terms of insurance mortgages, nor do they tend to use extremely high ratio mortgages for investment purposes, so the change may not actually have as big an impact as one might otherwise imagine.

MERIX Comments on Changes to Government Guaranteed Mortgages

There has been lots of discussion in the news about the recent changes to government guaranteed mortgages announced by the Minister of Finance.

However we believe the majority of Canadians do not understand what exactly it means to remove the “government guarantee” from some of these lending programs.

We’ll explain…

Many Canadians generally understand how mortgage insurance works. We’re not talking about mortgage life and critical illness insurance, we’re talking about mortgage default insurance. This is the premium that is applied to your mortgage amount and is paid to a mortgage insurer, who in turn agrees to insure your mortgage with your lender in the event you default. In other words, it is protection for the lender incase their customer cannot make their payments. This is a mandatory insurance for mortgages higher than 80% of the home value.

Well that’s great, but what happens if a lot of people all of a sudden can’t make their payments and the insurer who is supposed to protect the lender is unable to cover their insurance obligations?

Enter the government guarantee.

The Canadian government will guarantee up to 90% of the mortgage amount against insurer default. So, this is security for the lender in the event the insurer defaults. This Government Guarantee is in place for CMHC (Crown Corporation) as well as the private insurers, such as Genworth Financial Canada.

The government guarantee is also a criterion for high ratio loans to be sold into the Canada Mortgage Bond program, which is a relatively new cost-effective funding source for banks and mortgage lending companies. These Bonds are bought up by investors all around the world due to their higher yield than Government of Canada Bonds combined with their “government guarantee”.

So what has changed?

Well, the Finance Minister looked to our southerly neighbours as well as across the pond and noticed some pretty dire scenarios which begged the question: Are we guaranteeing mortgages that are a little too risky? After an analysis of the mortgages that fall within their guarantee, recent trends, and industry consultations, the Minister of Finance decided to cease guaranteeing high ratio mortgages with the following characteristics:
- LTV ratios in excess of 95%
- Amortizations in excess of 35 years
- Non-amortizing mortgages (Interest-Only Mortgages).
- Applications where the beacon score of both borrowers is less than 620.

How does this affect me?

If you are a current homeowner, who is happy in your home and have no intentions of moving in the near future than this probably doesn’t affect you. However if you are a prospective homebuyer, looking for 100% financing and a 40 year amortization then your financing options are becoming a little more limited. Most of the big chartered Banks and many lenders have already pulled the above products. Other lenders, such as MERIX are offering these products until October 13, 2008 (please speak with your mortgage originator concerning rules around this deadline).

Let’s take a closer look at the 40 year amortization phenomenon:

Why is it appealing when borrowers know they are paying many thousands of dollars in interest over the life of their mortgage? Well there are a couple of predominant reasons:

New homeowners are increasingly concerned more with their payment amount than the house price or the interest cost over the life of the mortgage. It’s a decision made largely on cashflow.
The vast majority of people who take 40 year amortizations actually qualify for 25 year amortizations but choose the former and accelerate their payments, which reduce their amortization to 32 years. Registering their mortgage with a 40-year amortization helps protect them in the future should they need to decrease their payment.

From a purely mathematical perspective, according to the Ministry of Finance:
“Reducing amortization from 40 years to 35 years on a mortgage loan of $200,000 with a 6 per cent interest rate results in a $41 increase in a borrower’s monthly payment, but the borrower will save $49,000 in interest payments.”

Looking ahead…

If the decision to take 40 year amortizations is based on cashflow, then we’d suggest $41 per month on its own will not cause any major disruptions in the housing market. The reality is that new mortgagors will have to spend a little more in their monthly mortgage obligations but the impact to the housing market will be isolated to those who needed the 40 year amortizations and 100% financing to qualify for their mortgage. As a replacement for 100% financing, we may see the increase in popularity of Cashback mortgages once again. The 100% financing programs have all but made CashBack offers obsolete, however they may be a decent option for some people once again - even if the interest rate is higher.

In the short term, we may see a small spike in homebuying and refinance activity as people try to accelerate their timelines in order to take advantage of these fleeting offers. This may keep the market relatively strong through 2008. In the medium to long term, we don’t expect these changes to have much of an impact to the housing market. 35 year amortizations are still available and for that matter 40 year amortizations will still be available by some lenders, such as MERIX, for those customers who have the minimum 20% down payment for conventional financing.

For more information about 40 year amortizations, we encourage you to read “Why 40 Year Mortgages Aren’t 40 Years Long”, by Peter Vukanovich, President, Genworth Financial Canada. This article can be found here: http://www.genworth.ca/mi/eng/downloads/HT_April_2008.pdf


Sincerely,

The MERIX Financial Team
And Your Mortgage Originator





By partnering with professional mortgage originators, our customers can be confident they are receiving the knowledge they require to make the right decision. And this is the advantage of dealing with MERIX Financial.

MERIX FINANCIAL KNOWLEDGE IS ADVANTAGE