“This is tricky due to the uncertainty in the income and any projections, despite historical data,” says Dr. Vivek Sah of UNLV's Lied Real Estate Institute. (Photo: Ronda Churchill)
Across America, working folk with no capital and lackluster credit are becoming vacation rental tycoons by amassing multiple properties. But with interest rates on the rise and a possible recession looming, the risky loan product that helps level the playing field for the little guy is falling out of favor with some lenders.
Debt service coverage ratio (DSCR) loans are popular among people who lack personal income but want to become landlords. Loans are based on the cash flow of the property, and require little to no documentation of a borrower’s financial standing.
“If you can cover the payment, then you’re looking good,” says Dan Sherbondy of All Western Mortgage in Las Vegas, who arranges loans for properties to be used as short-term rentals.
In recent years, DSCR loans have been a go-to vehicle for purchasing long-term rentals. The amount of the loan is determined in part by the monthly income projections of an appraiser.
“That’s a problem,” says Sherbondy. “You can’t really use short-term income. Appraisers usually won’t do that because there’s not a record of long-term rental income.”
But a story this month from Bloomberg says lenders are increasingly allowing borrowers to qualify based on projected income for STRs rather than long-term rentals. The higher income projections associated with STRs allow borrowers to get approved for higher loan amounts.
“Such deals are alarming longtime observers of the real estate market,” the story says. “In a weak economy, borrowers who qualified based on rental income are likely to default at as much as three times the rate of those with conventional mortgages, according to Court Lake, an analyst with Fitch Ratings.”
Some lenders have loan offerings tailored to STRs.
“Similar to our DSCR loans, our short-term rental loans do not require tax returns and personal income. We qualify the loan based upon future rents powered by AirDNA,” says an ad for Coast2Coast Mortgage. AirDNA is a short-term rental data analyst. “We can also use the last 12 months’ rental income from sources like VRBO or AirBNB.”
Bloomberg reports investment property loans with no federal backing totaled $9.9 billion last year, “an eightfold increase since 2018, according to industry publication Inside Mortgage Finance’s analysis of mortgage bond offerings. The vast majority qualified because of rental income.”
Some experts compare the loans to “no-documentation” subprime mortgages made popular during the run up to the Great Recession.
“This is tricky due to the uncertainty in the income and any projections, despite historical data,” says Dr. Vivek Sah of UNLV”s Lied Real Estate Institute. “Unlike office leases, which are signed on a long term basis, STRs are quite risky.”
“The way prices are now, and higher interest rates, I’m not seeing the payment being covered a whole lot, so most people will be in a negative cash flow situation,” says Sherbondy, who says rates for DSCR loans, which require little documentation, are “probably in the sevens, at least. If you have no cash flow, prices aren’t rising, and you have no equity, it’s kind of a dead end.”
STRs are still proliferating, says a new report from AirDNA. Bookings are up, too. But market demand, which was up 17.9% year to year, is not keeping pace with supply. Occupancy declined to 60% in May, down 8.6% year-to-year but up 8.6% from 2019.
“Occupancy came down in May 2022 as supply increases outpaced demand growth,” says the report. “Available listings hit an all-time record high of 1.34 million, up 24.7% from last year, with 84,000 new listings added in May 2022.”
AirDNA also reports:
- Average daily rates (ADRs) are up 4.6% year-to-year and up 31.5 from 2019
- Revenue is up 23.3% from last year and up 65.8% from 2019
- Nights booked were up 2.8% year-to-year to 17.1 million
With Clark County vowing to crack down beginning next month on thousands of illegal STRs, some borrowers who would be challenged to make their loan payment without vacation rental income may turn their units into long-term rentals or sell, experts say, adding to the rapidly increasing inventory of homes on the market.
In the meantime, Sah advises lenders adhere to strict underwriting policies.
“Best practice for lenders would be a lower loan-to-value exposure (LTV) and also higher vacancy assumptions on the future cash flow projections,” he says.
Sherbondy says the loans, at least for STRs, may disappear as the prospect of a recession takes hold and the transitory nature of the industry is revealed.
“Back in the day, six months ago, the payment was being covered,” says Sherbondy. “But since rates went up, it’s really not. So there’s going to be a negative cash flow, at least on paper.”
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