By the Numbers
DSCR loans may lift supply and convexity in non-QM MBS
Chris Helwig | October 22, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The sharp rise in home values over the last year or so has almost certainly made it more difficult for buyers of investment properties to qualify for a loan based on personal income alone. Investors may increasingly try to qualify by using the property’s rental income, which would boost non-QM supply. Stronger fundamental performance and more straightforward underwriting of these loans than other non-QM products likely provide a substantive tailwind to greater issuance going forward as well.
While the prime private-label market may be facing increased competition from Fannie Mae and Freddie Mac for loans backed by investment properties, the non-QM market has less to worry about. This is particularly true when it comes to investor property loans with less-than-full documentation. This removes substantial policy risk from non-QM supply. Rising home values and potentially higher interest rates may lead lenders to originate a growing amount of loans backed by investment properties underwritten using the property’s rental income, commonly referred to as debt service coverage ratio or DSCR underwriting.
DSCR loans have made up roughly 15% to 20% of total quarterly non-QM volumes over the past few years. Despite strong fundamental performance in DSCR loans through the pandemic, current issuance volumes are depressed relative to pre-pandemic levels. But this trend looks poised to reverse, and DSCR loans should make a substantial contribution to non-QM issuance volumes going forward (Exhibit 1).
Exhibit 1: DSCR volumes have fallen but appear poised to rise
The quality of DSCR originations has improved over time. The average loan size of a DSCR loan securitized in a non-QM trust has nearly doubled since 2018 from roughly $265,000 to over $480,000. The amount of initial borrower equity in these loans has remained consistent with the average LTV only increasing by two points from 64 in the first quarter of 2018 to 66 as of last quarter. And the average DSCR borrowers’ credit score has improved over the same observation period from 726 to 769. The presence of strong compensating credit characteristics on these loans has likely been the primary driver of stronger fundamental performance of these loans relative to the broader non-QM cohort.
Given that this type of underwriting was previously untested for residential lending, concerns arose about how these loans would perform as disruptions in rental income threatened to hurt borrowers’ ability to make payments. These concerns ultimately were largely unfounded as delinquency rates on DSCR loans currently run lower than those of full documentation or owner-occupied loans. They are broadly consistent with lower delinquency rates on limited documentation and investment property loans, likely a result of strong compensating credit characteristics (Exhibit 2).
Exhibit 2: DSCR loans exhibit lower delinquency rates than owner-occupied and full doc loans
DSCR originations may also rise as the product finds growing favor with originators. One of the material headwinds to growth in non-QM is the limited amount of qualified manual underwriters. In conversations with originators, the DSCR product, which can be underwritten using generally very transparent rental comparisons, is less manually onerous to underwrite than other forms of alternative documentation non-QM loans. DSCR lending also may get a bump what appears to be a substantial rise in transitional residential real estate operators who are looking to lock in longer term debt financing for properties they have renovated. Finally, DSCR lending may garner additional support from lenders shifting their mix of production from agency refinances and lower margin agency purchase loans to higher margin expanded credit lending as rates rise and agency volumes and margins fall. This rotation into expanded credit would be consistent with lender behavior observed in 2019 against the backdrop of higher interest rates.
It is also important to note that DSCR loans in non-QM trusts have prepaid substantially slower than other non-QM cohorts. Investor loans in non-QM trusts offer substantial prepayment protection, even more so than investor loans pooled in prime private-label deals. Given that the loans are commercial purpose loans and not consumer loans, they can carry prepayment penalties that create substantial friction to refinancing. Despite having the same commercial purpose designation, investor loans in prime trusts do not broadly carry any prepayment penalties—First Republic being the only large originator adding prepayment penalties to prime investor loans. In addition to penalties, speeds on DSCR loans are even slightly slower than those of the broader investor cohort, likely a function of fewer channels to refinance the more specialized DSCR underwritten loans. (Exhibit 3)
Exhibit 3: DSCR loans have prepaid slower than other non-QM cohorts
Sponsors of non-QM trusts likely have significant incentive to stock non-QM trusts with growing amounts of DSCR loans. As prices on loans backing non-QM trusts have risen, so have advance rates on the liabilities issued from those trusts. This means that sponsors’ risk retention requirements have shifted from holding both principal and interest cash flows to satisfy those requirements to holding mostly excess interest and a small amount of first loss principal to satisfy a 5% market value requirement. Given the shift in the retained risk profile toward IO, it seems likely that the amount of DSCR loans in these deals would grow as sponsors look to garner greater prepayment protection. Investors who have been subject to elevated prepayment rates in non-QM, especially investment grade investors in the open pay, pro-rata portion of the capital structure will likely welcome greater prepayment protection afforded by DSCR loans as well, which may ultimately translate into tighter spreads and better execution on deals perceived to have better convexity from larger populations of DSCR loans.