Morningstar: Enhanced Underwriting Benefits New Breed of Single-Family Rental Loans

Single-family rental investor loans where the property income exceeds 1.2 times the debt service generally experience better-than-average default rates, reported Morningstar Credit Ratings, New York.

Morningstar said a new type of investor property loans recently emerged from single-family rental originators such as B2R Finance, FirstKey Lending LLC and Colony American Finance LLC. Though underwriting guidelines vary, they all focus on qualifying borrowers based on property income rather than personal income, Morningstar said.

“This approach makes sense,” Morningstar said. “Borrowers should be less likely to default if a property generates enough rent to cover debt obligations and are more likely to default if the debt service exceeds the rent. It is common practice for commercial lenders to look at debt service coverage ratios as a key driver of default, and it seems logical to apply this approach to single-property investor loans.”

SFR loans for single properties have traditionally been underwritten as residential rather than commercial loans, Morningstar said. Borrowers provided the lender with the expected rental income with a portion of this rent added to the borrower’s personal income. But lenders typically focused on the borrower’s personal credit and income data rather than whether the property’s cash flow would cover the debt service.

Morningstar analyzed more than 900,000 non-agency investor property loans originated between 2002 and 2007 and compared rent estimates from SFR research firm RentRange LLC to individual investor properties in CoreLogic’s loan-level data to quantify the impact debt service coverage has on default. “The results showed significantly lower defaults for investor loans with rents exceeding debt service payments and higher defaults for similar loans with rents that do not cover debt obligations,” Morningstar reported.

For example, examining loans with a borrower FICO score greater than 699 and a combined LTV less than or equal to 70, Morningstar found that the default rate for loans where rental income covers only half of the debt service amount equaled 12 percent–more than double the 5.6 percent default rate for loans where rental income covers twice the debt service amount.

“Therefore, when underwriting an investor property loan where rent is available and verified, default projections can be adjusted based on the amount of (or lack of) excess rent,” the report said.