Flipping Out: The Evolution Of Residential Transition Loan Securitizations – Securitization & Structured Finance

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.

Footnotes

1. 12 CFR 1026.43.

2. 12 CFR 1026.19.

Visit us at mayerbrown.com

Mayer Brown is a global services provider comprising
associated legal practices that are separate entities, including
Mayer Brown LLP (Illinois, USA), Mayer Brown International LLP
(England & Wales), Mayer Brown (a Hong Kong partnership) and
Tauil & Chequer Advogados (a Brazilian law partnership) and
non-legal service providers, which provide consultancy services
(collectively, the “Mayer Brown Practices”). The Mayer
Brown Practices are established in various jurisdictions and may be
a legal person or a partnership. PK Wong & Nair LLC
(“PKWN”) is the constituent Singapore law practice of our
licensed joint law venture in Singapore, Mayer Brown PK Wong &
Nair Pte. Ltd. Details of the individual Mayer Brown Practices and
PKWN can be found in the Legal Notices section of our website.
“Mayer Brown” and the Mayer Brown logo are the trademarks
of Mayer Brown.

© Copyright 2023. The Mayer Brown Practices. All rights
reserved.

This Mayer Brown article provides information and
comments on legal issues and developments of interest. The
foregoing is not a comprehensive treatment of the subject matter
covered and is not intended to provide legal advice. Readers should
seek specific legal advice before taking any action with respect to
the matters discussed herein.