Introduction
Each morning I tune into CNBC while I read my favorite New York Times and my must-read (for local news) San Francisco Chronicle. While inverted yield curves, fed funds rates, private equity and hedge funds have been a daily diet for some time, the term subprime mortgage only made it into my consciousness a mere few months ago.

It being the start of a new month and an idea for a summer Pulse not yet revealing itself to me, I thought that a little investigation might be enlightening for both of us. After all, what could all this subprime fuss possibly have to do with San Francisco, where the average condominium costs $888,000 and the average single-family costs $1,215,000?  A lot!

The Squeeze is On
As one real estate loan officer commented, “five years ago loan brokers started to flood the market with so much money that in order to compete, the more traditional banks had to loosen their standards to compete in the new game.” Up until a short time ago – “If you could fog a mirror, you could get a mortgage.” 

Easy money leads to excesses, and excess has pushed the pendulum so far out of whack, that it is now swinging the other way, and with a vengeance. While we effectively don’t have subprime borrowers in San Francisco, we do have national (and local) mortgage brokers and national lenders who participate in markets across the country. This subprime melt down has been so severe that it has impacted the prime market even for well-heeled buyers. The effects of over-buying and over-lending are playing out throughout the country, leading the Feds to tell banks to tighten up: now. The cleanup has started, and its impact is being felt here in San Francisco.

Just Because You Can Afford It, Doesn’t Mean You Can Still Buy It – Or So They Say
If you go with “conventional wisdom” these days, even buyers with “superlative credit, money in the bank and a whopping down payment” can’t buy a home, as quoted in this week’s San Francisco Chronicle.  This well-heeled buyer with $500,000 in the bank had an “employment hiccup” that had lenders change their minds about making the loan – according to the real estate agent quoted n the story.  Yes, lenders are tightening up on the documentation side, requiring full documentation (read tax returns, etc.) of a buyer’s income, rather than a signed statement from the buyer to support his/her income. The non-doc loans have effectively dried up for the borrower. But, money is still available, but buyers need a competent agent to get it. Read further.

Here’s an example of what is happening on the qualification side of the loan business. Perhaps not all lenders are tightening up this way, but many are.

A before and after example - Let’s assume a buyer was interested in a $1.2 million condominium and was willing to put down a healthy 20% and wanted an interest-only 5-year ARM. A few months ago, he/she needed an income of $196,000+ to qualify for such a loan; today he/she needs an income of $258,000+ (31+% more). Here’s how it is calculated.

At 80% the loan would be $960,000. A 5/1 ARM loan at 6.0% would cost $4,800 in interest per month. The lender would add in property taxes at $1,250 and HOA dues at $500, for a total monthly debt load of $6,550 per month or $78,600 per year. Divide the $78,600 by 40% (the lender typically likes about 2.5 times coverage) and you get an income requirement of $196,500.

Today many lenders are using a fully indexed rate (LIBOR + 2.5% for example) to qualify this same buyer for the same 5/1 ARM. With the LIBOR rate at 5.25%, adding 2.5% gets us to a 7.75% rate, amortized over 30 years. For underwriting purposes, this means that the lender is looking at $960,000 x 7.75% or $6,877 (including principal) per month rather than $4,800. After adding in the property taxes and HOA dues, we get a $8,627 monthly debt or $103,524 per year. To qualify, the buyer now needs $258,810 of annual income. Same buyer; just different qualification standards.

It’s real simple. Yesterday’s buyer earning $196,500 could qualify to buy this $1.2 million condominium. Today he/she may only qualify for a $900,000 home. However, there may be other options for the astute.

Sellers Beware
Here’s a seemingly positive story. A client of mine was interested in a single-family home listed for $859,000 in Miraloma Park. She decided not to write an offer. I was curious about what happened so that I could keep my client apprised of the pulse of the market.  

There were 12 offers, and though the listing agent would not tell me the contract price, I learned from another source that the property went into contract at $1,050,000! That was the good news. But, here’s what I wonder: will the successful bidder be able to get the loan that he/she thought that they had been approved for? Did their lender tighten their qualification standards between the time they gave loan approval and the time that they were ready to fund? Did the lender back out all together and leave the buyer high and dry?

And was the buyer able to get an appraisal that justified the $1,050,000 purchase price? I hope so, but I would not be surprised if at least some of the answers to the previous questions were a definite no.

The lesson from this little story is that a seller/listing agent needs to be very diligent in examining the veracity of the loan approval letter submitted with an offer. In recent weeks, some folks have actually gone to the title company to sign documents only to find that the lender has no funds to fund the loan commitment. What happens in such a situation? Assuming the buyer and the seller want to close, it is panic time for both. The seller may be in the driver’s seat, but it would seem that accommodations would have to be made on both sides.

The Buy Side
No matter what business you are in, it always makes sense to know with whom you are doing business. In the olden days, six months ago, a buyer (and agent) could call a mortgage broker, get a pre-approval letter for submission with his/her offer, and be confident that an appraisal would come in at the right price and that the loan would fund. I have a list of mortgage brokers and banks that I have worked with over the years. I have vetted each of them, and have been confident that each can perform for my clients. I now have to vet them all over again, not because they are not competent but because their respective institutions and the institutions that they deal with may no longer be able to perform. In other words, I need to make sure that a specific mortgage broker or bank can in fact perform for this specific transaction. It may make sense for a buyer to pay a bit higher interest rate to have the assurance that the loan will be funded. My buyers know that I leave no stones unturned to get a deal done.

San Francisco
Though we have all read news stories about price declines in many cities throughout the country, average prices in San Francisco are up across the city through July 31, 2007: plus 5.7% for condominiums and plus 8.0% for single-family homes compared to average prices in 2006. The annualized rate of transaction volume in 2007 is running about even with last year for condominiums, and it is off 13% for single-family homes. For the four years from 2002 to 2005, annual transaction volume for single-family homes averaged 3,200+ units per year. In 2006 the number of transactions was down 19% from this average, and this year, at an estimated total transactions for the year of 2,281, we will be off 29%! Why aren’t more people selling? It’s not that they can’t get a very good price.

While single-family home demand is up and supply is down, thus supporting price appreciation in this market segment, I wonder about the near-term future of the condominium market, particularly with new developments south of Market St.

My sense is that many of the new development buyers have been going into contract with 10% down, an 80% first, and a 10% second mortgage with “limited docs.” There are still lenders/investors who will fund/purchase these loans, but the pool is shrinking. When this happens, deals are still made, but it takes longer and it is more expensive for the buyer, and perhaps the developer subsidizes part of the mortgage. Hence, sales velocity at the new developments will likely slow but not evaporate.

Summing Up
It’s crazy out there in the money markets: not only the mortgage market, but financings of any and every kind throughout the capital markets are feeling the heat. Let’s face it, for the past few years, money was easy, inexpensive, and sloshing around the world. This from one lender – “Purchasers of loans are taking a step back and asking themselves what they really have and what they can afford to buy now.  In basketball, it is essentially like taking a ‘time out’.  I’ll let you know when the ref blows the whistle to resume play.”

Bottom line, residential lenders are tightening up in many different ways, even though they have not been hurt directly by their own subprime business going south. For us in San Francisco it means that well-qualified buyers will be required to provide more extensive documentation to support their financial capabilities, and they will be able to employ less leverage than in the past. For sellers, it means fewer buyers and ultimately lower prices or other accommodations. For developers it means a slower sales rate and possibly some concessions.

This will pass. However, the market froth is now blown away, not to return for quite awhile. Good credit will prevail, and those who have the financial wherewithal will still buy in San Francisco, both older buildings and new developments. Ultimately, average prices will reflect a new reality.

It is times like the present when good (not just average) agents and mortgage brokers prove that they are a cut above the rest. The above issues are solvable, but it takes experience, expertise and good contacts to bring a transaction to a successful conclusion. Call me if you need help.