When a shareholder refinances, does he have to be approved by the board again? You don’t think so? Well, what if his financial circumstances have changed since he first bought? Reviewing your neighbor’s “refi” – how awkward is that?
Awkward or not, such reviews are a necessity. Lower interest rates have been a boon for both co-op purchasers, who can sometimes buy more for less, and co-op sellers, who have enjoyed the windfall of rapidly rising share prices. But less obvious is the impact of low rates on the co-op itself when an individual shareholder attempts to benefit by refinancing his or her existing mortgage.
Shareholders wanting to refinance sometimes argue it’s their property and may ask what business is it of the board? The short answer is that a co-op by nature is a collective and if one shareholder gets into trouble and potentially defaults on a mortgage and stops paying maintenance, everyone else has to shoulder more of the monthly load. In the worst case scenario, if the bank takes possession and sells the property, the building will only recoup with funds left over after the lender is paid off. If media reports are correct and a bubble in housing is about to burst, there may not be anything left over to pay the building.
That’s why it’s important to look at each refinancing, both in light of the individual and in terms of some broad outlines, say most building treasurers, managing agents, and finance industry leaders. “Any time the building is affected by an individual shareholder’s actions, it’s very important to assess the risk that individual now represents to the whole,” says Michael Kelley, former treasurer of a downtown Manhattan co-op of 154 units for three years who works in the financial services industry. “Are they still creditworthy? Do they have assets and income?”
Fortunately, buildings will only have to deal with two basic types of refinancing applications. The first is where people refinance the existing debt at a lower interest rate, sometimes extending the time period over which it is paid back. These cases can actually strengthen the overall fiscal position of the building as that individual shareholder is using less of his or her disposable income to make home payments. Such a scenario increases their ability to save and/or pay monthly maintenance. The other type of basic refinance application is more questionable. These are shareholders who want to take out an amount as much in excess of what they already owe as they possibly can.
This can put the building in a compromised financial position. “An existing tenant can become a problem tenant through over-leveraging,” observes Michael Crespo, president of Citadel Property Management.
What can a board do? “We treat refinance packages the same as we would the finance component of candidate shareholders,” says Paul Jacoby, who works in finance and is the treasurer of his 35-unit co-op at 215 West 78th Street. That is, they use the same financial standards and considerations as an initial purchase application, evaluating monthly and annual income, liquidity, net worth and level of indebtedness, total loan to apartment value ratio, and the type of mortgage.
Most buildings can easily acquire this information by asking for two consecutive W2 forms and tax returns, two consecutive pay stubs and bank statements, and a new credit report. Apartment value can be determined by using a third-party appraiser, which is most typically the bank lending the money.
Although reluctant to divulge specific numbers used in deciding the worthiness of a refinance applicant, Jacoby says “We’ve got general guidelines, but they are not hard and fast by any means. There is no formula.” Jacoby suggests the co-op’s exposure risk when evaluating a refinance application is the same as with a new shareholder. However, there is the added benefit of seeing a history of maintenance payments to help make the decision.
Carl Wish, a 20-year treasurer at a 50-unit co-op on Manhattan’s Upper West Side, says that, like Jacoby’s building, his co-op treats refinance applications the same as that of an initial sale, asking for full financial disclosure. He agrees a board is better informed because it has the maintenance payment history to add to the equation. “The only time we don’t ask [for full financial documentation] is if they are refinancing for an amount less than they have and are only going for a lower rate,” Wish adds.
Seeking to lower monthly payments is the basis of the majority of refinancing applications, Wish says, but when someone does look for extra funds, the board may informally ask what the extra money is to be used for. However, if the submitted financial statements indicate the applicant can more than cover the increased debt burden, even that unofficial query may never be made.
Wish reports that, so far, his building has never had a problem, but he believes it’s important to review refinancing applications when an applicant is taking on more debt. “If they don’t pay maintenance, it falls on the rest of the building,” he says.
Greg Carlson, executive director of the Federation of New York Housing Cooperatives & Condominiums, points out that evaluating refinancing applications becomes more crucial in smaller buildings where each shareholder shoulders a greater percentage of the overall operating costs. Irrespective of the building’s size, however, he recommends the total of a shareholder’s mortgage payment, maintenance charges, and any fees for parking and storage should not exceed 28 percent of gross earned income when all are calculated on a monthly basis. Add in other financial liabilities, such as credit cards or any outstanding loans, and total monthly liabilities should not exceed 36 percent of monthly gross earned income, he says.
“Once [a shareholder is] is accepted, all too many boards don’t interfere when it comes to refinancing,” Carlson says. But the co-op board “has a fiduciary responsibility to the shareholders at large.”
Citadel’s Crespo has similar criteria, advising refinance applications be reviewed on a case by case basis with the basic condition being the shareholders should meet the same standards as when they first applied to purchase. That’s to say mortgage, maintenance, garage, and storage expenses should not exceed 30 percent of the applicant’s gross income.
What all buildings want to avoid is the potential for payment shock to the borrower. A shareholder who has a long-term fixed-rate mortgage and converts to an adjustable-rate mortgage (ARM), fixed for a period of, say, one to seven years but then adjusting with market rates – may do well at the time of the refinancing but could be making much higher monthly payments when the ARM comes to the end of its fixed period and interest rates are expected to be higher.
Similarly, those who convert to an interest-only mortgage (IOM), where no principal is paid during the life of the loan, could also be forced into higher payments at a later date with no corresponding rise in income to cover those increased costs.
Of course, even when considering that a move to an ARM or IOM loan is more risky than a 30-year fixed rate mortgage, the potential for payment shock should be just one factor the board looks at. “An interest-only refinancing is often considered risky but only if the amount of the loan puts the homeowner at risk,” says Anthony Chan, managing director and senior economist at J.P. Morgan Asset Management in Columbus, Ohio. “The key is to measure the size of the loan and try to imagine what a worst-case scenario would do to the co-op owner.”
“To the extent that many co-op owners decide to refinance into more exotic interest-only or even negative amortization options, a board may have an obligation to other existing co-op owners to not approve such a move if it deems such a transaction to result in an unbearable amount of risk for the co-op,” Chan says.
Former treasurer Kelley suggests the refinancing approval question is relatively simple to answer. For the simpler type of application, where a shareholder keeps a comparable amount of debt and merely seeks to take advantage of reduced rates, he also suggests using the same criteria as with an initial purchase.
Where the shareholder wants to borrow much more than the initial or existing amount of debt, he recommends some added restrictions, such as using a lower loan-to-value restriction of, say, 50 percent or less of the current value, rather than the original 70 percent used in evaluating a purchase application.
That approach obviously opens up the question of how to determine current value. With a sale between two parties it’s relatively easy since the buyer is presumably paying market rate. A refinance application has no such arm’s length transaction. For most co-ops, the market value estimate is supplied by the bank that provides the financing. Though there has been some criticism that bank appraisers have been pressured to inflate market values so the loans can be justified, Kelley says this was never an issue during his time on the board.
Other co-ops are not so sure and have instituted procedures that remove the necessity to use the bank’s appraisal. One downtown 90-unit Brooklyn co-op uses a 12-month rolling average share price, calculated by dividing total sales in dollars for the building over the preceding 12 months by the total number of shares sold over the same period. An apartment’s market value is presumed to be the 12-month rolling average share price for the building multiplied by the individual apartment’s number of shares. Kelley’s building also declined to differentiate between refinance applications utilizing fixed or variable rate loans. Other co-ops do place greater restrictions on variable rate loans like ARMs.
But after much discussion on interest-only mortgages, which Kelley says are a cheap form of financing if the applicant never intends to repay the loan, his co-op did require a greater amount of shareholder assets in these cases, or a guarantor for the loan so that the building was better protected.
Still, with interest rates on the rise, there may be fewer refinancing applications to consider. “There is no question that mortgage applications are down and refinancings in general have fallen off sharply,” says Kelley.
Applications for U.S. residential mortgages have been waxing and waning with interest rates. The Mortgage Bankers Association’s seasonally adjusted index of mortgage applications – which measures the volume of requests for both home purchase and refinancing loans – rose 6.8 percent to 771.6 percent, in the week that ended September as rates hit two-month lows, recouping a 4.5 percent fall the prior week. The seasonally adjusted refinancing index climbed 7.7 percent to 2,357.1 percent, that same period, retracing the previous week’s 5.4 percent decline. But refinancings also rose as a percentage of all mortgage applications the same week, rising to 44.8 percent from 43.8 percent.
Paul Jacoby says the door hasn’t closed yet. “Rates are lower than they were a year ago and are still widely expected to go higher, so it is still an attractive option for many shareholders who may want to take advantage of low rates,” he notes. “The slowdown may more be a case that most shareholders who have wanted to refinance appear to have already done so, since the expectations for higher rates have been in place for so long.”
And there could even be another big wave to come. Shareholders who took out short- to medium-term adjustable rate mortgages on the assumption they would be in the apartment for less than the initial term of the loan may reevaluate their plans, or others could worry that interest rates will rise too rapidly and see more benefit in locking in their loan longer term while rates are still historically low.
Either of those scenarios could prompt a new bout of refinancing applications, leaving boards best advised to have the knowledge in place now to ensure they can evaluate effectively. Concludes J.P. Morgan’s Chan: “Since all refinancings are not created equal, co-op boards should look at each application with a close but fair eye.”