In early 2015, an investment banker and his wife were eyeing a two-bedroom condominium listed at $2 million on the Upper East Side. The couple was wealthy, according to their friend and broker Mike Loftus of William Raveis, but not wealthy enough to buy the unit outright.
They had $500,000 in cash and “a pretty big portfolio, but not that big,” Loftus said of their financial investments, which he pegged at between $5 million and $7 million. They needed to borrow the balance for the apartment — $1.5 million — but didn’t want to go through the hassle of a mortgage.
They also wanted the buyer’s advantage of having cash in hand.
“An all-cash offer rings stronger than any kind of contingent offer,” said Larry Link, the president and principal broker of Level Group.
In cases like this, brokers usually ask their clients to work with their financial advisers to find other assets to borrow against, most often another home but increasingly their investments in stocks and bonds.
The couple did just that and ended up with a “non-purpose loan,” or a loan backed by their own financial portfolio, enabling them to make an all-cash offer and seal the deal.
Also known as securities-based borrowing, this financial tool is playing a quiet but powerful role in driving “all-cash” deals in Manhattan’s luxury residential market, which these days account for over 50 percent of sales.
The practice — essentially a margin loan that the borrower can spend on anything except more securities — is becoming more prevalent, according to Manhattan-based real estate brokers, lawyers and wealth advisors.
Loftus, who spent three decades in the finance industry before going into real estate in 2013, said it’s especially common in New York.
Easy cash, faster closings
The benefits of going this route include near-instantaneous availability of millions of dollars, flexibility on repayment and low costs.
Non-purpose lending also enables wealthy Americans to compete in the real estate market with high-net-worth foreign buyers, who often come to the table with physical stacks of cash.
Loftus said his clients knew they could get cash “the next day,” which allowed them to close in 30 days rather than the 60 or 90 days typical with a mortgage.
Some banks have promoted this type of securities-based lending as a quicker alternative to traditional home-equity loans. “If you need money in a hurry … it may only take a few days to get the loan approved,” Citi’s Personal Wealth Management division stated in marketing materials posted online earlier this year. “It can take at least a few weeks, and sometimes much longer, to set up a home-equity loan or line of credit.”
Sellers are none the wiser about what type of loan is used. Nor do they care, according to Edward Mermelstein of real estate law firm RheemBell & Mermelstein.
But the practice is not for the risk averse, particularly those who prefer the fixed-interest rates and predictable payments of a mortgage. Non-purpose loans are typically used as a form of bridge financing because they expose the borrower to margin calls if the value of the portfolio used as collateral shrinks. So many of the buyers who use non-purpose loans for their initial purchase quickly line up mortgages after their deal is complete.
For example, Loftus said his clients, the investment banker and his wife, were in the process of “backing into a mortgage” on their Upper East Side condo.
Financial institutions determine based on a long list of rules how much a client can borrow and against which stocks and bonds. In general, a higher percentage of the holdings can be borrowed against U.S. government bonds than against stocks because stocks are more volatile.
Wells Fargo Advisors offers wealthy clients loans of at least $1 million and “generally $5 million and up” that equal 50 to 95 percent of the value of their investments, depending on what assets they hold, according to its website.
Stocks that trade below $10 a share are not eligible as collateral, said Shaun Van Vliet, a senior financial advisor at a Merrill Lynch subsidiary called Consilium Associates. Lower-priced stocks tend to be more volatile, meaning they can lose value quickly and dramatically. “The bank wants to protect you from yourself,” said Van Vliet, who advises high-net-worth families, executives and entrepreneurs.
Staying in the market
A non-purpose loan lets buyers remain invested in the market while avoiding the capital gains taxes they’d be subject to if they’d actually sold their securities and pulled out the cash needed to buy a property.
As an example, Level Group’s Link said that last year he advised a wealthy client, who was looking to buy a property for his son and daughter who were attending college in the city, on a transaction involving a non-purpose loan. Link, who estimated the 62-year-old retired executive’s net worth at $25 million to $30 million, said the client could have paid for the $2.3 million Union Square condo in cash by selling “a few things” but “wanted to keep things in the market.”
Moreover, the terms of the loan were too attractive to turn down, Link said.
Non-purpose loans are not free; a floating interest rate accrues until the balance is paid off, but that rate is usually lower than it would be on a traditional loan. Borrowers are also usually able to avoid the fees that come with personal loans and mortgages.
“A mortgage has closing costs, this does not,” Van Vliet said.
This type of financing is also helpful when buyers purchase properties using trusts, LLCs and other entities. Banks prefer to extend traditional mortgages to people rather than entities, said Bruce Cohen, of real estate law firm Cohen and Frankel.
The ‘rich man’s subprime’?
Some financial experts are sounding the alarm as non-purpose loans become more common.
In a December 2014 column in Fortune, Joshua Brown, the chief executive of New York-based investment advisory firm Ritholtz Wealth Management, called this type of borrowing the “rich man’s subprime.” And he noted that it’s simply a cash cow for the banks that are pushing and issuing the loans.
Here’s Brown’s thinking: If stocks fall across the globe, borrowers could lose much of their investments and lenders would get stuck selling off the remaining securities that backed those loans.
The borrower would own his real estate debt-free, but his other investments would take a hit. Banks, meanwhile, would be forced to write-down the value of the loans. In a doomsday scenario, that could even trigger another financial crisis requiring another government bailout.
“Then you’re selling into the worst environment possible,” Loftus said, noting that a seller would have no control over the timing of a sale or which stocks or bonds get sold.
Other brokers, lawyers and financial industry professionals downplayed the risks.
“Pain [of a margin call]? I have never seen that happen,” said mortgage broker Melissa Cohn of MC Home Loans. “The people who do this are sophisticated.”
Still, in January, the security industry’s self-regulatory organization noted its concern about the increased use of securities-backed lines of credit and how they are marketed.
In its annual letter, the Financial Industry Regulatory Authority urged broker-dealers to have “controls” to monitor these loans and to promptly notify customers if “collateral shortfalls occur.”
Sales can also trigger unexpected and unplanned tax obligations for the borrower.
The very nature of a non-purpose loan means the borrower can spend the money on anything they want, whether it be a new yacht or a shopping spree at Bergdorf Goodman.
Yet “the majority of [non-purpose borrowing] is going into real estate,” Loftus said. “Has it inflated prices? Perhaps it has.”
Increased use of these loans also provides more evidence that a bear market could send a chill through the high-end New York real estate market.
“I’ve had deals, when the stock market gets buried, the buyer pulls the offer the table,” Cohen said.