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February 26, 2016

The new second-mortgage program could be a game changer for Detroit

February 26, 2016

Many of Detroit's homes are in need of substantial rehabilitation. Once rehabbed, however, the weak housing market there means they are often appraised for less than the value of the home and the repairs. This creates an “appraisal gap,” which has been holding back the city’s housing market recovery.

Last week, Detroit’s Mayor Mike Duggan unveiled the Detroit Home Mortgage Initiative, a new program that could be a potential gamechanger. The new program, designed to address this appraisal gap, has valuable consumer protection features and has already earned widespread support from financial and government institutions.

What’s behind the appraisal gap?

The mortgage market in Detroit is quite limited in part because there are few comparable properties on which to base an appraisal. A home that was purchased for $30,000 and rehabbed for an additional $30,000 may be appraised at just $50,000. Even if someone is willing to buy it for $60,000, they would traditionally be unable to obtain a mortgage for that amount. This disparity creates a vicious cycle: rehabilitating is not profitable, so there is little incentive to invest in a home. Because there is a shortage of homes in good condition, when one sells a home, it is difficult to find comparable properties for appraisal purposes. As a result, the rehabbed home is generally appraised for less than the purchase price plus the cost of the rehab.  Even if a home becomes a comparison property later on, the next home will be undervalued as well.

Bringing the solution to scale

Detroit’s Rehabbed and Ready program, which we discussed a few months ago, was meant to jumpstart a solution to the appraisal problem by increasing the number of sales an appraiser can use to generate a home value. But because the Rehabbed and Ready program relies on subsidies, it is difficult to scale.

The Detroit Home Mortgage Initiative addresses the appraisal gap in a more scalable manner. Banks provide borrowers with a second mortgage that, combined with the first mortgage, can exceed the appraised value of the house. Because the second mortgage can be forgiven under certain circumstances (if the home is sold and the borrower has experienced a qualifying “hardship event”), it is often referred to a “soft second.” This soft second can be used for a home that has already been rehabilitated, or one still in need of rehab.

While the concept of a soft second mortgage sounds simple, it is not. To succeed, this program requires institutions willing to provide funds for loans with a combined loan-to-value ratio of over 100 percent. Success also requires a program to educate borrowers on the risks they are taking. If an expensive rehabilitation is involved, the consumer also needs to ensure that the repairs are being done properly.

At the urging of Duggan, and with organizing support from the Obama administration’s Detroit Federal Working Group, Clinton Global Initiative, local banks, foundations ,and nonprofits joined forces last summer to help solve Detroit’s appraisal gap problem.  The mayor’s office has brought together five banks: Flagstar Bank, Huntington Bank, Talmer Bank and Trust, Liberty Bank, and FirstMerit Michigan, as well as the Kresge Foundation, the Ford Foundation, the Michigan State Housing Development Authority, and the Community Reinvestment Fund, a Minnesota-based community development financial institution.

How does the program work?

Under the new program, the borrower takes out a first mortgage with a maximum loan-to-value ratio of 96.5 percent of the appraised value of the home from one of the five participating lenders, who will use common underwriting standards and will not charge bank fees. The borrower simultaneously obtains a second mortgage to cover the difference between the purchase price of the home plus rehab costs (if necessary) and the first mortgage. So far $40 million in funds has been earmarked for second mortgages and deposited into a second-lien fund provided by three banks (Flagstar, Talmer, and Huntington) as well as the Kresge Foundation and the Michigan State Housing Development Authority. The Ford Foundation provided start-up money. The second mortgage is limited to $75,000 (with no cap on the loan-to-value ratio); it has a fixed rate of 5 percent and a maximum term of 20 years. The borrower must demonstrate an ability to repay both the first and the second mortgage.

The second-lien fund will be administered by the Community Reinvestment Fund, which has considerable expertise in working with higher risk borrowers. Prior to closing, borrowers must complete an education course that spells out the risks of taking on a mortgage for an amount higher than the appraised value of the house. The first mortgage will be held in the portfolio of the participating lender, enhancing the lender’s incentive to ensure it is properly underwritten. (Because the combined loan-to-value ratio is well over 100, these mortgages cannot be accommodated in the FHA, VA, or GSE programs.) The second mortgages are guaranteed with funds provided by Kresge Foundation.

The program has some valuable consumer protection features. If there is a major rehab (over $35,000 or involving a structural renovation), the homeowner is required to hire a project manager with the skills to oversee the rehab. The project manager is required to vet contractors, meet biweekly with the homeowner to monitor construction, and perform inspections before the bank releases funds for further construction. Alternatively, the homeowner may contract with a Community Development Corporation (CDC) to manage the renovation. In this case, the CDC purchases the home and does the renovations. The borrower is prequalified for a take-out loan and when renovations are completed, the title is transferred and the take-out loan executed.

The Detroit Home Mortgage Initiative could have a huge impact on the city’s housing market. By allowing for mortgages with loan-to-value ratios over 100 percent, it could break the vicious appraisal spiral, which has systematically undervalued rehabbed homes. We’ll be closely watching the program’s implementation and hoping for its success, which could be a major turning point for Detroit.

In a photo from, Thursday, Jan. 22, 2015, a vacant house in southwest Detroit is shown. Photo by Carlos Osorio/AP

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