Real Estate
Financing in the U.S. and Mexico
By John Fleming
Oct 30, 2004, 12:46

Financing in the U.S. and Mexico

by John Fleming

I get calls every once in a while from people who want to buy property in Mexico and who are astounded when they find out financing is not generally available there. It shows how likely we are to take our own institutions for granted or to assume that business runs the same way everywhere as it does in the U.S.

To understand financing in Mexico it will be helpful to go back and review some history, since where Mexico is now is where the U.S. was a couple of generations ago.

Early U.S. financing institutions were the rural cooperatives and the savings and loan companies. If you remember the movie "It's a Wonderful Life" you'll recall that the character played by Jimmy Stewart was the president of a savings and loan, and as such he knew everyone in town, their families, their credit history, and their reputations. It was a good basis for doing business in the 1920's and 30's. As communities and businesses grew, more and more banks entered the picture, both state and federally chartered banks. Fewer people knew each other, and the old basis for doing business was replaced by a more distant and objective attitude where facts and figures were more important than personal acquaintance. There were, however, insufficient guarantees for many banks, as subsequent events showed.

After the financial disaster of 1929 and the resulting depression, the New Deal came in with Franklin D. Roosevelt in 1933. Under his administration more regulations were added to protect the banks and their customers, and a number of now familiar institutions, FHA, VA , FNMA, FHMLC, and the federal farm loan program, entered the financing picture. Now banks could make loans and have them guaranteed or insured by the federal government. This was a tremendous asset to the banking business. Additionally, the secondary mortgage market made it possible to keep money recirculating and the economy growing. When banks could sell their loans to Fannie Mae or Freddie Mac, it immediately freed up more money that could be used to make more loans.

Now let's review the major mechanisms by which Americans have been able to obtain financing on their residences.

The primary way of financing for many years was the mortgage. The mortgage has two parties, the Borrower, or Mortgagor; and the Lender, or Mortgagee. The financing instrument is a promissory note (IOU) which is secured by a mortgage, the security instrument. Notes can be bought, sold, and traded, based on the security of the real estate, the payment record, and the value of the note. The borrower has equitable title and possession of the property. The lender has the security of a lien on the property.

The advantages of using mortgages for financing were that it opened up the markets, making it possible for owners to sell their properties and for buyers to buy them. It put money into circulation. The disadvantages were that in cases of borrower default, the foreclosure procedure was a judicial one, involving lawsuits and legal fees and often taking several years. Lenders not only risked loss of payments during this period but also even the destruction of their collateral, the property itself. Buyers often faced stringent requirements to qualify for loans. Absent the intense competition we have today, there were few options as to down payments, terms, and interest rates. Nevertheless, the mortgage was--and still remains--a very powerful and effective mechanism for residential financing.

In 1974 the deed of  trust was introduced to the borrowing public as a response to some of the problems with mortgages. The deed of trust has three parties: the Borrower, or Trustor; the Lender, or Beneficiary; and the Trustee, usually a bank or financial institution. There is a note as the financing instrument, and the deed of trust is the security instrument. Just as with the mortgage, the Borrower has possession of the property and an equity interest in it. The Lender has the security, and the Trustee holds the bare legal title, sometimes called naked title. When the note is paid in full, the Trustee releases the title to the borrower. One great advantage of the deed of trust is that it eliminates the long judicial foreclosure process. When a borrower is in default, the property can be sold by the Trustee after 90 days.

Another financing mechanism that has been around for a long time is the land contract, also known as the contract for sale, contract for deed, contract to convey, or agreement for sale. As well as being used for land sales, this instrument is often used for seller financing with buyers whose qualifications may be a bit shaky. Since the sellers retain title until the entire purchase price is paid, their interest is protected that way. The buyers' interest is protected by the fact that the time for foreclosure is dependent on the amount of equity they have:

• 30 days for less than 20%
• 60 days for 20-30%
• 120 days for 30-50%
• 9 months for 50% or more

Still it is possible for buyers to lose the property by defaulting on payments or by death of a seller. Although the land contract is less than an optimal method of financing, it does have its uses.

All these mechanisms, along with title insurance, escrow services, professional real estate organizations, and Multiple Listing Services make it relatively easy for Americans to market and finance their properties. Now let's look at the situation in Mexico.
In many ways mexico today is where the U.S. was before the New Deal .

There is a need for the mecanisms  the U.S. already has. The good news is that the Mexican government and the financial institutions are working hard to bring about necessary changes. And many of them are in place already.

 But first, a bit of history that will help us understand how Mexico got where it is.

 In 1845, after a stormy divorce from Mexico, Texas became part of the U.S. In 1848, as part of the Treaty of Guadalupe Hidalgo that ended the Mexican War, a huge expanse of land was ceded to the U.S. by Mexico. It comprised all of California, Nevada, and Utah; most of Arizona; and parts of what are now New Mexico, Colorado, and Wyoming. It was roughly one-third of what had been Mexican territory. Then in 1853 the Gadsden purchase gave the U.S. the rest of Arizona and New Mexico.

Rightly or wrongly, Mexico perceived that it had been "ripped off" by the U.S. There was a paranoia that resulted in establishment of the Restricted Zone, 100 km from all international borders and 50 km from all coastlines. The Mexican constitution of 1917 prohibits ownership of real estate by foreigners within this Restricted Zone.

This solved the problem for a time, but Mexico found itself in a quandary. On the one hand it needed foreign investment to bolster its economy, but on the other it was prohibiting foreigners from owning property. The answer was establishment of the bank trust ("fideicomiso") in 1972. This instrument gives foreign buyers all the rights of ownership--they can use it, improve it, transfer it, leave it to their children--but the title is held in trust for them by a bank. The bank trust is similar to the deed of trust in the U.S. in that it has three parties: Seller, Buyer, and Trustee. One difference is that a bank trust is not a financeable security instrument like a deed of trust. Buyers must pay the entire purchase price before they can obtain it.  The other major difference is that in Mexico the bank trust is always held by the bank for the buyer and never released. This meant that to get the best ownership interest, until recently, foreigners had to buy real estate for cash.

Since few American buyers have enough spare cash to buy the vacation homes or condos they want in Mexico, they have come up with several ways around the problem. The most common is for them to refinance their homes in the U.S. to get the cash. Another solution is fractional ownership. An American Limited Liability Company (LLC) is formed and sells shares to different persons. The LLC then buys property in Mexico with a bank trust and schedules each stockholder for a certain number of weeks a year. Thus 10 stockholders could have 5 weeks apiece. Historically Mexican law has not recognized collateral for loans, but some developers are doing their own financing, using a document called a Promise of Bank Trust. In some ways this is like a land contract--the sellers retain title to the property until full payment is made, and the buyers have only an equity interest. Since this instrument is only a quasi-official document, it doesn't give buyers a really strong position regarding ownership rights. Still it does make financing possible. Another financing instrument called a guarantee trust was originally developed for personal property. Although it was never intended for real estate, it is being used to a limited extent for that purpose. It has possibilities, but there are some problems also. Nevertheless, my opinion is that it is a better instrument than the bank trust, which I would like to see abolished and replaced by the guarantee trust, or better yet, a note and deed of trust. 

Let me give you just a brief description of how a real estate transaction works in Mexico before I go on to discuss financing. Many Americans seem to think that because Mexico's real estate industry is not developed, it has no legal system. Nothing could be farther from the truth. Its legal system is ancient and well-developed, though quite different from our own. First of all, any transfer of real estate must take place before a notario público--not the same as a notary public in the U.S. The notario is a high-powered lawyer and tax accountant rolled into one. His job is to represent the government and make sure participants understand the law. He also calculates and collects the taxes due, which are based on an official appraisal, not on the actual purchase price. That payment is made by the buyer to the seller outside of the notario's office, as is the real estate commission.

In the U.S. an escrow officer figures out what is owed and makes out a closing cost statement in which everything is credited or debited to the appropriate party. Buyers write one check, and the service takes care of paying everything. In Mexico there is no escrow, as such, and so buyers and sellers often have to write multiple checks--to the notario for taxes and fees, to the city for property taxes, to the real estate agent, to the appraiser. Earnest money may be held by the real estate agent or given directly to the seller.

Bank trusts are well developed and useful instruments, but they do present several possible problems. First, it may take a long time to obtain one, depending on how much of a backlog the bank has and how efficient the notario is. Second, there is an initial charge to set up a trust and there are annual fees for administering it. Bank trusts are good for 50 years and renewable for another 50, so the banks have a good source of income, which they will be reluctant to give up, even though many financial experts think the bank trust has outlived its usefulness and should be abolished. Another problem is that the bank trust is like a mini-will; it requires buyers to name a substitute beneficiary, who will become the owner upon the death of the first buyer. This has nothing to do with the person's actual will or heirs. Circumstances change, and buyers may forget to change their beneficiaries.

Title insurance is not a familiar concept in Mexico, but several American companies are now offering it for Mexican properties. This is an important first step, since lenders are often reluctant to make loans without it. This too may take a long time to obtain in Mexico and be expensive.

Mexican banks do make loans on real estate and personal property, but typically interest rates have been extremely high, down payments about 50%, and terms short--from 6 months to 10 years. A 30-year loan was virtually unheard of until recently. This is about where the U.S. was before the New Deal.

There are several things that would make financing in Mexico easier and more affordable. Title insurance would be attractive to American or Canadian lenders, but perhaps to Mexican banks as well. Government insurance or guarantees would encourage banks to make more loans. More importantly, a secondary mortgage market (like Fannie Mae or Freddie Mac) would buy loans and recirculate funds, making more loans available. A well-regulated real estate industry and convenient escrow services would make properties more easily marketable. These improvements are all in progress right now. But there are some other, less obvious, factors that need to be noted.

Mexico's informal sector or subterranean economy is a large, sleeping cash cow. It is estimated that 30% of the country's gross domestic product (GDP) is produced in this sector, compared with 8.8% in U.S. About $245 billion worth of unregistered properties are held by poor Mexicans. Because they are unregistered, they are unusable as collateral for loans. An estimated $70 billion worth of small businesses are also unregistered--about 6.6 million.

The overall population of Mexico is about 105 million. 25 million people (almost 25% of the population) are “moderately poor” as opposed to 40% who are “desperately poor.” Of the moderately poor, an estimated 6 million households have housing and home businesses--4 million micro-enterprises. Most of these people will remain poor because they can't afford to enter the formal sector. Paperwork and procedures for starting a business can take  from 1 to 17 months and cost 40 times the average Mexican wage. There are unregistered assets in Mexico amounting to about $315 billion, 30 times the annual foreign investment. None of this can be used as collateral for loans because it is not on file in the public registry.

Dead capital (unregistered property) creates no wealth. A house is a dwelling, nothing more. By contrast, live capital sees a house as a vehicle for creating wealth. When money is borrowed with a house as collateral, the deed, contract, or note becomes a tradable asset, which increases value beyond the merely physical. Other factors that create wealth, beyond the intrinsic value of the property itself are:

• real estate tax incentives
• laws that accommodate the real estate industry
• registration of properties
• the possibility of financing
• the community's infrastructure and zoning
• planned communities with CC&Rs
• securitization
• lending institututions
• government backing
• a secondary market and paper (notes) that can be sold.
• title insurance and escrow services
• real estate organizations
• multiple listing services
• computerized databases

  Factors that hinder the creation of wealth fall into three categories: economic climate, real estate marketability, and physical conditions. The economic climate includes:

• existence of a subterranean economy
• an environment unfriendly to investors
• Bank trust
• Excessive taxes
• Bureaucratic red tape
• unavailability of financing
• Little government support
• No secondary market
  few mechanisms that promote smooth transfer of property
• Title insurance
• Secondary insurance (MIP)
• Escrow services
• insufficient data for calculating values
• insufficient community planning
• Limited services
• Faulty infrastructure
•  

The Mexican government under President Vicente Fox, who is an American-educated economist, and Mexican financial institutions are well aware of these factors and, as you read this, are taking active steps to make conditions more favorable for the creation of wealth. A group of laws called Miscellanea Secured Lending was passed in 2003. Its expressed aims are to

• Increase the supply of credit
• Foster conditions that will reduce risk to investors
• Promote the use of trust guarantees (like FHA and VA) and chattel mortgages
• Provide legal safeguards to borrowers and lenders

In another forward-looking step, the Mexican government has enlisted the services of ILD (Instituto Libertad y Democracia), the Liberty and  Democracy Institute, a Peruvian non-profit organization experienced in international reform programs, which has successfully implemented such programs in other countries. This organization has undertaken a Mexican project estimated to cost $5.6 million and take 33 months to implement. The steps in this project are:

• Assessment
• Reengineering the legal system
• Designing legal reforms
• Strategy for implementing reforms
• Incentives to enter formal sector

The last is perhaps the most important, since if property owners and small businesses can be encouraged to join the formal sector without undue hardship, it will make available large reserves of capital and collateral for loans, turning dead equity into a means for increasing wealth.

SEDESOL, the Ministry of Social Development, will be administering this reform program, which will comprise:

Land use planning

Urban and housing development

Equal opportunity for vulnerable groups (similar to Fair Housing in the U.S.)

Fostering community development

Another exciting development is that now long-term financing is becoming available in Mexico. It is backed by the government Sociedad Hipotecaria Federal (Federal Mortgage Society), an organization like FNMA in the U.S. This is a giant step forward for affordable housing.

One loan program that I recently found out about makes loans to Mexicans or the children of Mexicans, using Mexican property as security. The loans are based on U.S. income and are backed by the Mexican government. They are issued for a term of 25 years with as little as 10% down and a 9.8% interest rate. Other loan programs offer loans to U.S. citizens, using Mexican property as security, at an interest rate of 13.99%.  Programs like these make it possible for the children of Mexican parents living in the U.S. to buy housing for their parents in Mexico or retirement properties for themselves. At the same time foreigners who want to vacation or retire in Mexican can buy Mexican property with these loans.

I find these developments tremendously encouraging for the future of the real estate industry in Mexico. I believe that we will continue to see more offerings and better terms for financing as the necessary reforms are put in place.

 The real estate industry in Mexico also needs to continue to improve. What I see for the most basic needs for a strong real estate industry are:

A  estate education and licensing program
Title insurance

Escrow services

Securitization (foreclosure mechanism)

More notarios

Abolition of the bank trust

Secondary mortgage market

 The government of Sonora has made a strong beginning by requiring all persons acting as real estate agents to register with the state. The Arizona-Mexico Commission has also been working to introduce some of the above mechanisms for financing and settlement services. I predict that an education and licensing requirement for real estate agents will be coming in the near future.

As I mentioned above, a secondary mortgage market is in place and growing. Fulfillment of the objectives of IDL will probably help to streamline settlement of real estate transactions.

In summary, the news is very good, both for Mexicans and for foreign investors.