FEATURE ARTICLE, AUGUST 2008

MULTIFAMILY LENDING
What’s Hot, What’s Not?
Dan Smith and Sean O’Malley

Multifamily is undeniably the most active sector in commercial real estate today. In the Northeast, refinancings and acquisitions of multifamily properties account for more commercial real estate activity than any other property type.

Yet financing multifamily properties is by no means “easy money.” Lenders are carefully scrutinizing each deal’s fundamentals, evaluating the potential impact of condominium and house rentals and applying the more strict underwriting standards that reappeared in 2007.

That’s why understanding what is driving the multifamily market in the Northeast is valuable. Knowing “what’s hot” and “what’s not” among multifamily lenders can help mortgage bankers, mortgage brokers and property owners more effectively obtain the financing they need. 

Multifamily Market Dynamics

There are many reasons multifamily properties are more popular today than other types of commercial real estate. A receptive investor base tops the list, followed by growing demand.

The investor base for commercial real estate has changed radically since the residential subprime mortgage meltdown flared in mid-2007. Prior to that, a robust mix of institutional and leveraged investors (such as CDOs and special investment vehicles) eagerly welcomed CMBS bonds collateralized by loans on all types of commercial real estate.

Unfortunately, many of these investors also purchased bonds backed by subprime residential mortgages. When the value of those bonds plummeted, many investors suffered enormous losses that forced them out of the market. Remaining investors became extremely nervous and significantly scaled back CMBS purchases or stopped them entirely. Seemingly overnight, the capital markets investor base for commercial real estate loans evaporated. It has yet to recover.

Government-sponsored enterprises (“GSE”) such as Fannie Mae and Freddie Mac have filled the gap by stepping up their purchases of multifamily loans and providing liquidity to refinance or acquire multifamily properties. For the time being, Fannie Mae and Freddie Mac have effectively replaced many global capital markets investors – but only for multifamily properties.

Growing Demand

Increasing demand for multifamily housing is also fueling the sector’s popularity. The uncertain economy and subprime meltdown are spurring foreclosures across the nation; each represents an individual or family who must find an apartment in which to live. So at a time when demand for many types of commercial real estate may be softening, the need for apartments remains strong.

Today’s more stringent lending standards and limited loan programs are also adding to demand for multifamily housing. Many people who might previously have bought houses are now renting while they save for a down payment and establish the credit necessary to purchase a home. Demographics are also contributing to the need for multifamily housing, as children of the baby boom generation enter the market as new renters.  Although the presence of GSE investors and growing demand are indeed bright spots for multifamily properties in the Northeast, the picture is not entirely positive.

The Shadow Market

The term “shadow market” refers to condominiums or foreclosed houses that are being rented because they cannot be sold profitably in today’s market. These may compete with multifamily properties for tenants; if there are enough rental condos and houses in the market, they could also drive rents down.

The shadow market is having a major impact in areas such as South Florida, Las Vegas and other markets that experienced significant condominium development in recent years and are now seeing high rates of foreclosures. The condominium-based shadow market is generally less of a concern in the Northeast, where condominium sales in major markets such as New York City and Boston remain strong.

Nonetheless, some areas of the Northeast are suffering from a large number of single-family home foreclosures. For example, some sources place both Connecticut and Massachusetts among the top 10 states in the nation for foreclosures in first quarter 2008 and New Jersey at 16th. In these states, foreclosed homes and condominiums being offered for rent are likely competing with multifamily properties for renters. Ongoing investor appetite for multifamily loans and, to a lesser extent, growing demand for multifamily housing, are keeping lenders focused on the multifamily properties. What are lenders looking for in Northeastern multifamily deals?

What’s Hot?

Any number of characteristics can make a multifamily loan appealing to a lender, including:

Major Metropolitan Markets. Demand for and prices of multifamily properties in markets such as New York City, Philadelphia and Boston remain very strong. Interest in student housing and manufactured housing communities in upstate New York is equally robust.

Small Balance Loans. Acquisitions and refinancings for smaller multifamily properties (approximately $500,000 to $5 million) are extremely strong in the Northeast. Their smaller size (and thus, reduced risk), as well as appeal to GSE’s, makes small balance loans very attractive to lenders.

Conforming Loans. Lenders are most interested in multifamily loans that Fannie Mae or Freddie Mac will purchase. In fact, the GSEs’ requirements for a “conforming loan” define many of the deal attributes lenders seek today, including a qualitatively sound property, loan-to-value of 65 percent to 80 percent, local management and cash equity.

Fixed-Rate Loans. The interest rates on these loans are still relatively low, so most borrowers prefer a fixed-rate loan to the potential fluctuations of a floating rate loan. There are some cases in which floating-rate loans make more sense — for example, a transitional property whose buyer plans to grow the net operating income by increasing occupancy or rents and reducing expenses. However, most multifamily loans today are fixed-rate.

Acquisitions. Although multifamily financing activity in many areas of the country consists mainly of refinancing, multifamily loans in the Northeast are split equally between acquisitions and refinancing. Nimble buyers are making offers to multifamily property owners who are having difficulty in today’s more challenging market.  

Cash Equity. The days of full interest-only loans without any cash equity are long gone. Today, lenders insist that owners have a genuine stake in the property’s performance; most lenders are requiring minimum cash equity stakes of 10 to 20 percent. In more difficult markets, cash equity of at least 30 percent is required.

Debt Service Coverage. Lenders are interested in transactions that support debt service coverage of 1.20x and higher.

What’s Not?

Multifamily properties may be the most active sector in commercial real estate in the Northeast today, but lenders and investors are nonetheless proceeding cautiously. Today, loans that are less appealing include:

Locations with Extensive Home Foreclosures. The shadow market in areas of the Northeast that experienced significant home foreclosures is likely to present considerable competition to multifamily properties and make them less desirable to lenders.

Aggressive Underwriting. Commercial real estate underwriting standards had become overly competitive by 2006 and early 2007. The market turmoil that appeared in mid-2007 led lenders back to more conservative underwriting standards that are typical of commercial real estate finance, including cash equity requirements, reasonable debt service coverage and calculations based on actual rather than projected rents. Old school underwriting is back.

Questionable Borrowers. In today’s market, lenders are scrutinizing both the collateral and the borrower. Borrowers who have low credit scores and limited liquidity or are over-leveraged will find it difficult to obtain the capital needed to acquire or refinance a multifamily property, as will buyers without demonstrated multifamily experience.

Multifamily is the busiest sector in commercial real estate today. Thanks to GSEs’ continuing appetite for multifamily loans and strong demand for apartments, the outlook for financing multifamily properties in the Northeast is generally positive. Yet lenders and investors remain careful. Understanding what is driving the multifamily market in the Northeast and how lenders view potential deals is one key to success in today’s market. Mortgage bankers, mortgage brokers, property owners and potential borrowers who understand “what’s hot” and “what’s not” among lenders will have an edge in identifying promising deals — and in securing financing for them.

Dan Smith is managing director and Sean O’Malley is regional director for the Northeast region of RBC Capital Markets Real Estate Mortgage Capital

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