COVER STORY, JUNE 2008

MULTIFAMILY LENDING: WHAT’S HOT, WHAT’S NOT?
Sorting out the multifamily finance market.
Dan Smith and Sean O’Malley

Dan Smith, Managing Director, RBC Capital Markets Real Estate Mortgage Capital

Multifamily is undeniably the most active sector in commercial real estate today. In the Midwest, 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 stricter underwriting standards that reappeared in 2007.

That’s why understanding what is driving the multifamily market in the Midwest 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.

Sean O’Malley, Regional Director, RBC Capital Markets Real Estate Mortgage Capital

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 and has yet to recover.

Government-sponsored enterprises 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 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, especially in economically stressed areas of the Midwest. Each foreclosure represents an individual or family that 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 more limited loan programs are also adding to demand for multifamily housing. Many people that 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 the children of baby boomers enter the market as new renters.

Although the presence of government-sponsored enterprise investors and the growing demand are indeed bright spots for multifamily properties in the Midwest, 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, their presence could drive multifamily rents down.

The shadow market is having a major impact in areas that experienced significant condominium development in recent years and are now seeing high rates of home foreclosures. The condominium-based shadow market is generally less of a concern in the Midwest, where most markets experienced less condo development.

Nonetheless, depressed economies in Michigan, Ohio and Indiana have fueled high rates of single-family home foreclosures. Foreclosure rates are also increasing in other major markets, the result of subprime losses and declining property value. In these states, foreclosed homes that are being offered for rent may compete with multifamily properties by accommodating some potential renters.

Growing demand for multifamily housing, along with the ongoing investor appetite for multifamily loans, is keeping lenders focused on multifamily properties. What are lenders looking for in Midwestern multifamily deals?

What’s Hot

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

• Conforming Loans:

Lenders are most interested in multifamily loans that Fannie Mae or Freddie Mac will purchase. In fact, the government-sponsored enterprises’ requirements for a conforming loan define many of the deal attributes lenders seek today, including a qualitatively sound property, a loan-to-value ratio of 65 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 utilize a fixed rate.

• Short-Term Loans:

In stronger markets throughout the Midwest, owners and buyers of Class B multifamily properties that see potential for short-term NOI growth are seeking 3- to 5-year financing. These borrowers are confident that the market will turn around and offer more appealing long-term financing options.

• Local Management:

A locally managed property is likely to be better maintained, which improves retention and helps attract new tenants.

• 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.

• Complete Documentation:

Lenders and government-sponsored enterprise investors are insisting on documentation that demonstrates a multifamily property’s stability. Examples of such documentation include partnership and management agreements, the first mortgage loan, and assignment of rents.

What’s Not

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

• Locations with Extensive Condo Development:

The shadow market in areas that experienced significant condo development is likely to present considerable competition to multifamily properties. The same is true in markets with large numbers of home foreclosures.

• Economically Distressed Areas:

Pockets of the Midwest that are suffering economically due to losses in the auto and manufacturing industries can be troublesome. This phenomenon is not limited to the Rust Belt; the Northeast will also become more challenging due to job losses among large Wall Street financial institutions. In general, tertiary markets nationwide that depend on a single economic driver or one large employer may pose difficulties for lenders and investors.

• 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.

Multifamily is the busiest sector in commercial real estate today. Thanks to Fannie Mae’s and Freddie Mac’s continuing appetite for multifamily loans and strong demand for apartments, the outlook for financing multifamily properties in the Midwest is generally positive. Yet lenders and investors remain careful; understanding what is driving the multifamily market in the Midwest and how lenders view potential deals is one key to success in today’s market. Mortgage bankers, mortgage brokers, property owners and potential borrowers that 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 Midwest region of RBC Capital Markets Real Estate Mortgage Capital, which sources and securitizes commercial real estate loans on a variety of income-producing properties across the United States.

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