COVER STORY, AUGUST 2008

MULTIFAMILY LENDING: WHAT’S HOT, WHAT’S NOT?
Understanding what drives the market can help companies effectively obtain financing.
Dan Smith

Multifamily is undeniably the most active sector in commercial real estate today. In Texas, 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 Texas 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 either 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 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  in Texas and across the nation. 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 also is fueling the sector’s popularity. The uncertain economy and subprime meltdown are spurring foreclosures across the nation, including some Texas markets. Each foreclosure 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 more limited loan programs also are 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 also are contributing to the need for multifamily housing, as children of the baby boom generation enter the market as new renters. 

Although the presence of government-sponsored enterprise investors and growing demand are indeed bright spots for multifamily properties in Texas, 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 also could 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 followed by high rates of home foreclosures. The condominium-based shadow market is generally less of a concern in the Texas, where there was less condo development than in most markets.

Nonetheless, Texas has suffered from a large number of home foreclosures. In fact, some sources place Texas among the top 15 states for foreclosures in 2007. So in some markets, foreclosed homes 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 Texas-based multifamily deals?

What’s Hot?

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

• Larger Markets. The greater economic diversification in larger markets across Texas makes them hardier and better able to withstand economic cycles.

• Conforming Loans. Lenders are most interested in multifamily loans that Fannie Mae or Freddie Mac will purchase. In fact, government-sponsored enterprise 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 build its net operating income — but most multifamily loans today are fixed-rate.

• Short-Term Loans. In stronger markets throughout Texas, owners and buyers of Class B multifamily properties who see potential for short-term NOI growth are seeking 3- to 5-year financing. These borrowers are confident that the market will turn around by then and are offering 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 with no 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 1.20 times 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, assignment of rents, etc.

What’s Not?

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

• Locations with High Levels of Condo Development. The shadow market in areas that experienced extensive condo development is likely to present significant competition to multifamily properties. The same is true in markets with a large number of home foreclosures.

• Tertiary Markets. The less diversified economies of smaller markets or one-industry towns may be less resilient and, thus, more risky. This is true even in Texas markets in which a single industry — such as oil — is presently booming.

• Aggressive Underwriting. In 2006 and early 2007, commercial real estate underwriting standards had become too aggressive. The market turmoil that appeared in mid-2007 led lenders back to the 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 in Texas and across the country. Thanks to government-sponsored enterprises’ continuing appetite for multifamily loans and strong demand for apartments, the outlook for financing multifamily properties in Texas is generally positive.

Yet lenders and investors remain careful. Understanding what is driving the multifamily market in Texas 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” for lenders will have an edge in identifying promising deals — and in securing financing for them.

Dan Smith is managing director of RBC Capital Markets Real Estate Mortgage Capital. Smith is based in Dallas.

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