Much conjecture has been made about the changing tides in the residential real estate industry. The recovery is churning forward but finally showing signs of cooling as rent growth begins to normalize. However, the future remains somewhat murky, as new policy changes could alter the current state of domestic real estate.
Within the widely encompassing arena of residential real estate lies a subset of properties funded by small-balance loans of $1 million to $5 million. These properties carry a unique set of characteristics that differ from the widely discussed and publicized institutional multifamily communities.
Small-Balance-Loan Properties vs. Institutional Multifamily
Compared to the Class A high-rises found in central business districts and popular urban cores, small-balance loans often finance smaller projects with fewer units and amenities. Not only do the physical properties differ but geography plays a key role, as many small-balance-financed properties are located in suburban areas farther away from city centers.
The renter profile associated with smaller properties also changes, as more families are drawn to the geography and community. Despite the recent buzz created by luxury apartment development across the country, more people still live in small multifamily communities than in large apartment communities.
Key Risk Factors
It is the fundamental differences in renters and their apartments that make small-balance-loan communities unique compared to their larger counterparts. For real estate investors and lenders, risk is a key attribute when determining the viability of an investment or loan. Small-balance loans generally carry elevated risk for a number of reasons, such as the geography and renter profiles mentioned above but also because of the comparable impact of vacancy.
A five-unit community that loses one resident suddenly loses 20 percent of its occupancy and thus net operating income suffers tremendously, while a 300-unit property can withstand regular resident turnover without experiencing significant impact to its income statement.
Adding to the risk of small-balance-financed communities are the relatively few lenders willing and able to provide financing. Institutional real estate can access financing through a number of sources, such as CMBS, insurance companies, private equity and the government-sponsored enterprises; however, the vast majority of financing for small-balance loans is originated by banks. While the banking community is no cottage industry, the relatively limited financing options for small-balance loans inherently add risk to this financing type. “There are fewer players and less liquidity in the small-balance market,” noted Sam Chandan, founder & chief economist at Chandan Economics. “With less liquidity comes higher risk.”
The Cap Rate Scenario
The higher risk associated with small-balance-loan properties can be seen directly when looking at capitalization rates, which serve as a yield proxy for real estate investors. Cap rates for small-balance loans remain slightly elevated compared to average cap rates for the multifamily industry because of the risk premium required in the small-balance lending market.
When market risk is heightened, the spread between small-balance cap rates and institutional cap rates widens as investors and lenders demand a higher yield for the additional risk they assume. However, as risk—or the perception of risk—is phased out, as was the case in 2006-2007, cap rates fall and the spread between small balance and institutional compresses. While cap rates have come down in recent years, small-balance cap rates have maintained a spread to average multifamily cap rates, as risks remain evident in the real estate market.
The current bull market has benefited real estate professionals across the industry, and residential real estate of all sizes has been viewed as a low-risk asset. Cap rates have declined significantly, and small-balance cap-rate spreads have compressed. However, given the nature of the current market and certain lending regulations born out of the Great Recession, cap-rate spreads have not fully compressed to their pre-crisis levels.
Changing Times Ahead?
Given its differing characteristics, how will the small-balance financing industry be affected by a new president and changing economic currents?
A strong positive change could occur if lending regulations on financial institutions are pulled back. “Deregulation of banks could increase money flow for real estate deals, especially for small-balance transactions, as they are heavily dependent on banks for financing,” Chandan said. Since small-balance loans rely almost exclusively on banks, the deregulation will have a larger impact on small-balance financing compared to institutional loans, although institutional real estate will also reap the benefits.
Certain infrastructure and employment growth policies may also benefit the small-balance lending community, especially if jobs and infrastructure spending are focused in more suburban and rural parts of the United States. Increased demand for family housing away from urban areas would support many low-unit apartment communities.
That being said, the economic and political uncertainty ahead of us has given room for pause in the small-balance-loan community, as it has for many investors, brokers and lenders across the real estate landscape. “I can’t recall a time with as much fiscal uncertainty as we have now in the United States,” said Chandan. As a result of the unprecedented uncertainty, the real estate market—and the small balance market—will likely see periods of volatility in the future.
Investors seeking higher yields should be able to find them in small-balance-financed properties, but the risks remain prevalent. Rising construction costs and relative development value of high-end properties may put a damper on production of new low-unit communities. However, in turn, demand for such properties remains high and may grow as affordability issues loom.