Lending Starts to Open for Small Properties

Here is good news for owners of small multifamily properties who may be seeking financing: Lenders are becoming active in this sector again.

Low-balance financing is once again starting to become competitive for lenders, now that banks have cleaned their balance sheets and are returning to the sector, observes Bill Hughes, senior vice president and managing director of Marcus & Millichap Capital Corp. “The level of competition among lenders is equal to, or even greater than, that in conventional financing,” says Hughes. “One reason is that local and regional community banks are becoming highly active in the sector. They feel comfortable underwriting in their local markets.”

Borrowers interested in taking out small loans are starting to have a greater array of choices. According to Hughes, regional and local banks are the biggest sources of small loans today, followed by Fannie Mae, which had a 15 percent market share in 2009. (Freddie Mac does not have a small loans program.) A distant third as a capital source is credit unions, which are very localized in their approach, lending only to very local players. “Accessing credit union capital is a little more challenging, but we have done it,” he notes. Additionally, a handful of life insurance companies are interested players in the sector, though they are still very few in number, says Hughes.

Small loans make up the overwhelming majority of loans made in the country today. According to the Mortgage Bankers Association’s “2009 Survey on Multifamily Lending,” small loans of up to $3 million comprised 81 percent of all multifamily loans made, though by dollar volume, they are only 27 percent of the market. Small multifamily properties tend to be concentrated in urban areas such as New York City and Los Angeles, and tend to be targeted to the affordable and working classes. According to Fannie Mae’s January 2011 report on its role in the sector, the financing market for small loans is still fragmented, with 2,600 lenders originating an average of six small loans each.

Smaller multifamily properties can be considered riskier propositions by lenders. Their owners are small “shops” rather than professional investors and managers, and a few vacancies can push up the percentage of vacant units dramatically since the total number of units is relatively small. The sponsor’s personal financial wherewithal and propensity to sustain the loan servicing payments therefore takes on added importance for lenders who are extending small loans. And the underwriting on multifamily small loans may have a slightly different angle compared to that for larger loans.

Additionally, the pricing can be slightly higher than for larger loans, and small balance financing tends to be recourse, even under the Fannie Mae program. Loans below $3 million that are not in primary or secondary markets are typically recourse, whether the financing is obtained from Fannie Mae, banks or insurance companies. Fannie Mae allows non-recourse in certain markets and for lower leverage transactions. Recourse is required by Fannie Mae for loans of $750,000 or less with the principal executing a payment guarantee document.

Banks provide capital

With the improving economy, lenders are generally stepping back into the financing market in greater numbers, and this includes small loans lenders. JP Morgan Chase is one big bank that may be a source for small multifamily loans today, but national commercial banks are generally not in the small loans arena, says Hughes. However regional and local community banks are predominant in the sector, and many of them have re-entered the market. Hughes cites two banks that were not in the market six months ago but are competing “very aggressively” in the market today. “Banks are making a comeback,” agrees Tom Wilson, director at HFF (Holliday Fenoglio Fowler LP). “They have money they want to put out. The number of banks that are in the market looking to put out money has definitely fallen, but the ones that are still in the market are looking to do deals.”

In the experience of Michael Kelly, president and co-founder of Caldera Asset Management, a multifamily consultant and turnaround specialist, the bulk of the small loan business of less than $3 million is still almost exclusively “a local bank business.” He is seeing generally 60  percent to 75 percent loan-to-value (LTV) ratios and some sort of recourse including top-tier guarantees. Banks are generally lending only to clients with whom they have current relationships, he observes.

Life companies have returned in a big way on the conventional large-loan side of the market, but only a few of them will play in the small loans space. And at this point, these loans are limited to Class B or better quality assets in primary and secondary markets, says HFF’s Wilson. “If it is a good asset in a good market with a good sponsor and it is underwritten appropriately in the $1 million to $3 million range, there are a handful of life companies that will finance these transactions.” Wilson cites a transaction that HFF arranged: a $3.5 million Class B+ asset in a “triple-A” location in Portland, Ore. “The life companies jumped all over it,” he says.

Indeed, all over the commercial financing world, the bulk of the capital is still limiting itself to the major markets. The life companies will finance mostly in the primary markets. Fannie Mae will finance small loans in the primary down to the secondary markets, but not so much the tertiary markets, say financing brokers. For tertiary markets, borrowers will have to resort to regional or local banks. And for “micro” amounts of less than $500,000, the main supplier will also be regional or local banks, says Wilson. Life companies may finance a minimum of only $1 million.

In choosing among different capital sources, borrowers will find that Fannie Mae and bank small loan financing are comparable in pricing today, says Hughes. Borrowers can expect interest rates of 5.75 percent to 6.25 percent for 10-year fixed rate mortgages from Fannie Mae or banks, though 10-year bank financing may have interest rate resets after five years. Interest rates for five-year loans are slightly lower, at 5.25 percent to 5.75 percent. Life companies charge comparable interest rates, of about 5.5 percent to 6 percent, says Wilson.

One advantage life company small loan financing offers over Fannie Mae is the ability to lock interest rates upfront—-at loan application or one or two weeks after loan application, says Wilson. “There are a handful of life companies that can compete on rate and be inside of Fannie Mae, especially for infill locations and quality properties,” says Wilson.

The maximum LTV ratio for Fannie Mae small loans is now as high as 80 percent. However, a minimum debt service coverage (DSC) ratio of 1.25‑1.30 in many markets typically acts as a constraint on the loan dollars provided under the agency. “Given the DSC requirements, getting to 80 percent LTV can be a huge challenge,” says Hughes. Commercial banks will furnish up to 80 percent LTV, but they will come down to 1.15 DSC for “relatively new assets with good borrower sponsorships.” Credit unions’ maximum LTV is a lower 70 percent to 75 percent, with typical DSC of 1.25 percent, says Hughes. And life companies’ LTV requirements for small loans are topping out at about 70 percent, with a maximum DSC of 1.25 percent, says Wilson.

Lenders scrutinize loans

Underwriting on small-sized multifamily properties is more focused on the borrower than for larger loans. Lenders scrutinize the borrower, integrity of rent roll and consistency of cash flow closely. “There is a greater reliance on the borrower [for small loans] than for large loans because it is such a hands-on investment medium,” says Hughes. “[Lenders] want to really understand who the investor is.” Even if the property is older, the lender wants to ensure there is no deferred maintenance; the building has been brought functionally up-to-date; the rent rolls are stable; the property has been operating for a period of time; and the borrower has a certain amount of experience, say Hughes. Borrowers will typically need FICO scores above 650, he adds.

“Fannie Mae looks really hard at small borrower transactions. They are a stickler for well-maintained properties and local operators who are not first-time investors moving into the area,” says Hughes. “[Lenders] do not like absentee owners. Everyone wants local investors because those are the hands-on investors.”

Lenders will not hesitate to drill down to check whether there is any one concentration of residents that work with a certain employer, says Wilson. “If 50 percent of units are occupied by employees of Nike, that could be a concern,” he comments. “Deals in which 20 percent to 25 percent of residents are exposed to one employer can go from 100 percent to 75 percent occupancy very quickly.” Capital providers prefer longer leases of six to 12 months, and month-to-month leases are not viewed as favorably.

Players expect the small loans market to open up further in the months ahead as lenders look for business opportunities. As CMBS ramps up and becomes more competitive, players may already have begun to enter the $5-million-and-smaller multifamily financing segment, says Wilson. Caldera’s Kelly also expects more offerings in the second half of the year. Mortgage bankers will need to replace loans that have run off, and given that the land loans and new construction business are not very active, “the $3 million apartment loan with top-tier guarantee will look very good,” says Kelly.

To comment on this story, email Keat Foong at kfoong@multi-housingnews.com.