A Big Appetite for Small Loans

Seeking to ramp up business, banks are presenting features that are out-bidding Fannie Mae.

Marc Schillinger, vice president at George Smith Partners and a specialist in small multifamily loans, says that he receives phone calls day and night from banks that are “trying to get money out and get it out fast” asking for suggestions regarding how to better compete for the best multifamily transactions. “Banks are trying to create more aggressive lending programs in the small-balance multifamily financing space,” he says.

Indeed, as Schillinger describes, the multifamily small-balance financing market may be red hot. Banks are seeking to light the fire to their financing programs, and they are offering more advantageous features to attract customers. In the process, they are competing more effectively with Fannie Mae’s vaunted small loans program. “Banks in many instances are winning out over the Fannie Mae small-balance program,” observes William Hughes, senior vice president, managing director at Marcus & Millichap Capital Corp.

What is classified as “very small loans” of below $1 million may be still relatively more difficult to obtain in the market–—Fannie Mae’s minimum loan amount is $750,000—but the $1 million to $3 million loan size range may be the “sweet spot” for many banks today, and loans from $3 million to $5 million may be targeted by even more banks. “For commercial banks, loans of $1 million to $3 million are where most of the action is,” says Schillinger. In fact, according to the Mortgage Bankers Association, “very small” and “small” loans of under $3 million compose 72 percent of loans originated in the multifamily sector in 2010, although they account only for 22 percent of the dollar volume. This “very small” loans sector originating loans of less than $1 million is still very fragmented, though, as firms extending the debt averaged just five loans each.

According to Hughes, the most active financial institutional lenders in the small loans space today are the smaller regional and local banks as well as savings and loans. Credit unions have also become active again. On the other hand, the national big banks are not so aggressive in the small loans space, says Hughes, with the exception of Chase—which is active depending on the market. In fact, in the Los Angeles market, Chase has led the charge on small loans of less than $5 million, although they are not always the lowest cost provider, says Schillinger. Examples of the most active banks on the West Coast include Sterling, Luther Burbank Savings and Opus Bank, says Hughes. The First Republic Bank is active in New York, and the New Jersey Community Bank and Northfield Bank in New Jersey, notes Hughes.

Why banks zero in on small loans

The reasons that many banks are targeting small multifamily loans are that many have resolved their balance sheet issues and are seeking to balance their deposits and generate revenue again by putting out debt. “Banks overall now are ‘overdeposited,’” explains Allen Kirschenbaum, division manager of the Real Estate Industry’s division at the Bank of the West, a regional bank that covers 19 western states. “They have more deposits than invested in loans.” Corporations, adds Kirschenbaum, have more cash than ever before on their balance sheets that they are not using for inventory buildup but are depositing into banks, further increasing the pressure on banks to make a greater volume of loans relative to the deposits they are obtaining.

Banks are aggressively seeking out multifamily financing in the petite department also because the multifamily sector has recovered and fundamentals are strong. The greater risks of the smallest loans not-withstanding, James Poznik, senior vice president of KeyBank Community Development Lending, comments that banks generally favor the profile of small-balance multifamily housing as an asset class to lend into. “Banks are finding the multifamily product has a great risk profile. The vacancies are low, occupancies high, and the demand for rentals is strong. Multifamily seems to be an area in which there are good returns,” says Poznik. Bank of the West also favors small loans because they are “granular,” said Kirschenbaum. Small loans provide the bank with greater diversification by allowing lending to a greater number of properties and a broader range of maturities to balance larger loans that are being provided.

Fannie Mae’s financing has established the reputation of being “hard to beat” in the attractiveness of their terms. Although Fannie Mae financing is known for being non-recourse, mortgages of $750,000 to $3 million ($5 million in high-value markets) that are provided under its small-balance program are indeed recourse. The government-backed enterprise may still generally offer the lowest pricing, however. For example, Fannie Mae Tier 2++ pricing on a 10-year fixed rate small loan was about 4.43 percent in April, says Hughes. By comparison, 10-year fixed-rate loans provided by banks that offer it are mostly 5 to 5.5 percent. For shorter term loans, the five-year Fannie Mae rate is 3.64 percent, compared to 3.63 to 4.63 percent for bank loans of comparable terms.

Another long-standing advantage of Fannie Mae small loans compared to those of banks is that fixed-rate loans can extend to 10 years, whereas banks can more often offer fixed rates for only three, five and up to seven years. Additionally, Hughes also cites Fannie Mae’s supplemental financing as a key advantage. This program allows additional debt to be added to an existing Fannie Mae loan as the property’s value appreciates. Banks do not offer this option.

Banks compete with Fannie Mae

For all the advantages of Fannie Mae financing, banks may now be burning into the agency’s market share by offering a number of features that are winning favor with borrowers. George Smith Partners’ Schillinger suggests that banks are able to provide longer-term and fully amortizing mortgages. For a slightly higher interest rate, says Schillinger, banks can offer 30-year terms instead of balloon mortgages. “That is why banks are so active, and they are doing so much business,” he says. Interest in the first three or five years of the 30-year mortgage are fixed-rate, followed by adjustable interest rates for the remainder of the term. Schillinger expects more banks next to offer longer fixed-rate periods of seven and 10 years.

Banks are also competing on how those adjustable rates are calculated—whether they are based on Libor or 12 MAT (Month Average Treasury), says Schillinger. 12 MAT is preferred by borrowers as it is based on a moving average and less volatile than the Libor benchmark. Banks have the additional advantage, adds Bank of the West’s Kirschenbaum, of being able to offer rate swaps that enable borrowers to convert their loans from floating- to fixed-rate.

Further, banks provide more flexible prepayment arrangements. Many borrowers today are seeking to avoid yield maintenance, which require the borrower to compensate for the yield lost by the debt holder should the loan be paid before maturity. Most commercial banks impose a more favorable step-down prepayment penalty during the fixed rate terms, says Schillinger. For example, the prepayment will be five percent in the first year, four percent in the second year and three percent in the third year.

Even with regard to loan proceeds, banks are firing away at Fannie Mae. Maximum LTVs in the case of Fannie Mae and the financial institutions may be up to 80 percent. However, because Fannie Mae underwrites to a minimum 1.25 Debt Service Coverage (DSC) ratio, it often may not be able to hit 80 percent LTV in low-cap rate environments, explains Hughes. Banks’ minimum DSC is on average lower, at 1.15, for the best-in-class assets.

Longer term, albeit adjustable-rate, mortgages from banks also allow for the additional benefit of greater loan proceeds, argues Schillinger. Because of their shorter maturity, Fannie Mae’s mortgages need to be underwritten to the higher interest rate that is expected to be prevailing close to the loan maturity period. As a result, the loan proceeds are lower than those of longer-term bank mortgages.

Generally, commercial banks are most aggressive in lending in the primary gateway markets. However, when it comes to small loans, banks are often financing across the footprint of the country, says Bank of the West’s Kirschenbaum. “Local banks in particular know the area and are willing to lend to apartment projects in tertiary markets,” says Kirschenbaum. “This is a good asset class for them that performs reasonably well in downturns.” Kirschenbaum explains that regional and local banks can more readily ramp up their levels of activity in multifamily real estate financing as they are lending on their balance sheet and plan to retain their loans.

As a bank lender, Kirschenbaum sees that future interest rates could cause refinancing difficulties in the small loans lending space. “We are coming out of a time period with the 10-year Treasury at 2 percent. When the interest rates increase, they will increase quickly. My fear is that it may take a lot of borrowers by surprise and cause problems for them. You cannot always count on rents increasing at the same rate as interest rates would.” Kirschenbaum is working with borrowers to obtain interest rate protection, such as obtaining interest rate swaps to convert to fixed-rate mortgages.

On the other hand, as a financing intermediary, Schillinger is enjoying good sleep these days. He does not need to worry about making transactions work. “The only thing keeping me up at night are lenders calling trying to win deals,” he quips.