Fannie Mae Alternatives

Election year clouds prospects for GSE reform.

After going into government conservatorship in 2008, as a prelude to winding down the Government-Sponsored Enterprise’s role, ironically enough Fannie Mae now plays a more important role in the multifamily finance space than it did before.

As Richard Green, director of the University of Southern California’s Lusk Center for Real Estate points out, “For many, many years, Fannie and Freddie were important, but they weren’t huge players in the multifamily space. Now they’re enormous. If not for Fannie and Freddie, you’d have substantial negative lending in the multifamily space right now.”

Fannie Mae’s overarching impact

Private lenders have pulled out of the space because they are trying to build up capital. Besides, they find it difficult to compete with the attractive loan terms that the GSEs offer.

If not for Fannie Mae, Green expects that interest rates would now be higher and loan terms would be tougher, with loan-to-values of 65 percent, instead of the current 75 percent. This means borrowers would need to put  more equity into a deal, cap rates would increase, and prices of multifamily properties would fall.

Green sees an especially important role for Fannie Mae in the smaller five- to 50-unit multifamily property lending niche, because private-sector lenders don’t find that a convenient niche in which to operate.

Shekar Narasimhan, managing partner, Beekman Advisors, estimates that the GSE currently has about a 33 percent share of this market.

Narasimhan is concerned about the availability of financing to refinance the balloon mortgages that are coming due in the next five years. He expects that if there is not sufficient capital in the absence of Fannie Mae, there are likely to be defaults on multifamily loans.

Additionally, Fannie Mae plays a role in financing less-sought-after properties in second-  and third-tier markets. Narasimhan says, “That’s not where traditionally the institutions have gone. Will those markets continue to be served? Will much of Alabama have a multifamily market? I don’t know, and I am not sure I want to find out by experimenting with whether it is possible, because if it weren’t, it would cause a huge collapse in value within those markets.”

And David Twardock, president, Prudential Mortgage Capital,  points to a public policy reason to provide guaranteed liquidity in the multifamily market through Fannie Mae. Twardock says, “If capital doesn’t flow into the multifamily housing space, you have a situation where the quality of the housing can deteriorate pretty quickly. A severe credit crunch in multifamily—and I don’t think we’ve had one in a long time, largely because of Fannie and Freddie—[would] affect people’s lives directly.”

Possible alternatives to Fannie Mae

The government’s proposals for housing finance reform include three alternatives.  One envisages an almost entirely private system of housing finance, except for the Federal Housing Administration. A second alternative calls for, in addition to the private system, a limited government role as a backstop in case of a crisis situation. The third alternative sees the government providing reinsurance for certain securities guaranteed by private mortgage guarantee companies and meets strict underwriting standards.

Narasimhan believes that the third alternative is the ideal one for the housing sector, considering that it serves the need for liquidity and for a distribution of mortgage capital across the country, including the underserved markets. “That’s the approach that would both address some serious issues that have arisen within the current construct of Fannie and Freddie and also ensure that there is mortgage money and liquidity available across the country through these various capital market cycles that we seem to have regularly,” Narasimhan says.

He would like Fannie Mae’s multifamily business to be separate from its single-family, and for the company, along with Freddie Mac, to continue to perform its role as a guarantee company.

In regard to the potential for the development of a covered bond market to pick up any slack in the availability of financing, Narasimhan notes that this calls for banks to retain credit risk, for which, given upcoming Basel III regulations, he doesn’t expect they will have an appetite.

In the absence of the GSEs, Twardock expects that private sector financing will step up to fill any void left by the government. “I think a larger, nimbler FHA is one alternative. There’s discussion about having regulated companies that provide the guarantees and can have access to a federal backstop as a secondary form of liquidity. Or we can just deal with it in the private markets, but the liquidity might be impacted in a significant and long-term way,” Twardock says.

Private capital is likely to be more attracted to some multifamily niches, such as student housing, than to others, such as affordable housing, in which Fannie Mae plays a role.

While Twardock expects that CMBS financing and life insurance companies are likely to fill any void in the student housing arena, he sees a “fairly significant” impact for the multifamily affordable housing niche. This is because banks have Community Reinvestment Act requirements and FHA, another alternative, is a slower process.

Don’t put all eggs in Fannie basket

Given the uncertainty about the future of Fannie Mae, multifamily investors would do well to start preparing for a world without readily available Fannie Mae financing. Green advises that investors should take on as little debt as possible, given that it is not clear what their refinancing alternatives will be when it comes time to roll over their loans.

Narasimhan also advises that investors with balloon maturities and other loans coming due with the agencies in the next few years should try to deleverage. For instance, they could bring other partners into a deal to spread out the debt exposure and make the loan more refinanceable even if it ends up with another institutional investor.

In addition, he says multifamily investors should refinance all loans they possibly can, given today’s low interest rates, and put them away so that there is no issue for the near- to medium-term.

Twardock believes that investors should be thinking about diversifying their capital base and looking at alternative sources of multifamily financing. “I think that there are certainly good loans and good access to capital now through Fannie and Freddie, and there is every reason to continue accessing that capital. But I think it’s just prudent to have a broader range of relationships and alternatives.”

What lies ahead?

What is not clear is how long financing from Fannie Mae will continue to be available, given that there is no timetable for reform.

In the meantime, there has been an impact on Fannie Mae in the form of attrition of personnel, for one, which leads to a loss of expertise in the multifamily financing area. Narasimhan says, “It is very disheartening for people if they don’t know what the future is, and if they find their compensation under debate every day.”

Another fallout to the delay is that Fannie Mae is not engaged in new product development while in conservatorship, given that its conservator, the Federal Housing Finance Agency, believes that its role is to preserve the value of Fannie Mae until regulators decide how best to move forward.

One thing that is certain is that the Treasury authority to invest capital and keep the GSEs solvent expires at the end of 2012. As Narasimhan notes, “Everyone has been assuming that nothing will happen in 2012. Something needs to happen, because, if at the end of 2012, the Treasury no longer has this authority, what does this mean for the solvency of these entities in 2013?”

Reform Proposals Proliferate

As of the end of 2011, there was a slew of activity in terms of bills to reform the GSEs, with 15 smaller bills introduced by House Financial Services Committee Republicans, according to  the National Multi Housing Council (NMHC).

As well, House Republicans have two larger bills in consideration. One, introduced by Jeb Hensarling (R-TX), seeks to move housing finance to an entirely private system. Another, from Scott Garrett (R-NJ), looks to revive the private-label mortgage securities market without tacking on a government guarantee.

In addition there are the two bipartisan GSE reform bills introduced in the House, one of which seeks to blend Fannie Mae together with Freddie Mac to create a single government entity.

There is no lack of action in the Senate either, with a number of reform bills pending there as well.

Cindy Chetti, NMHC’s senior vice president of government affairs, notes, “I think a lot of the legislative proposals are laying down markers. It is debatable whether or not they will be able to move anything during an election year. However, I think there will be a lot of conversation about it, and [there will be] many more bills to come.”

According to Chetti, the interesting thing about these bills is that they mostly focus on the single-family side of the market and any impact on the multifamily side is more by default.

The NMHC is looking to educate government policymakers about the need to distinguish between the two markets in their reform efforts.  “We’re hoping that, as we move forward, policy makers can understand that certainly multifamily is different than single-family, and, as they continue to focus their efforts on fixing the problems in single-family, that we don’t end up being collateral damage,” Chetti says.

Equity Residential, Lehman Brothers Vie for Ownership Interest in Archstone

Equity Residential (EQR) announced late last year it signed a contract to acquire 26.5 percent ownership interest in Archstone. The agreement was for $1.325 billion in cash, and the closing of the contract is contingent on the remaining Archstone owner—Lehman Brothers—refusing its right of first offer to acquire the interest from the banks at the same price agreed to by Equity. The Archstone portfolio includes almost 50,000 stabilized apartment units, as well as 1,332 apartments under construction.

❝ Lehman’s efforts to acquire the initial stake in the Archstone portfolio at a price matching Equity Residential’s bid are not unreasonable. Even under bankruptcy protection, the firm will seek to act strategically. The judge’s determination that the banks involved may proceed with the sale to EQR will likely have the effect of raising Lehman’s overall costs in executing on its plan. In more general terms, the contest for a share of the Archstone assets signals the underlying value of its portfolio. But it also takes place during a period of relatively unrestrained enthusiasm for the apartment sector. A broader class of investors—for whom a degree of risk sensitivity is appropriate—should consider the latest Archstone developments in the context of the dealings’ participants.❞

Sam Chandan

President and Chief Economist

Chandan Economics

❝ The potential acquisition of a significant interest in Archstone will mean EQR gains an even more powerful position in the industry. EQR is an excellent owner and operator of properties and will most certainly gain market share as well as pricing power in many of their core markets. Archstone assets are very high quality, a good fit with EQR.

EQR will very likely prevail over attempts by Lehman Brothers Holdings to block the sale. In my view, Lehman had structural deficiencies in reasoning in the first place to acquire Archstone with Tishman-Speyer, and I don’t see them adding any value like EQR can, essentially keeping Archstone assets on a great platform.

The guys at EQR are great acquirers and operators. This industry has gone through a number of consolidations with some REITs going private, and some going public, but ultimately this is a business of property operations and balance. I believe EQR had the best interests at heart for current site teams and residents. They’re not buying this to wholesale deals to buyers, but to add to their own portfolio and manage complementary properties in their core markets.❞

Jack Kern

Managing Director

Kern Investment Research LLC

❝ It seems as though the EQR move to acquire an interest in Archstone is demonstrative of the fact that the multifamily sector has not only fully recovered but is leading the charge in the world of U.S. asset classes. While the pricing on an ‘apples-to-apples’ basis is considerably lower than when the company was acquired by Tishman, I think people will look back at this transaction as a relatively well-placed stake in terms of pricing and momentum. The critical question is what it means for players within the secondary quality markets and assets—will this trigger additional appreciation to cover what seems like widening spreads between quality classes? My sense is that it will continue to trigger interest and make the argument for asset class compression more viable.❞

Alex Hurst

Founder and Managing Partner

Palatine Capital Partners