Commercial Real Estate Lending: What is the Ideal Multifamily Loan?
Do you know what the greatest ongoing expense is for real estate investors?
Assuming debt was secured to acquire the asset, the great expense is the ongoing debt service.
Since the debt service is not included in the net operating income calculation, it do not impact the value of the investment. However, it does impact the cash flow, which in effect impacts the returns to passive investors.
Therefore, being the greatest expense and impacting the return to passive investors, securing the best loan is of the utmost importance.
The purpose of this blog post is to help active apartment syndicators and passive apartment investors alike to understand how to know what the most ideal commercial real estate loan for a particular multifamily investment is. To accomplish this task, this blog post will outline the following:
- What lender should be use?
- Should an agency approved lender always be used?
- Should a mortgage broker or a lender be used?
- When is the best time to engage with the lender/mortgage broker?
- What are the qualifications of the borrower, deal, and market?
- What are the upfront reserve requirements?
- Are renovation costs included in multifamily loans?
- What should be looked at when comparing multifamily loan options?
What lender should be used?
The ideal multifamily loan is an agency loan for most apartment syndications. The main exception is if the business plan includes an early exit – via a refinance or a sale. When this is the case, a non-agency bridge loan is ideal because a borrower won’t be required to pay a prepayment penalty (more on this in a later section) at sale or refinance?
When pursuing an agency loan, what lender should be used?
With an agency loan, a lender provides a borrower with debt to purchase an apartment. Rather than holding the mortgage loan on their books, the lender sells the mortgage to an agency. Hence, an agency loan.
The agency pools together thousands of mortgages, which are sold to private investors and investment firms on the open market as mortgage-backed securities (MBS).
The two agencies that purchase and resell mortgages as MBSs are Fannie Mae and Freddie Mac.
Both agencies guarantee the MBSs. Since Fannie Mae and Freddie Mac are government-sponsored entities (GSEs), the MBS are implicitly backed by the Unite States government. Therefore, in order to provide a guarantee, the agencies only buy certain types of mortgage from approved providers.
Fannie Mae was created first. Later, Freddie Mac was created to generate competition in order to drive down interest rates and fees for both the borrowers, the lenders, and the MBS investors.
Since Fannie Mae and Freddie Mac are buyers of mortgages, they do not work directly with borrowers. Therefore, to obtain an agency loan, a borrower must work with an approved lending institution.
Fannie Mae only buys loans originated from Delegated Underwriting and Servicing (DUS lenders). As the name implies, Fannie Mae delegates the underwriting and servicing of the loans underlying their MBS products to third-party institutions that meet their strict qualifications. Therefore, in order to obtain a Fannie Mae loan, a borrower must work with a DUS lender. Fannie Mae has a list of approved lending institutions on their website, which you can view here. Currently, 25 lending institutions qualify for DUS status.
Freddie Mac also has approved lenders called Optigo conventional lenders. The list of Optigo lenders is similar to the list of DUS lenders. You can view Freddie Mac’s list of approved lenders here.
Should an agency approved lender always be used?
One of the major benefits of an agency loan are the terms. Agency loans generally result in lower down payments and/or lower interest rates. Consequently, debt service payments are lower compared to non-agency loans, which means a higher cash-on-cash return.
However, as I mentioned above, the deal and the borrower (and their team) must meet the agencies strict qualifications.
So, yes, a borrower should always use an agency approved lender, assuming they and the deal qualify, and they projected hold period is longer than the prepayment period. If the borrower and/or the deal do not meet their criteria, or the plan is to exit the loan after a few years or less, the borrower may still be able to use an agency approved lender since most offer more than just agency loans. However, they will not qualify for the best rates and terms.
Should a mortgage broker or a lender buy used?
There is an exception when it comes to securing agency loans. Borrowers can secure an agency loan without working directly with an approved institution by working with a mortgage broker.
A mortgage broker acts as an intermediary between lending institutions and borrowers.
There are countless different multifamily loan programs offered at any given time. Rather than finding the best loan on their own, borrower relies on the expertise of a mortgage broker or lender. The borrower submits information about the deal and the mortgage broker or lenders returns the best loan program option/s.
A mortgage broker is not limited to loan programs offered by a single lending institution. They have a network of many lending institutions, which means they can find the lending institution that offers the best terms for that particular loan program. When a borrower works directly with a lending institution, their options are more limited.
Since the mortgage broker is an intermediary, however, they charge a fee for their services.
So, who should be use? I think it makes sense to work with a mortgage broker. Sure, the expense to secure the loan is higher. But since they have relationships with multiple lending institutions, they will likely underwrite a loan with better terms that offsets the broker’s fee.
When is the best time to engage with a mortgage broker/lender?
A borrower should already have engaged a lender or mortgage broker prior to looking for deals. Based on their and their teams background, the lender or mortgage broker will let them know which loan programs and how much debt they qualify for.
With this information, the borrower will know which type and sized deals to pursue.
Then, when the borrower is interested in submitting an offer an a specific deal, the mortgage broker or lender can quickly provide a quote (since all they need to do is fully underwrite the deal as opposed to fully underwriting the deal and the borrower). The borrower will have an idea of the down payment and debt service so that they can submit a more accurate offer.
When a borrower doesn’t engage a mortgage broker or lender before looking for deals, they may over-estimate the type and size of deal for which they qualify. They may submit an offer, get a deal under contract, and get forced to cancel the contract because they cannot qualify for financing (or the financing results in a higher than expect debt service). As a result, the borrower’s reputation is tainted in the eyes of the seller, listing commercial real estate broker, their property management company, and their passive investors (depending on how far into due diligence the deals was when the contract was cancelled).
To avoid these issues, the borrower should engage the mortgage broker or lender for even looking at deals.
What are the qualifications of the borrower, deals, and market?
Both the borrower and the deal must meet specified criteria in order to qualify for Fannie Mae and Freddie Mac debt.
The borrower includes the guarantor, key principals, and principals.
- The guarantor is who guarantees the loan.
- The key principals are any person who controls and/or manages the partnership or the property, is critical to the successful operation and management of the partnership or the property, and who may be required to provide a guaranty.
- The principals are any person who owns or controls specified interests in the partnership. When the partnership is an LLC, a principal is anyone who owns 25% or more membership interest (this includes passive investors too).
Agency lenders will analyze the borrower based on the organization (i.e., entity) structure, multifamily and business experience and qualifications, general credit history, and current and prospective financial strength. What is considered passing criteria is based on the size, complexity, structure, and risk of the deal.
- Organizational Structure: For most agency loans, only single purpose entities are eligible borrowers. This means you will need to create a new entity for each transaction. The exemptions are the small balance agency loans in which individuals and non-single asset entities are eligible borrowers.
- Multifamily and business experience and qualification: Fannie Mae and Freddie Mac have different ways to qualify the borrower based on experience. Fannie Mae uses a service called application experience check (ACheck). ACheck checks the borrowers experience with Fannie Mae loans in the past. Generally, a member of the borrower must have been a member of the borrower on a previous Fannie Mae loan to “pass”.
Freddie Mac provides more specifics on how they qualify borrowers. The borrower must have a minimum of three years’ experience in the same capacity that it will have for the proposed transaction, and acquired, developed, or owned a minimum of three properties. Also, the borrower must own and manages other properties in the market where the subject property is located. If the borrower is lacking in one or more of these areas, Freddie Mac may require a higher replacement reserve deposit.
- General credit check: The lender will conduct a general credit check on the borrower, checking for other loans and liabilities to determine their ability to fulfill the debt obligations based on the current and past debt obligations.
- Current and prospective financial strength: The agencies do not have specific liquidity and net worth requirements for the borrower on their conventional loan programs, which means it will vary from deal-to-deal. They may require more upfront reserves if the borrower has weak finances.
We can get an idea of what the agencies require regarding liquidity and net worth by looking at the stated requirements for their small loan programs.
For Fannie Mae’s small loan ($750,000 and $6,000,000) and Freddie Mac’s small balance loan ($1 million to $7.5 million) programs, a minimum liquidity of 9 months principal and interest and a new worth equal to the loan amount is required.
Assuming the borrower qualifies for agency debt, the next check is the deal.
To qualify the deal, the lender will analyze the property, the occupancy, the property management company, and the market.
- Property: The agencies only provide financing on certain types of properties. However, most multifamily properties you look at will meet their requirements. The requirements are standard characteristics like five or more units, accessible by road, the units have bathrooms and kitchens, water and sewer service, up to code, access to emergency services, etc.
- Occupancy: The major factor that determines if a deal qualifies for agency debt is the occupancy.
Fannie Mae’s conventional loan program requires a minimum physical occupancy of 85% and a minimum economic occupancy of 70% for 90 days. The occupancy requirements are even higher at 90% for their small loan program.
Freddie Mac’s conventional and small balance loans require a minimum physical occupancy of 90% for 90 days.
- Property management company: The property management company who will manage the deal post-closing will also be analyzed by the lender. The agencies do not have restrictions on the type of management company, which means it can be in-house or third party. However, the property management company must have adequate experience to ensure effective administration, leasing, marketing, and maintenance, and is staffed appropriately for the type and size of the property and the services provided.
- Market: The agency will also analyze the strengths and weaknesses of the market in which the deal is located. They characterize strong markets as having low vacancy, minimal rental concessions, stable or increasing tenant demand, good balance of housing supply and demand, stable economic base, and employment diversification.
Also, certain loan terms will vary based on the market. For example, Freddie Mac has different minimum DSCR and maximum LTVs for top markets, standard markets, small markets, and very small markets.
What are the upfront service requirements?
The agencies have increased their reserve requirements in responses to the coronavirus pandemic.
Fannie Mae is currently requiring 12 months of principal and interest for loans of $6 million and more, and 18 months for loans of less than $6 million. However, if the debt-service coverage ratio (DSCR) is 1.35 or higher and the loan-to-value (LTV) is 65% or lower, Fannie Mae only requires six months of principal and interest. If the DSCR is at least 1.55 and the LTV is 55% or less, no reserves are required.
Freddie Mac is currently requiring nine months of principal and interest on loan with DSCR less than 1.40, six months on loans with DSCR 1.40 or higher, and 12 months on small balance loans.
Are renovation costs included?
Both Fannie Mae and Freddie Mac offer loan programs which cover the costs of renovations.
Fannie Mae offers a DUS moderate rehabilitation supplemental loan (mod rehab). This is a supplemental loan that can be secured in addition to the conventional DUS loan to cover renovation costs. Unlike standard supplemental loans, the mod rehab loan doesn’t have a one-year waiting period. The main requirements for the mod rehab loan is that Fannie Mae must be the only debt holder on the property and minimum renovation costs of at least $10,000.
Freddie Mac offers two renovation loans – moderate rehab loan and value-add loan. The main different are the renovation costs requirements. For the value-add loan, renovations must be between $10,000 and $25,000 per unit. For the moderate rehab loan, the renovations must be between $25,000 and $60,000 per unit with a minimum of $7,500 per unit designated for interior work.
Therefore, if renovations are less than $10,000 per unit or greater than $60,000 per unit, a borrower will have to cover 100% of the renovation costs with passive investor capital or secure a bridge loan through a mortgage broker.
What should be looked at when comparing multifamily loan options?
Here is a list of factors to be aware of when you are analyzing loan options.
Debt service is the payment owed to the lender each month. The lower the debt service, the greater the cash flow. However, the loan option with the lowest debt services isn’t automatically the best option. The debt service may start low and gradually increase if the interest rate isn’t fixed. The debt service may be low but the closing fees are too high, or the loan may not be assumable, the prepayment penalties may be high, etc. Therefore, the other factors which are outline below must be taken into account in addition to the debt service.
Loan amount is the total amount of money a borrower will receive from the lender. The different between the loan amount and the total project costs is the amount of equity a borrower will need to raise.
Loan term is the number of months until the loan must be repaid in full. On shorter-term loans, a borrower may have the option to purchase one or multiple loan term extensions. Ideally, the total possible loan term is at 2x the projected business plan. For example, for a value-add business plan with a renovation timeline of 24 months, the maximum loan term should be four years. That way, a borrower isn’t forced to sell or refinance. However, the longer the loan term, the higher the interest rate, so the longest term isn’t necessarily the best term.
Amortization is the time period the principal and interest payments are spread over. The greater the amortization, the lower the debt service. Usually, the interest payments aren’t spread out evenly during the amortization period. Instead, the first payments are mostly interest (so the lender makes their money upfront) and the interest gradually reduces over time.
Interest-only period is the number of months of interest-only payments. At the end of the interest-only period, principal and interest payments are due.
The main benefit of interest-only periods is the increase in cash flow, resulting in a higher internal rate of return (IRR) since money is returned sooner. This increase in cash flow is even more beneficial on value-add deals because cash flow is generated from day one before the increase in revenue is realized from the renovations.
However, there are a few potential drawbacks. Firstly, there is no principal paydown, which impacts future supplemental loan or refinance proceeds. Secondly, once the interest-only period expires, the debt service increases, which reduces cash flow. Lastly, a borrower may convince themselves to do a bad deal because of the lowered debt service during the interest-only period.
Debt-service coverage ratio (DSCR) is a ratio of net operating income to debt service.
This is one of the factors the lender will use to calculate the maximum loan amount.
Loan-to-value (LTV) is the ratio of the loan amount to the appraised value of the apartment community. All lenders will provide financing up to a maximum percentage of the appraised value.
The higher the LTV, the more leveraged the deal. This is beneficial because of the lower down payment but is also riskier since a borrower has less equity in the deal as a protective cushion against market fluctuations. Therefore, don’t secure a loan with an LTV that is greater than 85%.
Interest rate is the rate the lender charges a borrower to borrow their money. The interest rate is either fixed, meaning it will remain unchanged during the loan term, or is floating, which means it fluctuates up and down during the loan term. Generally, the initial interest rate is lower when floating. But it doesn’t mean it will remain lower.
If the interest rate is floating, a borrower will want to know what the rate is tied to, which is referred to as the index. Then, they can see how the index is trending to determine if your interest rate will go up or down during the hold period (to the best of their knowledge, of course)
If the interest rate is floating, a borrower may also want to consider purchasing an interest rate cap. For an upfront fee, they can place a ceiling on how high the interest rate can rise. This is always ideal since it is impossible to predict whether interest rates will rise or fall during the hold period.
Whether the interest rate is fixed or floating, a borrower will also want to know when the rate is locked in. If interest rates are raising, they want to rate to lock as quickly as possible. Sometimes, a borrower has the option to expedite the rate lock period for a fee.
Recourse determines if the guarantor is personally liable for the loan. If the loan is recourse, the guarantor is personally liable. If the loan is non-recourse, the guarantor is not personally liable.
If the loan is non-recourse, a borrower will want to determine what the exemptions are that converts the loan to recourse, which are typically fraud, misrepresentation, and gross negligence.
Tax and insurance escrows: a borrower may be required to submit monthly deposits into a tax and insurance escrow account, even if taxes and insurance payments are due quarterly or annually. If monthly escrow deposits aren’t required, they may need to raise extra money upfront to cover lumpsum tax/insurance payments, depending on how quickly each is due after closing
Lender reserves is the amount of money the lender requires each month to be deposited in a reserves account. Usually, lenders require between $200 and $300 per unit per year.
Besides the deposit amount required, a borrower also wants to know when they stop making deposits and when they can pull the money out if it isn’t used.
For agency loans, expect to continue to make the payments until payoff the loan. Also, don’t expect to be able to access the funds until payoff of the loan either. For non-agency loans, the lender reserves are usually negotiable.
Prepayment penalties is a fee incurred if a borrower pays back the full or a certain percentage of the loan amount before a specified date.
The prepayment penalties are important if they expect to refinance or sell before the prepayment period expires. If this is the case, they will need to include the prepayment expense into your sales disposition calculations.
Assumable: if the loan is assumable, when you are ready to sell the deal, a prospective buyer has the option to either secure new debt at new terms or assume the existing debt at the existing terms. This is attractive to buyers if the existing terms are better than the new terms currently available.
Typically, there is a fee incurred to the buyer who assumes the loan.
Supplemental loans: these are secondary loans taken out on top of the existing mortgage. If a borrower is allowed to secure a supplemental loan, they will want to know how many they can secure and when they can be secured. Generally, they are able to secure a supplemental loan one year after the origination of the first loan.
Require reports: the lender will order reports to be conducted on the property. These generally include an appraisal, property condition assessment, and phase I environmental, at minimum. A borrower will want to know which reports are required, when they are due, and the costs associated with each.
Financing fees: these are the fees charged by the lender (or mortgage broker) to put together a loan. Common fees are applications fees, processing fees, origination fees, good faith deposits, and interest rate lock fees.
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Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.