The distance from Earth to Mars is approximately 141 million miles. For many inexperienced borrowers and mortgage bankers, making the transition from bank multifamily lending to agency multifamily lending can feel like traveling to another planet. That is according to Mark Besharaty, director of Hunt Mortgage Group. In the exclusive commentary below, he says that although there are quite a number of underlying similarities between these two types of loan executions, the stark differences surprise even experienced industry veterans.
The views expressed in the guest column below are Besharaty’s own.
It may be helpful to review some basic definitions before we start on our interstellar exploration journey of multifamily finance. Agency Lending refers to Government-Sponsored Enterprises such as Fannie Mae, Freddie Mac, and the Federal Housing Authority. For the purposes of this article, we will be focusing on the two most active multifamily agencies – namely Freddie Mac and Fannie Mae. We will further confine our analysis to loans ranging from $1 million to $10 million since these loan amounts constitute the greatest number of multifamily financing transactions nationwide.
On the banking front, it is important to understand that there are a multitude of federally regulated bank institutions providing multifamily loans throughout the United States. Each individual bank has a lending program unique to the scope of their particular business practice. Therefore, it is challenging to provide a homogeneous outline of the lending guidelines of all banks. However, a general analysis can be offered by applying some broad brushstrokes applicable to the vast majority of banking institutions that are currently engaged in the field of multifamily finance.
Non-recourse versus Recourse lending
One of the biggest differentiating factors between agency and bank lending programs is in the nature of liability for borrowers. This liability can take the form of recourse or non-recourse debt. The difference in both types of loan terms comes if money is still owed after the collateral is seized and sold. In case of default, recourse lenders have the ability to gain access to the individual borrower’s personal assets to satisfy the debt owed by a borrower. Personal assets could include the borrower’s checking and savings accounts, personal residence, business assets and so forth. On the other hand, non-recourse loans only allow lenders to gain satisfaction for their loan through seizure of the collateral supporting the debt (i.e. the multifamily property). Therefore, recourse lending is considered to be preferable for portfolio lenders such as banks. All else being equal, non-recourse loans are considered to be preferable for borrowers in all cases.
The vast majority of Fannie Mae and Freddie Mac loans are non-recourse. There may be extenuating circumstances on a very small percentage of agency loans which require some limited recourse to the borrower. Conversely, the vast majority of bank lending is funded through recourse transactions. These types of loans are generally not considered desirable for most sophisticated real estate investors. Since there are a vast multitude of banks offering a variety of multifamily loan programs, a small segment of those banks will have the ability to offer non-recourse loans in the small balance multifamily space – albeit with probable increases in rates and costs accompanied by decrease in leverage and loan proceeds.
Underwriting Parameters – Borrower Tax Returns
This leads us to another area that is closely related to the non-recourse vs. recourse nature of our comparison. Since non-recourse lenders traditionally look to the underlying asset as the main source of repayment, the focus of underwriting for agency lenders is primarily the historical, current and projected operations of the multifamily property. The borrower’s strength is also significant in that their experience net worth and liquidity requirements must meet certain minimum standards.
The contrast with bank lending is the degree to which borrowers are scrutinized. For example, most banks have a strict requirement that borrowers must supply their individual tax returns for the past two years. Bank underwriters are tasked with analyzing these tax returns to determine if individual debt-to-income ratio requirements are met. Frequently, these debt-to-income requirements have nothing to do with the underlying asset itself. This type of underwriting may create insurmountable issues for borrowers with complicated individual tax returns. For example, many multi-family borrowers are real estate investors who may have net loss carryforward write-offs, heavy depreciation schedules, or a multitude of partnership and K-1 income and losses to deal with. Bank underwriters also have to provision for borrower credit card debt, car loan debt, personal loans, and a variety of other types of debt to satisfy the bank’s individual underwriting requirements. This type of analysis is very similar to how individual borrowers are underwritten for home loans. Agency lenders do not require individual tax returns and do not focus on this type of borrower debt-to-income analysis due to the aforementioned non-recourse nature of their lending activity.
Underwriting Parameters – The Multifamily Property
The Lord Giveth and the Lord Taketh away. Although banks may take a deep dive into the income analysis of borrower tax returns, they are frequently less rigorous in their analysis of the multifamily property than their agency counterparts. This should be expected as the primary source of repayments for non-recourse agency lenders is the asset itself.
The additional scope for due-diligence required by agency lenders is generally related to the operations and maintenance of the property. For example, most banks will rely on an appraisal for almost all information related to the property. Agency lenders, on the other hand, require a representative from an independent engineering company to accompany the appraiser when visiting the property. The function of this secondary engineer/property inspector is to provide a comprehensive report regarding any maintenance deficiency that may be present at the time of inspection. Any deficiency will be noted as a repair item that must be fixed. Repair items need to be addressed either prior-to-close if the deficiency is considered critical, or post-close if the deficiency is of lower priority.
Securitization versus Portfolio Lending
Multi-family debt originated by Banks is usually financed through the depository side of the institution and the debt is usually held in the bank’s loan portfolio. The transfer of loans from origination to servicing is a fairly simple process for most banks. By contrast, agency loans are funded through a process called securitization. Securitization involves selling either individual loans or a pool of loans to investors in the secondary market. The selling of loans is an inherently more complex process than keeping loans in the original lender’s portfolio. Therefore, agency lenders require the services of attorneys that are proficient in preparing the enhanced documentation required for loan securitization. The addition of attorneys, even on a limited basis, can add to the loan costs for agencies versus banks. Agency lenders recognize that costs need to be kept to a minimum for smaller borrowers and usually obtain volume discounts from legal service providers.
Agency Limitations – Transactions Suitable for Banks
Due to the more sophisticated nature of transactions, agency loans are generally not cost effective for very small transactions. Agency lenders prefer larger loan amounts and the minimum loan amount requirement for most agency loans is $1 million. Since agency loans require more third-party vendors such as inspectors and lawyers, the overall due diligence fees required to process and close loans may be slightly higher than fees required by banks. These additional vendor costs are offset by potentially lower rates and higher loan proceeds available via agency loan programs.
Smaller loan amounts can be provided by agencies on a case-by-case basis. However, transaction costs expressed as a percentage of the loan amount are commonly too high for very small loan amounts. Bank debt is considered far more suitable for loan amounts that range from $100,000 to $1,000,000.
Also, given the requirement for thorough property inspections, agency loans should generally be avoided for properties that display very poor maintenance levels or a lack of proper on-site management.
Bank Limitations – Transactions Suitable for Agencies
Other than a handful of large national institutions, the vast majority of banks focus their lending activities in a specific geographical market. Smaller banks may only focus on particular submarkets or neighborhoods within a larger metro region. Others may avoid adjacent lending areas where the particular banking institution had experienced loan losses in the past.
By contrast, Fannie Mae and Freddie Mac are mandated by congress to provide affordable housing opportunities across all 50 states and in all communities across the nation. Therefore, real estate investors seeking to own multiple multifamily properties across a broad geographic spectrum, usually prefer agency loans over bank loans. These are the same type of income property investors who prefer non-recourse transactions and who have a high level of experience in the ownership, operation, and maintenance of multifamily properties.
Real estate investors seeking to grow their wealth by accumulating multiple multifamily properties tend to migrate towards agency loans. The simple reason is that banks are prudent lenders that prefer to spread their risk across a broad spectrum of borrowers. Most multifamily loans originated by banks are held in their own portfolio from cradle (origination) to grave (payoff). Therefore, banks seek to avoid “over-exposure” to any single borrower by applying lending limits to individual investors. By contrast, agencies do not have an over-exposure issue with individual borrowers because each loan is a securitized and sold off in the secondary market. In effect, multifamily property investors have unlimited access to Fannie Mae and Freddie Mac multifamily loans as long as each loan transaction meets the underwriting requirements for the agency. These are the types of investors that dream big and look up to the stars – no matter how many millions of mile away.