Government-sponsored enterprises (GSEs) have been lending to borrowers for many decades. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) have popular multifamily lending programs so much so that they now control the bulk of the market. For example, Freddie Mac’s total multifamily finance activity for 2018 was $77.5B, and Fannie Mae’s was $65.4B which means that if you have to compete, your bank needs to do so carefully as you have a high probability of getting adversely selected.
The multifamily loan category has performed well in this cycle, and most lenders are optimistic about the market. However, we often hear community bankers complaining about the pricing, terms, and conditions offered by both GSEs for multifamily financing. In this article, we review the GSE’s multifamily general structures and rates to help community bankers understand how to sell around these programs and how to compete effectively against them.
The GSEs will generally offer five to 10-year terms. Fannie Mae has a program that allows borrowers to finance up to a 30-year term. Many community banks lament that they cannot match the long-term commitment from the Fannie Mae program. However, that program has prohibitive prepayment provisions, little flexibility to restructure the loan in the future, and minimal options for cash out or loan repayment. Community bankers should point out that borrowers obtain substantial flexibility in dealing with community banks for future borrower substitution, and collateral and loan restructuring. We work with community banks around the country that effectively compete with the GSE programs by offering 20 and, in some instances, 25-year terms.
While loan spreads are competitive for quality credits, pricing from GSE programs is within our observed market-based pricing. GSEs offer floating, hybrid, and fixed-rate loans. The majority of loans are fixed-rate, and this is driven by borrower demand and the desire by the GSEs to stabilize debt service coverage ratio (DSCR). Fixed-rate terms range from five to 30 years. The pricing sheets that we have recently reviewed have ranged from 1.82% to 2.49% over the swap rate for various terms. This pricing is in-line with what most community banks’ price multifamily category and the complaint that the GSEs are underpricing the market does not seem substantiated.
Most spreads are constant regardless of the fixed-rate term, however, we have seen both premiums and discounts offered by GSEs to extend term. The spread difference between top markets and B and C markets is anywhere from zero to 30bps. This differential in the spread is based on the quality and size of the market, also approximates what we see community banks price for this loan category.
The GSE programs rely on retaining earning assets as long as possible. The prepayment penalties are stiff and one-sided (the borrower is never “in-the-money” or seldom able to prepay without a penalty). On 10-year loans, prepayments can be as severe as 10,9,8 …1 declining balance for the life of the loan. At best the prepayments are 5,5,4,4,3,3,2,2,1,1 for 10 years. Freddie Mac also offers a one-sided yield maintenance provision (which provides no upside to the borrower, and a severe penalty under any circumstance).
The difference in rate to the borrower between the one-sided yield maintenance and the declining balance prepayment provision for a 10-year loan is currently about 40bps. The borrower can obtain 40bps better loan spread by signing up for a prepayment provision that almost guarantees no prepayment of the loan. This is an indication of how much value the GSE place in retaining earning assets and the profitability that may be achieved with longer customer lifetime value.
Community banks can structure much more flexible and innovative prepayment provisions and charge customers accordingly.
Freddie Mac offers non-recourse financing with standard carve-outs. However, to obtain non-recourse financing, the borrower has to meet various criteria, such as the eligibility of the property (stabilized cash flow, number of units, minimum occupancy, exclusion of specialized housing), minimum DSCR (in some cases as high as 1.40x), maximum loan-to-value (LTV) of 70 to 80%, and interest and maintenance reserve requirements. Taken in totality, Freddie Mac is obtaining stronger credit criteria by waiving personal guaranties that have historically been demonstrated as only moderately credit enhancing.
Generally, the GSEs spreads will vary based on LTV. While 80% is the maximum, spreads are reduced by 10 to 20bps for properties with lower LTV. This makes sense as the GSEs are targeting minimum debt yield – generally 8% to 9% depending on the market. The cutthroat pricing is reserved for the highest credit quality borrowers (lowest LTV, highest DSCR, and highest debt yield).
The GSE programs will permit up to 30-year amortization and some interest-only (IO) period. Typically, the IO period is up to 30% of the loan term (three-year IO on a 10-year term and two-year IO on a seven-year term). However, bankers should be aware that IO periods increase loan spreads, and most loans booked with IO periods are booked well below 80% LTV. Many of the loans that we see with IO periods start at a lower LTV, and these credits will have a lower outstanding LTV at the end of the IO period than a comparable loan at 80% LTV without an IO period. When all of the credit levers are measured, the GSEs are structuring more sound credits by offering incentives to lower LTV (even if IO periods are permitted).
Similarly, the GSEs multifamily financing programs decrease loan spreads for stronger DSCR. Financing is typically available only for stabilized properties, and minimum DSCR is 1.20x. Loan spreads are further reduced by up to 25bps for properties that demonstrate above 1.50x DSCR and this makes sense in a risk-return analysis.
How Your Bank Should Compete
The GSEs have substantial criteria and minimum requirements for their various programs. These programs require a minimum and maximum loan size, location requirements, minimum and maximum unit requirements, and severe restriction on junior liens. The underwriting and funding may take a long time (typically several months), and terms and conditions are not assured until the day of funding. Closing costs may be higher, and the borrower will not have a relationship with the lender for any future servicing needs. Some borrowers have complained of bait-and-switch tactics from agents that use the GSE multifamily programs. Community banks must highlight their flexibility in being able to structure a more tailored borrowing solution, and being able to accommodate unexpected borrower needs such as a collateral substitution, prepayment options, assignments, subordinated debt, and cash-out requests. Some community bankers sound defeated when their customers mention the GSE multifamily lending solutions because of the lower loan spread. However, ask your borrower to show you their car in the parking lot, then ask them why they do not drive the cheapest car in the lot. There is value in every product that convinces customers to pay a premium – that is the value that your bank must demonstrate to the borrower for a multifamily loan.