The distance from Earth to Mars is approximately 141 million miles. For many inexperienced borrowers and mortgage bankers, the transition from multi-family lending through banks to multi-family lending to agencies can feel like a trip to another planet. That’s what Mark Besharaty, director of the Hunt Mortgage Group, says. In the exclusive comment below, he says that while there are a number of fundamental similarities between these two types of loan execution, the stark differences surprise even seasoned industry veterans.
The views expressed in the guest column below are Besharaty’s own.
It can be helpful to review some basic definitions before starting our interstellar exploration of multi-family finance. Agency lending refers to government sponsored companies like Fannie Mae, Freddie Mac, and the Federal Housing Authority. In this article, we’ll focus on the two most active multi-family agencies – namely Freddie Mac and Fannie Mae. We will continue to limit our analysis to loans in the $ 1 million to $ 10 million range, as these loan amounts represent the largest number of multi-family finance transactions nationwide.
On the banking front, it’s important to understand that there are a variety of government-regulated banking institutions in the United States that offer multi-family loans. Each individual bank has a unique credit program for the scope of their particular business practice. It is therefore difficult to provide a uniform overview of the lending policies of all banks. However, a general analysis can be offered by applying some rough brushstrokes applicable to the vast majority of banking institutions currently in the multi-family finance space.
Non-recourse lending versus recourse loans
One of the biggest differences between agency and bank loan programs lies in the nature of the liability for borrowers. This liability can take the form of recourse or non-recourse debt. The difference between the two types of loan repayment periods is that after the collateral is seized and sold, there is still money owed. In the event of default, recourse lenders have the option of accessing the individual borrower’s personal assets to help settle a borrower’s debts. Personal assets can include the borrower’s checking and savings accounts, personal residence, business assets, etc. On the flip side, no recourse loans only allow lenders to satisfy their loan by seizing the collateral securing the debt (i.e., the apartment building). Hence, recourse credit is preferred for portfolio lenders such as banks. All other things being equal, non-recourse borrowers will be considered preferred in all cases.
The vast majority of Fannie Mae and Freddie Mac loans are non-recourse. A very small percentage of agency loans may have extenuating circumstances that require limited borrowing from the borrower. Conversely, the majority of bank loans are financed through recourse transactions. These types of loans are generally not considered desirable to most discerning real estate investors. Since there is a large variety of banks that offer a variety of multi-family loan programs, a small proportion of these banks will have the option of offering non-recourse multi-family loans with low balance sheets – albeit with probable increases in interest rates and costs that are accompanied by a decline in Leverage and loan proceeds.
Underwriting parameters – borrower’s tax returns
This leads us to another area that is closely related to the nature of non-recourse or recourse comparison. Because non-recourse lenders traditionally view the underlying asset as the primary source of repayment, the primary focus of underwriting for agency lenders is on the historical, ongoing, and planned operations of the apartment building. The strength of the borrower is also important in that his experience and liquidity requirements must meet certain minimum standards.
It differs from bank lending in the degree to which borrowers are scrutinized. For example, most banks have a strict requirement that borrowers submit their individual tax returns for the past two years. It is the job of bank insurers to analyze these tax returns to determine whether the individual debt-to-income ratio requirements are met. Often times, these debt-to-income requirements have nothing to do with the underlying asset itself. This type of underwriting can pose insurmountable problems for borrowers with complicated individual tax returns. For example, many multi-family borrowers are real estate investors who may face net loss carryforwards, heavy depreciation plans, or a variety of partnerships and K-1 income and losses. Bank insurers must also prepare for borrower credit card debt, auto loan debt, personal loans, and a variety of other types of debt to meet the bank’s individual underwriting requirements. This type of analysis is very similar to the way individual home loan borrowers are drawn. Agency lenders do not require individual tax returns and, due to the non-recourse nature of their lending activity mentioned above, do not focus on this type of borrower debt-income analysis.
Underwriting parameters – the apartment building
The Lord gives and the Lord takes away. Although banks delve into the income analysis of borrowers’ tax returns, they are often less rigorous than their agency counterparts when it comes to analyzing multi-family home ownership. This is to be expected since the primary source of repayment for non-recourse lenders is the asset itself.
The additional due diligence obligations of lenders usually relate to the operation and maintenance of the property. For example, most banks 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 firm to accompany the appraiser when viewing the property. The role of this secondary engineer / property inspector is to provide a comprehensive report of any lack of maintenance that may be present at the time of the inspection. Any deficiency is noted as an item for repair that needs to be corrected. Items for repair must be fixed either before closure if the defect is considered critical, or after closure if the defect is of lower priority.
Securitization versus Portfolio Loans
Multi-family debts issued by banks are usually funded through the deposit side of the institution and the debts are usually held in the bank’s loan portfolio. Moving loans from being issued to servicing is a fairly straightforward process for most banks. In contrast, agency loans are funded through a process called securitization. In securitization, either individual loans or a pool of loans are sold to investors on the secondary market. Selling loans is inherently more complex than keeping loans in the original lender’s portfolio. Therefore, agency lenders require the services of attorneys who are knowledgeable in preparing the advanced documentation required for loan securitization. The involvement of lawyers, even to a limited extent, can increase the cost of borrowing for agencies from banks. Agency lenders recognize that the costs for smaller borrowers must be kept as low as possible and usually receive volume discounts from legal service providers.
Agency restrictions – transactions suitable for banks
Because of the more complex 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 for most agency loans is $ 1 million. Since agency loans require more third party providers such as inspectors and lawyers, the overall due diligence fees required to process and close loans can be slightly higher than the fees charged by banks. These additional seller costs are offset by potentially lower interest rates and higher loan proceeds available through agency loan programs.
Smaller loan amounts can be provided by agencies in individual cases. However, the transaction costs, expressed as a percentage of the loan amount, are usually too high for very small loan amounts. Bank debt is considered far more appropriate for loan amounts of $ 100,000 to $ 1,000,000.
In view of the requirement for a thorough property inspection, agency loans should generally be avoided even for properties with a very poor state of maintenance or a lack of proper on-site management.
Bank restrictions – transactions that are suitable for agencies
Apart from a handful of large national institutions, the vast majority of banks focus their lending in a specific geographic market. Smaller banks can only concentrate on certain sub-markets or neighborhoods within a larger metropolitan area. Others may avoid adjoining credit areas in which the respective banking institution has suffered credit losses in the past.
In contrast, Fannie Mae and Freddie Mac are mandated by Congress to provide affordable housing in all 50 states and in all municipalities in the country. Hence, real estate investors looking to own multiple apartment buildings in a wide geographic range tend to prefer agency loans over bank loans. These are the same types of investment property investors who prefer non-recourse transactions and have a high level of experience owning, operating, and maintaining multi-family homes.
Real estate investors looking to grow their wealth by building multiple apartment buildings tend to switch to agency loans. The simple reason for this is that banks are prudent lenders who prefer to spread their risk across a wide range of borrowers. Most multi-family loans issued by banks are held from cradle (origin) to grave (disbursement) in your own portfolio. Therefore, banks try to avoid “over-exposure” to a single borrower by imposing credit limits on individual investors. In contrast, agencies have no problem of overpositioning with individual borrowers as each loan is securitized and sold in the secondary market. In fact, multi-family home investors have unrestricted access to Fannie Mae and Freddie Mac multi-family loans, as long as each loan transaction meets the agency’s underwriting requirements. These are the types of investors who dream big and look up to the stars – no matter how many millions of miles away.