by Peter Wessel
Turmoil in the capital markets has brought about significant changes in the way lenders and borrowers view and manage risk in financing multifamily properties. Fortunately, the Federal Housing Administration, which runs a mortgage insurance program for multifamily loans, has not sat idly by. The agency has made a number of changes to its underwriting policies in recent months to reduce the risk of insurance loss and ensure that the mortgage insurance program continues to help multifamily borrowers meet increasing market demand. In addition, borrowers need to view risk through more lenses than in years past in making decisions concerning their secured borrowings.
FHA-insured loans are available for the funding of new construction of apartment projects, and the rehabilitation and refinancing of existing properties. Through its mortgage insurance program, the government enables borrowers to enjoy a number of benefits that they wouldn’t otherwise. Because the government enjoys the highest credit rating, its guarantees enable lenders to access capital on behalf of borrowers at the lowest risk-adjusted rates. The lower cost of capital enables apartment owners to charge lower rents and still achieve an acceptable return. Lower rents translate to more discretionary income that renters can put back into the economy. And higher leverage compared to alternate sources of financing translates to lower blended cost of capital, as equity typically requires a higher return than debt.
The reason the FHA multifamily program has been able to continue to offer such attractive benefits to borrowers is the fact that it has continued to adjust its underwriting standards to protect against default. In fact, the agency takes in more borrower premiums each year than it pays out in claims, generating a profit for the federal government. In recent months, the agency has made a number of changes to its underwriting guidelines to help maintain the program’s success.
One significant change the FHA has made is in its loan sizing criteria. FHA is now differentiating underwriting among asset classes, with more conservative coverage, LTV, and vacancy criteria the greater the loan’s size and the number of units. FHA has also increased credit support escrows for new construction financing. For example, FHA added an owner’s hard-cost contingency escrow to cover unforeseen conditions and change orders that require sponsor investment. Escrows for the initial lease-up deficit have also increased to provide greater economic support for the project. If not needed, the balance remaining in these escrows is returned to the developer upon stabilization.
Finally, sponsorship is being examined more closely. For loans above $25 million, FHA requires minimum net worth of 20 percent of the loan and 7.5 percent liquidity among the principals. Specialized properties, such as those that restrict occupancy based on age, require demonstrated experience with the ownership and management of senior housing. FHA has also introduced “creditworthiness” underwriting, requiring real estate owned and maturing debt schedules to evaluate prudence in the sponsors’ historical management of real estate and debt.
Borrowers also need to adjust how they view risk, with particular focus on future loan maturity, in making financing decisions today. Historically, borrowers focused on two main types of risk associated with future financing. “Interest rate risk” is the risk that rates will be higher than current rates at construction take-out or at permanent loan maturity. Interest rates affect loan sizing and cash flow. “Market risk” is the risk that economic conditions or valuations that could affect the ability to refinance maturing debt will be less favorable than current conditions.
Borrowers now need to consider two additional forms of risk. “Liquidity risk” refers to capital availability at time of a required refinancing, and usually manifests itself in how long it will take to obtain financing. This risk exposes the property owner with maturing debt to penalties, renegotiation or foreclosure. “Underwriting risk” is the risk that current loan underwriting criteria will change, thereby impeding a successful future refinancing of existing debt.
FHA-insured loans are an effective hedge against these risks. FHA multifamily loan features include long-term, low fixed-rate, nonrecourse financing, with no balloon maturity. In addition, declining call protection is transferrable to a new owner. In today’s risk-focused environment, these features can add value and help manage risk.
Last year, the agency insured 1,143 apartment loans nation- wide, or $11.6 billion in total loan volume. The agency is on track to exceed that amount this year. It helps to understand how changes in the capital markets are affecting decisions concerning risk. If you are unsure how these changes will affect you, be sure to reach out to a lender with FHA multifamily experience for an evaluation of how they are likely to impact your specific plans.
This article appeared in the Colorado Real Estate Journal on August 15.