Apartment financing gets a boost: non-traditional sources move into multi-family marketplace.

Multi-family properties have been the easiest to finance during the last year, although no financing has been easy. The decline in new construction, continued reluctance by new home buyers, and the poor performance of other property types have encouraged many new investors and lenders to move into the multi-family market place. However, the bulk of interest in apartment financing and investment has been in the higher-quality Class A projects.

While apartment financing has been the easiest property to finance recently, it is getting tougher as vacancy rates, rent concessions, and collection losses increase and competition from foreclosed property becomes more prevalent. Another important drain on potential capital comes from properties that need to be refinanced. Many financial institutions who might want to originate new apartment loans must focus their apartment lending on refinancing of their existing portfolios due to the scarcity of takeout financing.

Refinancing apartments today can often be a surprise and challenge for borrowers. Lenders typically only want to refinance 80-to-90 percent of the loan balance, thus requiring a new equity infusion by borrowers. Rates are typically 200-to-250 basis points over corresponding length treasuries, with typical terms being 7-to-10 years. Higher loan-to-value ratio financing is possible from credit companies, but the trade is often a floating rate structure where the overall interest rate costs can be significantly higher over the term of the mortgage.

The majority of Class B properties are currently financed by Fannie Mae. Approximately 20 designated Fannie Mae underwriters and services originated $3.4 billion in apartment financing throughout 1991. Fannie Mae's rates are not typically competitive for the higher quality projects, but are one of the only games in town for the $1-to-$5 million average quality properties.

Class C and D multi-family properties, once served by local savings and loans and community banks, are now often financed through private mortgage conduits, mortgage REITs, and securitized pools. Individual investors still dominate this market.

An important apartment financing option is the FHA 223 (F) program, an insurance program for the purchase or refinancing of moderate rehabilitation of apartments. Insured loans are secured by the property and are nonrecourse to the owner. 35-year fixed-rate level payment terms are available.

The FHA 223 (F) program provides insurance for purchase or refinance of mortgages up to a maximum of 85% of the appraised value of the project, if certain debt service coverage and other tests are met. Insurance for secondary financing is also available under certain conditions.

To be eligible, projects must consist of 5 or more dwelling units which have been occupied for at least 3 years. The project must attain sustaining occupancy (sufficient to pay operating expense, annual debt service and a replacement reserve requirement) prior to insurance endorsement, or an operating deficit escrow must be provided until sustaining occupancy is reached.

To access the insurance program, select financial institutions or specialized mortgage banking firms can be utilized. One such firm, American Capital Resource, Inc., offers mortgages insured by FHA 223 (F) (existing projects), FHA 221 D4 (construction projects) and other services. Particularly noteworthy is their ability to offer mortgages on C and D quality buildings, older properties and properties with asbestos, flat roofs, master meters and other characteristics which typically make projects difficult to finance.

The general collapse of real estate values nationally has contributed to financing problems. A recent study by the Real Estate Analysis and Planning Service at DRI/F.W. Dodge forecasted a peak-to-trough decline in value of 33% across all regions and property types nationally. Accordingly, while apartment values have done better than most other property types, financing has still been negatively effected.

Based on a survey of nearly 500 examiners and liquidators at U.S. banks in late 1992 by the Federal Deposit Insurance Corporation, commercial real estate conditions continue to be stagnant, showing no improvement since the quarterly survey began in April, 1991. The West, as a region, reported the worst conditions nationally and was the only region where overall responses currently show weaker condition than earlier surveys.

New Sources of Apartment Capital

Pension Funds have become somewhat more active in the apartment equity and lending marketplace, but their investments are typically limited to the highest quality projects. An interesting development that could potentially bode well for apartments and other less traditional pension fund investments is the new countercyclical investment program the California Public Employment Retirement System (CalPERS) recently initiated.

CalPERS, as a leader in the pension real estate investment area, has selected four new real estate separate account advisors to pursue countercyclical real estate investments. Although no specific allocations where made, CalPERS will evaluate (on a deal-by-deal basis) non-traditional property investments brought by the four advisors selected.

While CalPERS has already selected specific advisors to bring in apartment investment opportunities, it is expected that the countercyclical investment advisors will also bring apartment deals. While this investment strategy by CalPERS is not widespread in the pension arena, it does reflect a growing market perception that some of the best real estate deals can be made in non-traditional property markets.

New construction financing for apartments is expensive and difficult to find. However, the FHA 221 (D4) program, insurance company joint ventures, and participating forward loans offer some help. The FHA 221 (D4) program insures mortgages and projects with five or more dwelling units that provide complete living facilities, including full bath and kitchen. The maximum insurable mortgage can be up to 90% of cost allowed by HUD. Qualifying non-profits are eligible for 100% financing.

Participating forward loans fund to-be-built properties that need a take-out commitment. The forward commitment enables the borrower to obtain favorable construction loan financing. The provider of the forward commitment receives a participating interest in the value created. Borrower track records are key in this type of arrangement.

Commercial Mortgage Securitization 

Over 200 real estate transactions have been securitized over the last five years. Approximately 40 percent were apartment or cooperative deals and the rest were a variety of property types, but typically, only a single property type was covered in each transaction.

Only a few mixed asset portfolios have been securitized to date, although this area is growing quickly as improved methods for valuing the transactions -- such as Deloitte & Touche's Collateral Risk Evaluation Methodology -- are developed. These new methodologies enable buyer and sellers to estimate potential collateral deficits in an acceptably accurate and cost-effective manner. With these new methodologies in place, costly credit enhancements required to get deals related can be reduced from current levels of 30% to 50%.

Sales of large numbers of poorly performing apartment mortgages from the RTC and FDIC have enabled some asset managers to aggregate large portfolios of apartment mortgages, which can then be analyzed, credit enhanced and rated by agencies like Standard & Poors, Duff & Phelps, and Moodys.

Most of the securitized apartment deals have involved mortgage pass-through certificates in which savings and loans or other mortgage holders create mortgage pass-through bonds backed by the collateral underlying a large number of apartment mortgages. Once the bonds are sold, the mortgages are paid off.

Refinancing Outlook

With stock prices high, bond yields declining, and the spread between the cost of funds and mortgage rates up to 400 basis points, financial institutions can make significant profits on refinancing. Accordingly, many institutions are expected to continue to restructure and refinance existing loans. Furthermore, while many of the large insurers are having significant problems in real estate, many small and medium size insurance companies are not as negatively impacted and have continued lending.

Underwriting standards for refinancing continue to be tough. Lenders are quite strict on loan-to-value ratios of 65-to-75 percent. While (in the "go-go" 1980s) debt service coverage ratios were often in the 1-to-1.1 range, debt service coverage ratios today are more likely to be 1.15-to-1.35.

Where five-to-seven year interest-only loans use to be common, now most loans require some amortization, although most still have a significant balloon payment at maturity. Thirty year amortization is typical for newer higher quality properties, while twenty year amortization periods for older properties (or those that require significant maintenance or higher replacement reserves) is common.

Continuing favorites of lenders today are net lease deals, existing mature apartment projects, industrial warehouses, and 100,000-to-300,000 square foot neighborhood shopping centers.

Scott Muldavin is a Principal, Deloitte & Touche. Aaron Gershenberg is Senior Consultant, Deloitte & Touche.