One of the distinguishing features of investment in the US multifamily rental industry is the presence of US Federally supported enterprises in its financing.
This is very different than the other real estate sectors which primarily rely on life insurance companies, banks, pension funds, foreign investors, and capital markets to fund both the debt and equity levels of investment.
This difference was not so much in evidence during the boom periods, most recently from 2004-2007, but has been very much so since 2008, even before Lehman Brothers collapse. During the boom period, the GSEs (Fannie Mae and Freddie Mac), along with the US Dept of Housing and Urban Development’s financing programmes, constituted about 30 per cent of all property level debt financing.
Today they are >90 per cent of all mortgages originated, and at overall transaction levels that are 90 per cent off of the peak level of activity. In 2009 they combined held about US $100B in multifamily mortgages.
As the GSEs were not under any US congressional mandate to make imprudent loans (as was the case in the single family residential market), their underwriting criteria hardly changed at all over the years—65 per cent -75 per cent gearing ratio, 1.2-1.25X Debt Service Coverage Ratio, up to 10 year terms, 30 year amortization, 6.5 per cent interest rates, and all based on actually verifiable financials. According to people inside both GSEs, multifamily mortgages have never been more than 10 per cent of loans, but accounted for >30 per cent of profits (when there were any).
Now, it is one of a few profit centres left. HUD programmes, because of their long lead times, unpredictable documentation needs, and onerous cash distribution limits, were used rarely and usually only for Affordable Housing (truly government subsidised housing, which accounted for about 100,000 of the normalised 300,000 unit multifamily construction starts over the last 15 -20 years).
“Hot Money” deals went into the CMBS market (Collateralised Mortgage Backed Securities), where underwriting was looser to non-existent, where during 2007 a total of $270 B in CMBs was issued, about a third of that being multifamily property. Today multifamily CMBS default rates are around 9 per cent and climbing, with more trouble ahead. Meanwhile, the GSE default rates have not exceeded more than 1 per cent, and were as low as 0.3 per cent for quite a while.
When the CMBS market crashed in early 2008, the GSE and HUD was the only game left in town. In a bid to put a floor under valuations, the GSE dropped their rates to 6 per cent, and have gone as low as 5.5 per cent and provided an open window for firms refinancing their debt, as long as they did not attempt to get cash out during the refinancing.
Underwriting has gotten more restrictive- certain cities, owners and property ages have been required to go through “prior review”, and cash flow modeling has gotten stiffer. Nonetheless, the GSE’s “posted” rates are such that few private market participants are willing to compete with them (at a 230 basis point spread to US 10 yr Treasuries, the spread is pretty narrow). This spread has resulted in the equivalent of a subsidy in the valuation of around 100 basis points (or about 20 per cent in value).
HUD’s construction financing programme has been the only functioning source of multifamily construction capital, and supports just about all of the 40,000 unit starts in 2009. Recent losses in the construction and permanent financing programs have resulted in a just announced set of underwriting restrictions which more HUD’s programmes more closely in line to that of the GSEs.
So, if you plan to invest in US multifamily real estate in the equity portion of the capital structure, understand that you are accepting some political risk. With single family housing in the dumpster and the government on the hook for huge losses in high risk mortgages, the risk is more a budgetary one rather than a policy risk. Up until recently there have been few alternatives to obtaining exposure to the US multifamily market, which has had a history of meeting of exceeding US inflation.
Email the writer:
j.alder@alrroya.com
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