Lenders become increasingly selective about projects and grow wary of market saturation.

The multifamily housing market remains one of the strongest sectors in real estate. Still, the nation's lenders are approaching the next six months with caution.

Although capital still is readily available for development, acquisition, refinancing and renovation, some lenders are becoming much more prudent and selective. Additionally, the number of lenders is shrinking as mergers and acquisitions on Wall Street and in the banking industry point to a consolidation trend.

Housing affordability also is becoming a problematic issue that lenders and developers will need to address as rents continue to rise past what many middle- and low-income families can afford. Despite the industry's growing cautiousness, multifamily housing remains one of the most popular investments today.

"There was some concern about nine months ago when it appeared the Federal Reserve Board might tighten sharply [increase rates], and the resultant rise in borrowing costs would bring our 18-month-long string of stability to an end," says Mark Obrinsky, chief economist for the Washington, D.C.-based National Multi Housing Council (NMHC). "Last July's NMHC survey, however, has given us optimism that borrowing costs may have reached a plateau and might even edge down a little bit."

Strong demand spurs growth Even though possible rises in borrowing costs have caused some concern, strong demand may continue driving the multifamily housing market's growth. "We expect the multifamily sector to remain strong in the foreseeable future mainly because of the continued demand for new construction financing," says Bernard "Bud" Malone, president of Dallas-based Malone Mortgage Co., which focuses on the Southwest market. "Because the phone keeps ringing, we haven't needed to go out and promote ourselves."

However, Malone's optimism doesn't reach into every regional market. On recent deals over the last four years, Malone Mortgage has increased its due diligence on all prospective projects and especially in markets that have begun to soften. "To some extent, demand has been met in parts of Phoenix, and we're watching Houston very closely," notes Malone. "Until downtown Fort Worth gets some absorption of existing units, that market has been sated as well."

On the other hand, Malone sees Austin and San Antonio, Texas, selected areas throughout Florida and parts of the Dallas Metroplex as areas with multifamily lending potential in the moderate- to upper-income bracket.

While some lenders are cautious about certain areas of the country, Jeffrey S. Juster, president and CEO of Newport Mortgage Co. LP, Dallas, which has a servicing portfolio that exceeds $1 billion, says there are no areas in the country in which his firm is hesitant to do business. "We might be cautious of an economic trend in a submarket, but today we primarily look at the number of projects in the area we're looking at," he says.

Cleveland-based Key Commercial Real Estate, which expected to generate more than $2 billion in construction and interim financing loans for multifamily developments in 2000, considers multifamily the strongest sector today. Key Commericial Real Estate is a subsidiary of KeyCorp.

"I think multifamily is the strongest market when you compare it to the office or retail sectors," says John Case, senior vice president and managing director of Key Commercial Mortgage, a division of Key Commercial Real Estate.

Another lender, New York-based American Property Financing (APF), a Fannie Mae and Freddie Mac specialist that was on track to close more than $1.3 billion in multifamily financing in 2000, favors multifamily projects as well. "Fewer financings in all product types are being done, but multifamily housing continues to be the product profile of choice for the majority of lenders," says Van Provosty, senior vice president of APF.

While the multifamily sector is strong, the first signs of a tightening market might be surfacing. According to Case, the strength, experience, and equity of a developer, combined with the equity of the project, the loan-to-value ratio and the projected lease-up are more stringently reviewed than ever before by lenders such as Key.

Consequently, fewer projects receive construction loan financing.

"From our perspective, we know what we can achieve in the way of a permanent loan, but I see other banks are only doing the open-ended construction loan with the hopes there will someday be a permanent loan in place," says Case. The difference between the permanent and construction loan amount is the equity the developer must contribute or raise.

"We're not going to gamble at the end of the day that rents are going to rise during the development cycle and in turn that will help enhance our permanent loan," adds Case. "So we want all parts of a deal identified before we even start a project. This might slow us from doing more projects, but it assures we've got everything covered upfront."

Juster echoes that point. "If there's one thing that's more prevalent today than in the 1980s, it's that lenders are much more disciplined," he says. "Plus, there's a lot more information available about how permanent markets operate and exactly how the take-outs are going to work when the construction period ends and lease-up occurs. This process alone has to slow up a lot of transactions."

Dan Charleston, regional vice president of Chicago-based Capri Capital, which services a $3.5 billion portfolio of almost exclusively multifamily properties, offers a different perspective. "Capital suppliers would love to be doing deals, but capital is being priced fairly, in my opinion, and that means not all the available capital is being put out there," he says.

Consolidation craze Industry consolidation of multifamily lenders continued in 2000, and more acquisitions and mergers are expected this year. Bigger company infrastructures are now favored by lenders that are attempting to offer customers a one-stop shop of comprehensive financing products.

A recent consolidation example is KeyCorp's acquisition of Dallas-based Newport Mortgage Company LP. KeyCorp still is absorbing a recent acquisition of National Realty Funding to strengthen its CMBS origination and loan-servicing capabilities. KeyCorp, which is one of the nation's largest financial services companies, with $85 billion in assets, also recently acquired Cleveland-based McDonald Investments, an investment banking and brokerage firm, and brought the company into its newly realigned commercial real estate division.

Meanwhile, the proposed Newport deal will add another dimension to KeyCorp's ongoing strategy of developing a national mortgage finance company. Newport, which specializes in the origination, underwriting, funding and servicing of multifamily real estate loans under Fannie Mae, Freddie Mac Program Plus and other agency programs, will enhance Key's expertise in the multifamily sector, which represents nearly 30% of the $7.5 billion in total financing by its commercial real estate group.

The growing complexity of multifamily projects also is leading the trend toward consolidation. Developers are running into more challenges that demand a wider array of financial products and services from lenders. Therefore, more lenders are merging with each other to create comprehensive packages of services.

"From a macro point of view on the finance side, we're expecting the next three to five years of permanent financing to be slower than it was in the late 1990s," explains Juster, who will assume the title of agency director for KeyCorp once the acquisition is consummated. "There was a tremendous amount of refinancing activity that occurred between late 1996 and early 1999. The velocity of transactions literally doubled from the same period before. As everyone knows, the majority of permanent mortgages that get done today have lock-out, defeasance or yield maintenance requirements, which makes it very difficult to prepay in the early stages of the loan."

"Having a large national company provides for very beneficial economies of scale and almost creates a brand identity in today's market," adds Juster. "A company with a reputation of building a quality community that is a good place to live develops a brand identity that attracts tenants."

According to Juster, the branding trend is evident among companies such as JPI, an Irving, Texas-based multifamily developer that manages and/or leases more than 24,000 apartment units with another 17,318 currently under development. Cleveland-based Forest City Enterprises, a $3 billion real estate firm with a portfolio of more than 200 retail, residential, office and hotel properties in 21 states, is another example of the branding trend.

Big Creek Apartment Community, a 244-unit complex in Parma Heights, Ohio, serves as an example of how a developer's brand recognition can help lease-up a project. According to Case, the project's success was partly due to the high-profile brand recognition of Forest City Enterprises, which co-developed the property with Goldberg Cos. of Beachwood, Ohio. Key financed the project through a $12.5 million Fannie Mae construction loan secured under a 30-year amortization.

CMBS consolidation The banking industry isn't the only market facing consolidation. The CMBS market is decidedly different than it was 18 months ago. Consolidation in banking, brokerage and money management, combined with the exit of smaller conduit companies, is giving multifamily lenders fewer choices and more standard pricing, according to Capri's Charleston.

Many industry members hoped the Paine Webber purchase by Swiss banking giant UBS for $16 billion in 2000 was an isolated case of brokerage acquisition. However, multifamily lenders now fear the brokerage business might be entering a trend of merger mania if New York-based Donaldson Lufkin & Jenrette's agreement to be acquired by Credit Suisse First Boston for $11.5 billion is an indication of what's evolving.

The speculation is that other companies ranging from large investment banks to mid-sized retail brokerages will become possible targets of worldwide financial-services companies that find mergers and acquisitions are cheaper means of growth than building from within.

Nevertheless, the trend is a concern for multifamily lenders that depend on a large selection of choices to get the most competitive prices.

"You could call five conduit companies in 1999 and get five substantially different prices with usually one clearly being the cheapest," says Charleston. "Now there are fewer companies to call, and the deal you finally get today isn't as good as a deal you got in 1999."

Unaffordable housing Although the state of the multifamily industry is healthy, some lenders claim the disappearance of affordable housing is one problem that's lurking on the horizon.

In Dallas as well as other big cities, the cost of land and construction, along with higher interest rates compared with two years ago has put affordable housing out of reach for many lower-income families, according to Malone.

Additionally, the U.S. government's trend toward decreasing housing subsidies for welfare recipients has sent multifamily rents out of the affordability range, says Malone, whose firm services an $850 million portfolio. "We think there's a housing affordability problem that's growing nationwide."

According to an article in the Dallas Business Journal, average rents in Dallas rose by 17.1% from 1995 to 1999. Consequently, about 30,000 Dallas households now use more than 50% of their incomes to pay for housing, while the Department of Housing and Urban Development (HUD) considers housing to be affordable only if it consumes no more than 30% of household income.

Although rents and household income appear to be moving in opposite directions, Malone Mortgage believes it has found a meaningful way to help lower-income families. The company combines agency lending, such as that provided by the Federal Housing Administration (FHA) and Government National Mortgage Association (Ginnie Mae), with tax-exempt bond financing that's available to non-profit groups. "We're trying to combine the programs to achieve savings on interest rates on the mortgage loan as well as the savings on ad valorem taxes, which can often be waived," says Malone. "This combination might enable projects to offer lower rents by offsetting the fixed costs of land and construction."

With rents for new multifamily housing projects averaging $1.05 to $1.10 per sq. ft., Malone believes the tax-exempt bond and Ginnie Mae financing will offer more affordable rents that range from 65 cents to 70 cents per sq. ft.

Hurst Manor Apartments in Hurst, Texas, serves as an example of the benefits of this kind of financing. The suburban Dallas property was reorganized into 112 rental units by a non-profit affordable housing developer, American Housing Foundation based in Amarillo, Texas. Malone provided a major rehab loan through FHA that guaranteed both construction advances and permanent loan totaling $2.9 million. The project reopened early last year and now stands at 100% occupancy.

"We turned around what was a rundown property with a history of drug-dealing problems into a decent place to live," says Gary Moore, asset manager for Malone Mortgage.

However, the process of combining tax-exempt bonds with agency financing was no easy task. Malone, who had more than 20 years of experience in real estate law before founding Malone Mortgage, found the financing process nothing like any other real estate project he previously participated in. Compliances required by the bond council, investment banking houses and HUD were difficult, according to Malone. "But now that we understand the process, I think future projects will be easier," says Malone.

While Hurst Manor Apartments is an example of affordability, Malone thinks recent requests he has received from metropolitan housing agencies for rates of 40 cents and 50 cents per sq. ft. are impossible to meet. "This type of project (Hurst Manor) made sense at 65 cents to 70 cents per sq. ft. for middle- and lower-middle income families, but I don't see any kind of financing strategy that's going to help families in the low-income bracket," notes Malone.

Capital improvement reserves (CIR) and their collection is another important matter in the multifamily housing arena. According to Juster, every lender collected CIR five years ago, but that isn't the case today. "Depending on the strength of the developer and the good condition of newer projects, a lender will underwrite the number, but he or she will waive the actual collection of the CIR," says Juster.

Fannie Mae, Freddie Mac and other agency programs still are popular with multifamily lenders. Capri Capital recently used a Fannie Mae program to arrange $15.3 million in financing for Saratoga Apartments in Alpharetta, Ga., in June 2000. The 284-unit garden apartment complex was acquired by Chicago-based TVO Realty. The deal was financed with a first mortgage of $11.8 million through Fannie Mae's Tax-Exempt Bond Substitute Credit Enhancement program, plus a conventional adjustable rate second mortgage.

The credit enhancement of the lower, floating tax-exempt bonds is for a 25-year term. It was structured to require interest-only payments for the initial 10 years of the term. The bonds mature on Oct. 1, 2025. The second mortgage carries a 10-year term with a 30-year amortization and floats over the London Interbank Offered Rate (LIBOR).

APF's refinancing of Fresh Meadows Development, a 3,285-unit affordable housing property in New York's Queens borough, shows agency lending at its best. The property is owned by affiliates of The Witkoff Group, Cammeby's International Ltd. and Insignia Financial Services, all of which are based in New York. The $152.5 million taxable floating-rate refinancing is the largest single-asset transaction in Fannie Mae's Delegated Underwriting and Servicing (DUS) history.

While most industry members expect the multifamily market to remain strong, going forward the financing process should become even more stringent. According to Provosty, the marketplace is definitely experiencing compression.