In the lending world, Fannie Mae and Freddie Mac are household names that drive the multifamily housing market. Consider that in 2000, Fannie Mae purchased $13.5 billion in multifamily mortgages from lenders, while Freddie Mac purchased $7.1 billion worth of those mortgages.
This is good news for the 35 million families renting apartments in the United States, and for the lenders whose funds end up touching Washington, D.C.-based Fannie Mae and McLean, Va.-based Freddie Mac, in one way or another.
Steven Fayne, a managing director at ARCS Commercial Mortgage Co., San Francisco, said both programs continue to play an increasingly important role in the multifamily housing sector.
“Fannie Mae and Freddie Mac provide a stable, predictable source of capital to the marketplace during good times and bad,” he said. “They provide tremendous liquidity and they serve the interests of both the renter and the debt markets.” ARCS, he added, chooses to participate in Fannie Mae instead of the Wall Street conduit market.
“We could choose to be involved in the conduit side. The Street tends to be very fickle and not as predictable. Fannie Mae and Freddie Mac are predictable investors,” Fayne reiterated.
So, who are these multifamily housing entities with the familiar names, and how have they become so important to the multifamily housing industry?
Meet Fannie Mae
Fannie Mae provides liquidity to the multifamily housing business through a nationwide network of carefully screened correspondents called Delegated Underwriting and Servicing (DUS) lenders. Under its corporate charter, Fannie Mae cannot originate loans directly. Instead, the company deals exclusively with DUS lenders that underwrite and extend the loans, and in turn sell them to Fannie Mae, which must purchase the loans under the DUS agreement. While the number of DUS lenders changes from time to time, the current network consists of 25 companies.
Fannie Mae operates under a unique business plan that enables the DUS network to make lending decisions without Fannie Mae's prior review and approval. To insure this system, the DUS lender must guarantee a portion of each loan, according to a scale specified by Fannie Mae.
In the event of a default, the DUS lender covers the first 5% of the loan amount, according to Jeffrey S. Juster, senior vice president and agency lending director for Cleveland-based Key Commercial Real Estate, a DUS lender. The DUS lender must make good on 25% of the next 20% of the loan amount. For additional losses, the lender holds a 10% payment responsibility.
If an entire building were lost, with no insurance and no collection, a highly unlikely scenario, the DUS lender would lose a maximum of 17.5% of the loan amount.
“The first 5%, called Level I loss sharing, gives the lender a very strong incentive not to have the deal go bad in the first place,” Juster added.
The loss-sharing system coupled with the careful selection of DUS lenders, rigorous underwriting and due diligence guidelines make the system work.
Fannie Mae's underwriting guidelines include specific occupancy rate, loan-to-value and debt-service coverage criteria, while due-diligence examinations typically include property condition and property-valuation reviews. Due diligence also includes investigations into the quality of the property's management.
As a result, Fannie Mae's $65 billion multifamily portfolio boasts an extremely low loss rate. According to the company's annual report, serious delinquencies totaled 0.05% of loan dollars in 2000.
The Freddie Mac way
Freddie Mac takes a different approach to the business of providing liquidity to the multifamily housing markets, by exercising prior approval. In other words, Freddie Mac does not delegate underwriting responsibilities but reviews and approves individual loans.
That said, Freddie Mac, like Fannie Mae, works with a network of correspondents, called Program Plus lenders, that bring in the deals. The prior approval system relieves these correspondents from any responsibility for risk sharing. Since Freddie Mac makes the final lending decisions, Freddie Mac takes the risk. Freddie Mac's Web site currently lists 35 Program Plus correspondents.
While Fannie Mae's DUS lenders all operate nationally, Program Plus lenders receive state and regional authority from Freddie Mac. “We're more focused on geographic representation,” said Mitchell Kiffe, a vice president with Freddie Mac. “Our view is that multifamily mortgage origination should be driven by market knowledge and an understanding of local market dynamics. So we deal with lenders with this kind of expertise.”
A number of lenders work as both a Fannie Mae DUS lender and a Freddie Mac Program Plus lender. Key Commercial, for example, has worked as a DUS lender for many years. In September 2000, the company became a Freddie Mac Program Plus lender as well, following the acquisition of Dallas-based Newport Mortgage, a commercial finance company specializing in multifamily lending through DUS, Program Plus and the Department of Housing and Urban Development.
Fannie vs. Freddie
Historically, Fannie Mae has held a dominant share of the annual multifamily business. But Freddie Mac's market share has climbed steadily. Both agencies compete fiercely for business these days.
According to DUS and Program Plus lenders, both agencies typically apply a 90/90 rule, meaning that the agencies want a property to be stabilized to the extent of having 90% occupancy for 90 days prior to the funding of a loan. A typical maximum loan-to-value is 80%, and typical debt-service coverage is 1.25. Both offer terms from five to 30 years, with 30-year amortizations. Both agencies offer risk-based pricing programs for loan requests above and below 80% loan-to-value. It is at this point that differences begin to emerge.
Fannie Mae's risk-based pricing scheme assigns deals to one of five tiers, with tier one handling transactions considered riskier than tier five.
Freddie Mac uses a linear programming model for pricing. This model factors in all the different variables and allows qualitative judgments about issues that don't enter into pricing decisions with Fannie Mae, Juster noted. For example, a borrower with a large net worth or a borrower that leaves a lot of cash in the deal might receive a lower-priced loan offer from Freddie Mac.
Freddie Mac presses this advantage with an early rate-lock program. “If a customer comes to me with a project that is built but won't be leased up for 10 months, I will think of this as a good Freddie Mac candidate,” said Van Provosty, senior vice president in the Atlanta office of New York-based American Property Financing Inc., a DUS and Program Plus lender. “Freddie will lock the rate today for a closing within 10 months. Whereas with Fannie Mae, we would have to buy a hedge against that rate to insure the rate in 10 months, which would add cost to the deal.”
Provosty noted that the early rate lock doesn't necessarily mean that the Freddie Mac offer will beat a Fannie Mae offer. “I will still price both so the customer can consider all the options,” he said.
By way of illustrating the competition between Freddie Mac and Fannie Mae, Juster of Key Commercial said that Fannie Mae is currently developing an early rate-lock product.
Freddie Mac recently introduced an adjustable rate, multifamily product pegged to Reference Bills, which Freddie issues in the capital markets as corporate debt. The Reference Bill index maintained by Freddie Mac acts as an alternative to London Interbank Offered Rate (LIBOR) pricing. Another new Freddie Mac program enables the agency to buy first mortgages that include mezzanine financing within the capital structure.
Both Freddie Mac and Fannie Mae provide second mortgages as well. At the same time, Fannie Mae has programs that Freddie Mac doesn't offer. For example, Fannie Mae offers a market-rate, forward commitment program. “This lets us make a forward commitment to fund a fixed-rate loan on a project to be built — which can't be funded until the project is completed and leased,” Juster said. “The program enables the borrower to control rate risk.”
While Freddie Mac has no formal forward commitment product, the agency is working toward one. “We are increasing our forward lending activity,” said Kiffe of Freddie Mac. “We have a pilot program to do forward commitments on tax-credit properties.”
In another Fannie Mae product category, Provosty has used a loan aggregation product to fuel a deal for a student housing property located near the campus of Louisiana State University in Baton Rouge. The customer, a developer, wanted to rehab the property, Provosty said.
Starting with bank financing, the customer undertook the rehab and turned the rent rolls, believing this would enable him to raise rents, improve his net operating income, and then acquire more money on a permanent financing deal.
The borrower wanted $4.15 million. In looking at the deal, Provosty decided it would be advantageous for the borrower to take a conduit-type loan. “Fannie Mae has a product called an aggregation loan,” he said.
“Essentially, it's a Fannie Mae conduit loan. If a property has a few quirks and doesn't fit within the basic Fannie Mae guidelines, the aggregation product offers more flexibility,” Provosty said.” For example, a borrower can obtain credit for a little more income than the regular program might offer.”
The borrower opted for the aggregation product, despite the higher interest rate, because the loan amount met his needs. According to Provosty, Freddie Mac would probably have financed the deal, but at a lower loan amount.
Lenders that work with both Fannie Mae and Freddie Mac hesitate to pigeonhole either in terms of deals. Most seem to think, however, that Fannie Mae programs generally compete more aggressively for borrowers focused on loan dollars over interest rates, while Freddie Mac programs compete more aggressively when pricing is critical.
Both Freddie Mac and Fannie Mae primarily handle smaller deals that average around $8 million. However, both get involved in some larger deals as well.
In the first quarter of 2000, for example, Bethesda, Md.-based Green Park Financial, a DUS lender, originated the largest deal that Fannie Mae had completed up until that time. Green Park provided $630 million for the $1 billion privatization of Dallas-based Walden Residential Properties, said Herman Bulls, president of Green Park.
“This was a credit-facility transaction, which is one of the products that Fannie Mae offers. Credit facilities are useful with cross-collateralized pools of assets,” Bulls said. “Typically, credit facilities are not highly leveraged, running perhaps up to 65%. But they are designed to give flexibility to the borrower in terms of substituting, re-leasing and adding properties.” Green Park has also arranged credit facilities for Smith Trust and United Dominion Realty, two REITs with substantial multifamily holdings.
“These are atypical deals,” Bulls said. “Typical transactions probably range from $6 million to $9 million. We'll do 80 to 100 of these transactions in a year, both new deals and re-financings.”
Freddie Mac will fund large deals as well. In the middle of May 2001, Key Commercial completed a $202 million Freddie Mac Program Plus transaction with Denver-based Archstone Communities Trust. The financing enabled Archstone to finance loans on 11 multifamily properties across the U.S. The properties were sold to a joint venture that included Archstone. Individual properties in the transaction averaged about $18 million.
Archstone took the deal to both Fannie Mae and Freddie Mac, using different lenders for each application to maintain competition. Archstone asked Key Commercial to wear only its Freddie Mac hat this time around. “The request for the quote came in on a Friday, and we had all the information by Friday night,” Juster said. “Our staff worked the weekend and finished 11 underwriting assignments over the weekend, sending the information to Freddie Mac on Monday morning. By Tuesday morning, we had the quote.”
Some details remain confidential. Archstone declined to disclose the Fannie Mae quote.“On any given deal, each agency can be strong,” Juster said. “I do know that the client picked Freddie Mac's offer because the pricing was superior in this case. Freddie was very aggressive on this deal in terms of pricing and on some of the ancillary terms and conditions, which included substitution rights and re-lease provisions.”
Freddie Mac also agreed to the client's desire for an interest-only 10-year deal, a nominal loan-to-value of 70% for the total portfolio and an early rate lock. Archstone's strong operating history played a major role in developing the attractive pricing scheme for the deal, Juster said.
“The mortgage bankers involved in the deals are critical to the transaction. They bring in the relationships, while Fannie Mae and Freddie Mac bring inexpensive money.”
— Jeffrey S. Juster
Key Commerical Real Estate
Lenders make it work
In the end, it's important to remember that neither Fannie Mae nor Freddie Mac loan money. The DUS and Program Plus lenders make the loans, which the agencies then purchase and in the process restore liquidity to the capital market.
“The mortgage bankers involved in the deals are critical to the transaction,” Juster said. “They bring in the relationships, while Fannie Mae and Freddie Mac bring inexpensive money. Together, they enable affordable housing to be built and refinanced.”
The Archstone deal put together by Key Commercial and Freddie Mac exemplifies this. The deal worked because the bank has REIT and permanent lending divisions. Key Commercial, meanwhile, is a full-service lender that offers many types of loans.
Such broad funding capabilities lead to long-standing relationships with customers. And when customers have multifamily business to transact, they typically go to broadly capable lenders on a first-name basis with Fannie or Freddie.
Mike Fickes is a Baltimore-based writer.
The low cost of Fannie Mae and Freddie Mac money
Fannie Mae and Freddie Mac funds carry such low interest rates that many industry players assume that the federal government guarantees the money. It doesn't.
As independent, private corporations, neither Fannie Mae nor Freddie Mac can fall back on any explicit government guarantees. So how can these agencies provide money at such low cost? Perception, according to industry observers.
Jeffrey S. Juster, senior vice president and agency lending director for Cleveland-based Key Commercial Real Estate, a Delegated Underwriting and Servicing (DUS) and Program Plus lender, calls this perception an implicit guarantee by the federal government. “When investors buy Fannie Mae or Freddie Mac bonds, they view those bonds as carrying the highest possible rating. In fact, these bonds trade better than triple-A bonds — not quite as good as Treasuries, but close.”
This kind of perception in the marketplace reduces the agencies' cost of funds by several basis points. Both Fannie Mae and Freddie Mac are religious about passing those savings on to borrowers to build housing, Juster said.
Van Provosty, senior vice president with New York-based American Property Financing Inc., agrees. “The marketplace dictates rates,” he said. “And what someone perceives you to be is what creates rates in the market. The people at Freddie Mac and Fannie Mae and their Program Plus and DUS lenders have been in the business for a long time and been very successful. The market responds to these strengths by providing low rates.”