How Understanding the Lending Requirements from Fannie Mae & Freddie Mac Can Make You a Wiser Passive Investor

As a limited partner, your role in the life cycle of the deal is passive, but not on the front end.  You have a lot of due diligence to perform with what could be a significant investment in your portfolio – track record of the operator, the MSA, the property, the business plan, and the exit strategy, to name a few.  How about the debt structure? Considering that the lender is bringing up to 80% of the capital to the deal, their terms are going to have a tremendous impact on the outcome and your subsequent returns.

The two largest government-sponsored enterprises (GSE’s or “agencies”) providing capital for multifamily deals, Fannie Mae (FNMA – Federal National Mortgage Association) and Freddie Mac (FHLMC – Federal Home Loan Mortgage Corporation), now have the most attractive terms in apartment lending history.  Credit unions, banks, bridge lenders, commercial mortgage-backed securities, HUD, and even life insurance companies all offer multifamily products.  Agency debt may have the best and most flexible terms, but they also have stricter qualifications.  As a limited partner, understanding what agencies are looking for in a borrower, how they underwrite the property, and the details of the terms makes you a more informed investor. 

The purpose of this article is to focus on the general guidelines that are similar between agencies.  It is not to distinguish between Freddie and Fannie, or any number of the programs within each agency. 

Let’s break it down so we can be better investors, thereby finding the right passive investments for our risk tolerance and to boost our returns.

The Property

When it comes to the deal, the property is the most important factor determining Fannie and Freddie’s appetite.  They want to be in the “top markets”.  Top markets are identified by populations exceeding 60,000 people, with a significant portion of that MSA being renters.  The loan size must be at least $1 million.  They will lend up to 80% loan-to-value (LTV), and the property must meet a debt-service coverage ratio of at least 1.2. 

They are also looking for properties that are stabilized with a minimum physical occupancy of 85% (90% on a refinance).  Having 90% occupancy for 90 days is what’s considered an appropriate occupancy history to meet this criteria. 

If your sponsor plans to reposition the property by upgrading units and raising rents, they would have to bring capital for the rehab or access a supplemental loan, depending on the program.  Freddie Mac’s Small Balance Program, for example, will not finance improvements.   With that, some operators are using some form of a bridge loan on the front end of the deal, implementing their value-add strategy, and then refinancing into the agency loan when the property meets requirements.  This is why you, as the limited partner, should understand how these details affect the return of your principal, the risk, and the return on your investment. 

The Borrower

Fannie and Freddie love repeat borrowers.  A track record always gives a sponsor a leg up on the deal.  This is good news for you as an investor because you want to see an operator with a history of success as well!  However, since the property is the most important aspect of the underwriting process, it is possible to obtain an agency loan without experience.  Many times that will come in the form of the general partner teaming up with other operators who have closed deals.  As a limited partner, this is clearly an important detail in evaluating a potential deal and what parties are involved. 

Agency underwriters are not interested in the sponsor’s tax returns or their depository relationship with the bank.  They just want to feel comfortable that the sponsor team can handle the property and execute their vision. 

To ensure that, they require professional property management and prefer a sponsor who resides within an hour drive of the property.  Only the most experienced operators access agency debt for out-of-state deals by having a very clear vision of their operations plan.

The Terms

The details of the loan terms are where qualifying borrowers get very excited.  All loans are non-recourse.  That means the amount brought to closing for the down payment is the maximum amount that can be lost by the general and limited partners.  If the bank has to take the property back, they want to know the cash flow can support the operation, thereby limiting potential losses in that scenario.  

All loans are assumable, meaning that if the sponsor team sells the property, the buyer can take over the existing loan for only a 1% fee.

Currently, these loans can be financed at rates in the high 2% to low 3% range. That’s not a misprint!  Fannie and Freddie are doing their part to fund multifamily deals by incentivizing borrowers and keeping transactions flowing.

The maximum loan-to-value is 80 percent and the loan can be amortized up to 30 years.  The interest rate can be fixed or floating for five, seven, or ten years and interest-only options are available in the first few years depending on the LTV ratio.  If a general partner can bring 35% of the deal to closing, a 65% LTV would allow the borrower ten years of interest-only payments with a fixed rate.  This would not necessarily make sense in every deal; however it’s meant to illustrate the flexibility to meet the goals of the investment.  

The longer a rate is fixed, the higher the penalty for exiting the deal early.  Beware of yield maintenance, which is a prepayment penalty designed to protect lenders from declining interest rates.  If interest rates decline, a fixed rate loan is not as attractive, thus enticing the sponsor to refinance at a lower rate.  This puts the lender in a tough spot because they will lose a higher-yielding loan that will be replaced with a lower one.  Yield maintenance protects the lender, but will cost the borrower.  There’s always a trade-off in finance!  Be cognizant of the exit strategy and whether the financing used marries up to the overall life cycle projection of the deal.  If you’re looking at a value-add reposition with a 3-5 year exit plan, but have a 10 year fixed rate loan, it’s worth asking the sponsor what their rationale is. 

Tax escrows are required, and there have been a few changes in 2020 to protect lender downside in the COVID-19 era.  Insurance is also escrowed in addition to replacement reserves for properties with over 50 units.  This is prudent in today’s environment. 

 Wrap-up

We are all investors with completely different financial objectives and tolerance for risk. Understanding how agency debt is structured and the terms operators are accessing is imperative to successfully managing that risk.  Additionally, studying how interest rates move and affect debt markets on a macro-level is paramount for verifying pro forma reversion cap rates and how they affect the internal rate of return of the deal. 

Debt structure is one aspect of the deal. But it’s a big one.  Be sure you do your own due diligence on the leverage the sponsor intends to use.  After all, it could make or break the deal!

Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications.  Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room.  After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019.  Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties.  He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com

Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.

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