Eight things that impact the rate on your multifamily loan
Many borrowers think of Fannie Mae and Freddie Mac multifamily loans as commodity products that are a one-size-fits-all solution. They often wonder why their interest rate and terms might be different from a colleague’s. The fact is that there are many nuances to structuring the right loan for your investment objectives. While many factors play a role in determining the interest rate on your next multifamily loan, here are eight of the most important things you should know. For the purpose of this article, any reference to “pricing” pertains to interest rate.
Market
The location of the property drives pricing. Things like local economic trends, population, apartment supply and demand, employment growth and wages, as well as competition in specific markets, all play a role in driving the interest rate you pay.
Let’s use both Freddie Mac Small Balance Loan (SBL) program and Fannie Mae as examples.
Freddie Mac SBL divides the nation into five regions – South Central, North Central, Western, Northeast, and Southeast. These five regions offer different rates for multifamily transactions. They further classify markets into one of four buckets: Top, which offer the best pricing, Standard, which offers great pricing, Small, and Very Small. For those in Texas, Dallas is considered a Top market, Houston a Standard market, Beaumont a Small market, and markets like Lufkin or Nacogdoches, Very Small markets.
Fannie Mae has what they consider Strong, Nationwide and Pre-Review Markets. New York and San Francisco are two examples of Strong markets whereas Nationwide markets are any market not otherwise designated as being in a “Strong” or “Pre-Review” market.
Freddie Mac Small Balance Loan Regions
If you’d like to know in which market (Top, Standard, Small, Very Small or Strong, Nationwide, Pre-Review) your property is located, email the complete property address, including county, to tony.talamas@lument.com).
Loan Amount
Pricing improves for larger loans. For example, all other things being equal, Fannie Mae loans over $20 million will offer better rates than a $5 million loan. As the loan amount decreases and approaches the $6 million to $7 million threshold, you will see rates increase. This becomes even more obvious as you approach loan amounts between $1-3 million. The bottom line is that larger loans get lower rates.
Loan-to-Value (LTV)
- Lower LTV = Reduced Risk
- Reduced Risk = Better Pricing (Lower Interest Rate)
The higher the loan amount relative to the value of the property, the greater the risk associated with any unanticipated changes to value; and hence the higher the expected return (interest rate) for that risk.
Fannie Mae: Pricing discounts start at 65% and 55% LTV, which are known as Tier 3 and Tier 4, respectively. These Tiers also require higher DSCR ratios of 1.35x and 1.55x respectively.
Freddie Mac SBL: Pricing discounts start at 70% LTV and may be available for every five percentage points below 70% (i.e. 70% - 65% -60% -55% - 50% - 45%).
Debt Service Coverage Ratio (DSCR)
- Higher DSCR = Reduced Risk
- Reduced Risk = Better Pricing (Lower Interest Rate)
For those unfamiliar with this term, DSCR is your Net Cash Flow (or NOI) divided by total debt service payments. It is a measure of how much free cash flow is available to service debt.
DSCR = NOI / Total Debt Service
For example, a 1.20x/1.25x DSCR (the minimum depending on market and execution) means that your free cash flow is 1.20 – 1.25 times your total debt service payments. A higher DSCR means you have more wiggle room for unanticipated disruptions to your operations. Similar to the preceding point on LTV discounts, the lower the DSCR, the greater the perceived risk with any unexpected decreases to collections (think market pressure from new inventory coming online) or increases to expenses (think increases to real estate taxes or insurance); hence the higher the expected return (interest rate) for that risk.
Fannie Mae: Pricing discounts start at 1.35x and 1.55x respectively, which are known as Tier 3 and Tier 4 respectively. These Tiers also require lower LTV ratios of 65% and 55% LTV respectively.
Freddie Mac SBL: Discounts start at 1.30x DSCR and offer additional discounts for 1.40x, 1.50x, 1.60x and 1.70x DSCR.
Prepayment Structure
Fixed-rate Fannie Mae and Freddie Mac multifamily mortgages come with prepayment penalties. Prepayment penalties are designed to ensure that investors in mortgages (lenders/investors) receive a targeted return on their investment in the event that the mortgage is paid off early. It delivers some degree of certainty and stability for lenders/investors who rely on that income stream to deliver future certainty. Think of it this way. As an apartment owner-operator, you rely on a tenant to stay in his/her unit through the full term of a 6- or 12-month lease and not breaking the lease early. An early move out would be met with early termination fees.
The two more popular prepayment structures are Graduated Stepdown and Yield Maintenance. A graduated stepdown prepayment penalty is a declining percentage of the outstanding loan balance in each year. One example is a 5-4-3-2-1% in years 1-5, respectively, for a 5-year fixed-rate mortgage. There are many variations to this type of prepayment penalty structure that offer more or less flexibility. As a borrower, you should know that the more flexibility you structure in a mortgage (i.e. 3-1-0-0-0% on a 5-year fixed-rate term), the higher the rate.
The other type of prepayment penalty structure is Yield Maintenance. Yield Maintenance basically takes the present value of the remaining interest payments through maturity. It takes into account the actual fixed rate of your mortgage, current market rates at the time of payoff, outstanding principal balance, and the remaining term of the mortgage. It is a more accurate method of delivering investors/lenders the return on their investment in the event of an early payoff. On a side note, the higher that current market rates move relative to your fixed rate, the lower your prepayment penalty; and the lower they move relative to your rate, the higher the prepayment penalty. As you get closer to maturity and pay down principal, your prepayment dollar amount will decrease.
As for its impact on interest rates, yield maintenance delivers a lower interest rate than a graduated stepdown prepayment structure. This is due to its accuracy in ensuring more stable and predictable returns/cash flows to investors in the event of an early payoff.
Note: Many borrowers are not aware that graduated stepdown structures are available for Fannie Mae loans and are often structured for Small Balance Loans. Contact me at tony.talamas@lument.com to learn more.
Affordability
One of the primary missions of the agencies is to finance quality, sustainable, and affordable rental housing. As such, you’ll find that lower interest rates are generally available for multifamily properties with strong “affordability” components. While the term “affordable” includes Low-Income Housing Tax Credit (LIHTC) communities and properties encumbered by regulatory agreements, with respect to pricing (interest rates), “affordability” is not exclusive to such properties.
An affordable, market-rate project is one in which a certain percentage of multifamily units is considered affordable relative to the Area Median Income (AMI). Properties that have a high percentage of affordable units are eligible for big discounts to interest rates. Both Fannie Mae and Freddie Mac have different models to determine affordability. A licensed Fannie Mae DUS Lender and Freddie Mac Optigo Lender such as Hunt Real Estate Capital, can determine eligibility with a physical property address and rent roll that includes contractual rents per unit type (i.e. 1-, 2-, 3-bedroom).
(To see if your property is eligible for affordability discounts, contact me directly. Send the two items above to tony.talamas@lument.com).
Fixed-Rate Term
Fannie and Freddie fixed-rate mortgages are priced over U.S. Treasuries (UST). The most common being the 5-, 7-, 10-, and 30-year USTs. Without getting into detail, factors such as risk, fiscal and monetary policy, economic growth, and inflation all impact UST yields in different ways.
At any given time, investors/lenders will weigh economic data and compare perceived risk and returns on multifamily mortgages to alternative investments. This will drive their appetite for specific U.S Treasuries, changing the supply and demand curve for specific USTs and causing yields to fluctuate. For example, 10-year fixed-rate mortgages are currently priced lower than 5-year fixed rate mortgages in Texas; however, that’s not always the case. To keep things simple, fixed-rate terms determine rates.
Investor Demand
Economics 101 – Supply & Demand: The more borrowers there are in the market seeking loans from Fannie & Freddie (demand) relative to liquidity (supply), the wider the spreads and higher the rates. Conversely, the more available liquidity there is in the market (supply – i.e. lenders looking to make more loans), the tighter the spreads and the lower the rate.
Take Fannie Mae for example. Pricing is comprised of a gross spread over the corresponding U.S. Treasury. The gross spread is further comprised of Servicing and Guaranty Fees as set by Fannie Mae plus an Investor spread (Wall Street). Depending on what’s going on in the market, investors will evaluate the demand for multifamily mortgages to alternative investments, taking into consideration risk and rate of return. This will cause the supply and demand curve to shift, and spreads will move up or down accordingly.
Chart of the 10-Year U.S. Treasury Yield as of June 17, 2020
Written by Tony Talamas: Connect with me on LinkedIn
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