First lets talk about who makes these loans. These loans are made by one of a few select small loan lenders and then are either sold to Fannie Mae or are sold as Fannie Mae guaranteed mortgage-backed securities. Because Fannie either buys the loans or guarantees the bonds backing the loans they must follow Fannie Mae guidelines. According to the Fannie Mae web site there are 12 Market Rate Small Loan Lenders. However, not all of these lend in every market and many are really not active in lending today. My experience shows that there are really 4-5 lenders who are actively pursuing this business. These lenders predominantly work through mortgage bankers/brokers and do not work directly with borrowers.
Let’s take a brief look at the program. The basic program terms (listed below) are very similar to the standard Fannie Mae DUS program. These are long-term fixed rate balloon mortgages with excellent rates, but a harsh prepayment premium.
Loan Amount: $500,000 – $3,000,000 ($5,000,000 in major markets)
Loan Term: 5, 7, 10 or 15 year terms
Amortization: Typically 30 years, but shorter amortization is available
Loan to Value Ratios: Up to 80% LTV, but 75% is more typical
Debt Coverage Ratios: Over 1.25x, based on a floor underwriting rate
Pricing/Rates: Risk based pricing based on the properties LTV and DSCR
Personal Recourse: Non-recourse is available in major markets, but recourse is sometimes required. Recourse is typically required in other markets
Prepayment Premium: Typically Yield Maintenance; Step-down prepayment premiums are available for a cost.
While these are the basic terms, it must be understood that these terms are not offered on every deal or in every market. Most lenders are only interested in making these loans in major metro markets. Loans are available in smaller markets, but typically on more conservative terms and not with every lender. Also, while Fannie Mae has guidelines some lenders are more conservative than Fannie and won’t make certain loans even if they fit the guidelines. Others stick to the letter of the law and won’t ask Fannie for a waiver of the guidelines when it might be warranted.
The Process – The first thing to understand is that these loans have a process and they require a bunch of documentation. These lenders do not issue a commitment or lock rate until all the reports are in and all the underwriting is complete. However, once the commitment is issued rate lock and closing can be done quickly. As a general overview of the process the lender will review some basic information about the properties historical income and the borrower’s financial situation and then issue a quote or application. This application will not guarantee the borrower anything, but is an indication of what the lender believes they can do. If the borrower likes the quote they will sign the application and provide the lender with an application deposit. The lender will request a number of other documents from the borrower and will order the appraisal and other reports. Once the reports are in and the borrower has submitted all the required documentation they will complete their underwriting and issue a commitment. Total time from application to commitment is typically 45-60 days. After the commitment is accepted and the borrower posts a good faith/rate lock deposit (1%-2% of the loan amount) the lender will lock the rate and quickly close the loan.
The biggest issue in the process is the amount of paperwork that the lender will request. They will ask for organizational documents, personal financial statements, copies of bank statements, real estate schedules, property income and expense statements for 2-3 years, trailing 12 month income and expense statements (though you can get away with just income), copies of leases as well a numerous forms. These are required and there really are no shortcuts. You need to give them this information when they ask for it in order to get your loan. On a positive side they don’t require tax returns which most banks require. The process will go smoother with a mortgage broker/banker who has experience with this program and if you have a good attorney who is brought on board at the beginning. However there is no way to eliminate the paperwork or process. Just go with the flow and know that in the end you will get a good loan.
Rates – The rate is determined by a number of factors including the LTV and DSCR (based on the actual rate or a floor underwriting rate) on the property as well as the loan size and term. Because of this you may get different quotes from different lenders depending on how aggressive they are in both their preliminary (quoting) underwriting and in their final underwriting. Some lenders will be much more aggressive on their preliminary underwriting in order to get a borrower to sign an application, but may not deliver that quote at commitment. The rate may also consist of pricing add ons for different features or fees to the lender or broker. There are also pricing add ons based on loan size with smaller loans having higher prices. It is hard to determine what add ons have been charged and if the lender or broker is taking excess premium (up front income from sale of the loan). If you ask your broker/banker about the rate build up, they should be able to give you an idea of how the rate is created.
Since the rate on these loans is not locked until after commitment the rate can change. When getting a quote a lender will give you the current rate as well as a spread on the loan. While the spread is not locked it should not change much during the process. Having the spread allows you to track the rate. If, when you get the commitment, the spread is different than on the quote you should ask about this to understand the differences and what occurred.
Costs – The transaction costs on these loans vary by market and lender. The processing of these loans costs lender almost as much as on a larger Fannie Mae loan. The lender must pay for their staff, an appraisal, physical needs and environmental reports and lender legal. These costs often run well over $10,000 per loan. Some lenders are taking a deposit at application and charging actual costs of the appraisal, engineering report, and lender legal to the borrower. However, most are capping their fee at the amount of the application deposit and paying for any additional costs by increasing the rate. Today most lenders are charging a deposit $4,500 in major markets and up to $8,500 in smaller markets.
In addition to the transaction costs on these loans you will have to pay for title, possibly a current survey and your own legal. These costs vary by market and property. The other cost of the transaction is the origination fee. The lender themselves will charge some fee, but this is often built into the rate and is not identifiable. However, the mortgage broker or banker showing you this loan needs to make a fee. This can be paid as a direct fee or as additional rate into the loan. Depending on the loan term, amount of fee being added and LTV the add-on can increase your rate by ½% or more. I encourage you to ask the broker/banker if they are getting paid by the lender and if so how much the rate has been increased for their origination fee. Typically brokers will make 1% of the loan amount (1 ½% for some smaller loans). If you are getting charged more than that you should check around or give me a call. Mortgage brokers/bankers should get paid for their work because they do provide you value, but that does not mean they should overcharge you for their services.
Underwriting – The underwriting of these loans is also a bit different than most small multifamily owners are used to. The income and expense analysis is straightforward. The lender looks at the current rent roll, adds in miscellaneous income and applies a vacancy rate to get their underwritten effective gross income (EGI). Today lenders will be very careful to compare the EGI to historical collections and may ask for a trailing 12 month statement to show collections for the last 3, 6, 9 or 12 months. If the trend is not favorable then the lender may underwrite a more conservative vacancy figure. Expenses are underwritten based on the last full year’s expenses and what the appraiser says are stabilized expenses for the property. Additionally a replacement reserve figure is underwritten based on the engineer’s estimate of replacement over the life of the loan. This is typically $250-$300 per unit per year, but can be higher on older properties and is often the number most understated at preliminary underwriting.
The borrower and borrowing principals are also carefully underwritten by the lender. They are looking for borrowers with FICO scores over 680 (over 720 is better) and who have strong financial strength. Typically they want to see borrowers with a net worth greater than the loan amount and liquidity greater than 9 months of loan payments (principal and interest). This was recently raised from 6 months. Lenders will verify liquidity by requesting bank statements and will only consider liquidity they verify as legitimate. The other borrower item underwritten is their global real estate schedule. The lender will require a complete real estate schedule listing all properties, their current loans and current income and expense. They will analyze the borrowers’ global cash flow and make sure there are no properties with either risky ballooning mortgages or significant negative cash flow.
One additional item to consider in underwriting is the engineering report/analysis. Each lender has someone look at the physical condition of the property. This may be an engineer or just a property inspector. This person will determine what items at the property are not in good condition and need to be repaired or replaced. They will also estimate the costs of capital improvements over the term of the loan and thus the replacement reserve used in underwriting. This is probably the biggest difference between this type of loan and a typical bank loan. Be prepared, the lender may make you repair/replace some items before closing or within a few months of closing. This does not mean you are running a bad property; it’s just that they are looking at this as a loan for a long term and want to make sure there are no life-safety issues that could cause a problem and that the property is maintained in good condition. One way to avoid this issue is to make sure the property is in its best condition before an inspection and to know about the property so any questions that occur are answered quickly and thoroughly.
Why this loan – With all these requirements why should I even consider this loan. Well the main reason is a long-term loan at very low fixed rates. Most of these loans are for 10 years with the rate fixed for the term of the loan. There are not many lenders willing to offer long-term loans on smaller properties. Also, the rates are very attractive. For most of 2009 the rates being offered on these 10 year loans were a good 1/4% lower than rates on 3 or 5 year loans being offered by banks. And for shorter term loans such as a 5 year loan the rates are often ¾%- 1% lower than bank offerings. The real bargain if for lower LTV – higher DSCR loans where the risk based pricing offers very low pricing. Additionally, today many banks are only lending 70%-75% LTV while these loans are typically 75% LTV, sometimes up to 80%.
The second reason is these are often non-recourse loans. Banks are almost always recourse lenders. This means if the deal fails and you default on the loan they can go after your personal assets to pay the loan (this varies based on local law). On a non recourse loan they can only take the property leaving all your other assets protected. This is especially important for someone with investors and therefore does not own the whole property.
From my perspective the biggest negative of these loans is the prepayment premium. These loans almost always carry a yield maintenance prepayment premium. I won’t explain how that works here, but let’s just say it means you should not expect to pay off the loan until shortly before it matures. You can pay it off, but the premium (penalty) may be very high. Smaller owners are used to a step-down prepayment premium. This way you know the amount of the prepayment premium and you have some flexibility if you want to sell. Such flexibility is nice, but it comes at a cost. If you want a long-term loan and this type of rate this is the cost of obtaining it. These lenders can offer you a step-down, but the rate is much higher. The loan still allows you to sell the property and have the new owner assume this loan, so you are not totally stuck, but your flexibility is limited.
Things to watch –
- Understand the quote before you decide to take the loan. Talk with your broker and make sure you are considering all the issues when comparing this to another quote. One item to evaluate is that these loans are quoted with an actual/360 calculation so the rate is not fully comparable to a 30/360 quote from a bank. Another issue is many of these lenders quote the loan on just the DSCR. They don’t cut the loan quote based on value, but state the maximum LTV for the loan. Make sure you are comfortable the value that is needed before you start the process.
- Know the costs of the deal. If you have to give a deposit of more than $4,500 in a major market or $10,000 in a smaller market you should know why. Also, make sure the costs are capped or spelled out. Finally, manage your own costs. While I believe you need an attorney to close one of these loans, they should understand that the documents are not negotiable so don’t waste time, and money, trying to negotiate them.
- Understand the rates/spread. There are lots of premiums being included in these loans to pay for the transaction costs and to make sure the lender is adequately compensated for their work. However, this leaves opportunity for lenders and brokers to overcharge you for your loans. Fannie does have some rules limiting the amount of premium, but don’t leave it all up to them, do your own work and ask about premiums.
- Know the lender you are dealing with. All of the lenders participating in this program are not the same and each treats things differently. Some will push for and can get waivers from Fannie and some wont. I suggest you work with a broker/banker who has experience working with more than one of these lenders so they can advise you as to which lender is best for your individual situation and property.
This article tries to explain the main issues and with this program, but there are lots of features and issues that I did not address. If you have more detailed questions on this program or want to discuss any specific deal please shoot me an e-mail at firstname.lastname@example.org or give me a call at 847-421-2217.