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Community Developments Investments (May 2015)

Secondary Market Options to Finance Small Multifamily Properties

This photo shows a four-story apartment building.Source: Thinkstock.
This photo shows a four-story apartment building.

Sharon Canavan, Community Relations Expert, OCC

One-third of all multifamily units are in small multifamily properties, which are an important component of the affordable rental housing stock for low- and moderate- income individuals.1 Although many small multifamily properties receive some form of government subsidy, unsubsidized units account for three-fourths of units with rents below $600. This article discusses the role of Fannie Mae and Freddie Mac in financing small multifamily properties.

Multifamily mortgage debt origination and investment is highly fragmented—although a handful of institutions holds about one-third of outstanding multifamily debt, the remainder is held in portfolio by almost 6,000 Federal Deposit Insurance Corporation-insured institutions.2 Figure 9 shows that although securitization plays an important role in supporting multifamily finance, unsecuritized portfolio holdings remain a significant source of multifamily investment. Commercial multifamily mortgage securitization, which virtually halted in 2008, is slowly recovering, and life insurance companies play a measurable role as multifamily investors.

Figure 9: 2014 Multifamily Mortgage Debt Outstanding (in Billions)

Figure 9: 2014 Multifamily Mortgage Debt Outstanding (in Billions)

Source: Mortgage Bankers Association.

There is less fragmentation in the multifamily housing lender segment that is focused on originations above $3 million. In contrast, small multifamily housing lending is much more highly dispersed among institutions, many of which view this business line as a complement to their broader banking business relationship with customers.3

Although small multifamily properties are commonly defined as those with five to 50 units, both Fannie Mae and Freddie Mac define small multifamily properties by loan size, ranging from $1 million to $5 million. Smaller properties with two to four units are also an important source of affordable rental housing, but are not the focus of this article; loans for these smaller properties are originated using Fannie Mae and Freddie Mac single family underwriting guidelines. (The sidebar to this article provides more information.)

In recent years, small multifamily housing loans have represented a limited segment of the total multifamily business activities of Fannie Mae and Freddie Mac, the two large government-sponsored enterprises (GSE), that provide a secondary market for residential mortgages. In 2013, Fannie Mae provided $28.8 billion in financing to the multifamily market, and small loans accounted for $2.3 billion, or 8 percent, of the total multifamily investment activity. In 2013, Freddie Mac provided $25.9 billion in multifamily financing on 1,600 loans. Freddie Mac’s total volume of loans in amounts of less than $3 million, or $5 million in high-cost areas, was $1 billion, or approximately 4 percent of its total multifamily production.

Challenges to GSE Participation in Small Multifamily Housing Finance

As secondary market investors, the GSEs’ role in providing liquidity to the multifamily market is an important one; however, they face a number of challenges in financing multifamily properties. These hurdles are particularly acute for small multifamily loans.

The characteristics of small multifamily properties make financing more challenging. More than half of the small multifamily housing stock is more than 30 years old and tends to have higher maintenance costs than larger properties. Although vacancy rates for smaller properties are only marginally higher than those for properties with more than 50 units, losses due to vacancy are higher for smaller properties. To manage these concerns, adequate reserves to cover temporary liquidity problems and meet anticipated capital expenses are even more critical for smaller properties.

Although individual borrowers are important contributors in the small multifamily arena, they have unique characteristics that present challenges to financing. In small multifamily properties with less than 25 units, borrowers tend to be individual property investors or smaller commercial enterprises that invest in just a few properties. Typically, in small properties with more than 25 units, the ownership structure involves more formal legal arrangements, such as limited liability partnerships, limited liability companies, or other types of corporate entities.

Individual small multifamily borrowers operate on thinner cash flow margins than larger property owners, and are exposed to higher income fluctuation risk when vacancies occur. Many individual borrowers do not have the resources to outsource the management of their properties; instead, they manage their properties themselves, which can impact the maintenance of the units or the speed of filling vacancies.

Accessing the secondary market is particularly difficult for individual small multifamily borrowers who often lack the deep pockets to meet secondary market underwriting requirements for minimum net worth, liquidity reserves, or escrowed reserves for capital expenditures. In addition, individual borrowers may not have audited financial statements to meet reporting requirements.

Evaluating these multiple factors not only adds to the complexity and cost of underwriting small-balance multifamily loans, but also limits the field of investors willing to purchase these loans. Due to a combination of unique factors that are typical of small multifamily loans, investors view the market as highly heterogeneous. In every loan transaction, all of the distinctive characteristics of both the property and the borrower must be considered. In many instances, these characteristics render a loan to a particular borrower, or on a small multifamily property, ineligible for purchase by the GSEs.

Variability in the small multifamily market segment runs counter to many of the inherent strengths of the GSEs’ securitization business model. The widely divergent characteristics of small multifamily loans make standardization, which is the hallmark of the GSEs’ secondary market securitization model, extremely challenging. It is far more difficult to securitize non-homogeneous loans. Credit rating agencies face the same hurdles in assessing a mortgage-backed security (MBS) offering that is secured or backed by small multifamily loans. Also, MBS investors expect the underlying assets to conform to specified standards, generate predictable revenue streams, and reflect a high level of credit performance.

Lenders operating in narrower local or regional markets may safely and soundly offer more flexible underwriting to small multifamily borrowers than the GSEs because their geographic focus helps them gain a considerable understanding of their communities and borrowers. Lenders in these communities, such as national banks and federal savings associations (collectively, banks), may actively originate small multifamily loans and then hold them in their portfolios. In 2013, multifamily originations by banks represented 39 percent, or $67.9 billion, of total multifamily originations. Bank and thrift institutions’ portfolio holdings totaled 30 percent, or $281 billion,4 of outstanding multifamily mortgage debt.5

GSEs’ Multifamily Business Model

The GSEs support multifamily lending needs generally by offering standardized multifamily underwriting on a nationwide basis. In particular, the GSEs’ multifamily programs provide a critical source of financing in smaller and regional markets that may not attract adequate sources of funding.

Before 2009, the GSEs’ multifamily business strategy relied heavily on purchasing multifamily loans, intending that they be held in portfolio. After the GSEs entered conservatorship in September 2008, however, they were directed to reduce their portfolio holdings by 10 percent per year. As a result, the GSEs rapidly shifted their emphasis to securitizing multifamily loans. Fannie Mae, which had an existing securitization product at the time, scaled up rapidly, so its multifamily securitization jumped from 17 percent in 2008 to 81 percent in 2009. Freddie Mac’s issuance of multifamily mortgage participation certificates and structured securities rose from $700 million in 2008, to $2.5 billion in 2009.

Today, securitization is still the primary way that the GSEs provide liquidity to the small multifamily market. In their roles as credit guarantors, the GSEs assure timely payment of principal and interest to investors. In 2013, virtually all of Fannie Mae’s multifamily financing was structured as MBSs. Similarly, Freddie Mac relies heavily on securitization—since 2012, less than 5 percent of its multifamily new loan volume has been held in its portfolio for investment purposes. Despite the shift in strategy from portfolio investment to securitization, the GSEs continue to support liquidity in the multifamily market, as demonstrated by the number of multifamily mortgages that they securitize each year.

Fannie Mae and Freddie Mac maintain business relationships with a small set of approved multifamily lenders that are capable of meeting capital and infrastructure requirements. The GSEs also manage their multifamily credit risk exposure by usually requiring their lender partners to assume a portion of the credit risk.

Even if a bank generally originates multifamily loans for its portfolio, from time to time an institution may need to manage its balance sheet for capital purposes or other reasons, so a secondary market execution for seasoned loans serves a valuable purpose. On a limited scale, both Fannie Mae and Freddie Mac purchase multifamily loans from other lenders on a negotiated basis. Freddie Mac evaluates the purchase or guarantee of bulk pools consisting of one or more seasoned multifamily loans. Similarly, Fannie Mae does a small amount of negotiated business with non-delegated underwriting and servicing (DUS) multifamily lenders. The GSEs’ credit loss risk sharing requirements, however, often dissuade lenders from partnering with the GSEs.

Fannie Mae

DUS lenders are approved by Fannie Mae based on an analysis of financial strength, experience with underwriting and servicing multifamily loans, and past loan performance. Once approved, DUS lenders are delegated the authority to underwrite, close, deliver, and service multifamily loans, in adherence with Fannie Mae’s credit and underwriting standards. The delegated authority results in streamlined loan processing. Fannie Mae oversees its DUS lenders on an ongoing basis.

Two dozen multifamily lending firms are currently approved under the DUS program, and these lenders deliver most of the multifamily loans financed by Fannie Mae. Any DUS lender is eligible to participate in Fannie Mae’s Small Loans Program, but only a small number of the DUS lenders actively participate. One DUS lender helps to expand access to secondary market solutions for non-DUS lenders by acting as a small loan facilitator. Although most DUS lenders are non-bank institutions, one-third of the DUS lenders are regulated financial institutions, and these banks provide 35 percent of Fannie Mae’s guaranty book of multifamily business.

A national bank or federal savings association that is not a DUS lender, but is interested in originating or selling small multifamily loans, can work with a DUS lender, either as a broker or correspondent. As a broker, an institution can negotiate a fee for referring a potential borrower to a DUS lender. A correspondent relationship with a DUS lender could be a better fit for institutions with a more robust multifamily presence. A DUS lender can negotiate the level of loan processing work that a correspondent lender does and the compensation, but the DUS lender always remains the counterparty to Fannie Mae.

When multifamily loans are delivered, Fannie Mae creates an MBS supported by the underlying multifamily mortgage or mortgages. A DUS MBS is typically backed by a single mortgage loan. A DUS MBS offers advantages for investors, including prepayment protection and competitive yields.

Fannie Mae’s DUS model is based on a shared risk approach. As a safeguard to ensure high-quality origination and servicing, Fannie Mae requires DUS lenders to share a portion of the credit loss in the event of default. “Pari passu” is the most common loss-sharing structure, in which the agreement requires the DUS lender to absorb one-third of the first loss on a pro rata basis, with Fannie Mae absorbing the remainder. The “standard” approach uses a tiered loss-sharing formula (that incorporates factors such as loan-to-value [LTV] and debt service coverage ratios) in which the DUS lender assumes the first loss, up to a cap of 20 percent of the original loan amount. In transactions with non-DUS lenders, agreements to share or absorb credit losses are negotiated on a percentage of the loan or the pool balance.

Fannie Mae’s Small Loans Program offers financing for multifamily loans up to $3 million in most areas and up to $5 million in eligible high-cost areas.6Although small multifamily properties are frequently defined as having five to 50 units, Fannie Mae uses loan size as a proxy for small multifamily properties, even if a smaller balance loan is made on a project with more than 50 units.

Fannie Mae’s Small Loans Program offers acquisition and refinance loan options for existing, stabilized properties. Loan terms can range from five to 30 years, with an amortization period of up to 30 years. Borrowers can choose either fixed or variable interest rate options, as well as yield maintenance or other graduated prepayment options. The maximum LTV ratio for an acquisition loan is 80 percent, and the minimum debt service coverage ratio is 1.25. Because many small multifamily borrowers, such as partnerships or corporate entities, are more like single family borrowers than traditional multifamily borrowers, Fannie Mae requires increased underwriting scrutiny of individual borrowers’ personal creditworthiness under the Small Loans Program.

Freddie Mac

In contrast with Fannie Mae’s delegated underwriting approach, Freddie Mac relies on a prior approval lending model. Freddie Mac purchases multifamily mortgages through its Program Plus network, which consists of about two dozen lenders that are approved as correspondents.7 These multifamily lenders submit multifamily loan packages to Freddie Mac, which performs a complete underwriting evaluation and credit review before issuing a final approval.

Once the multifamily loans are approved and delivered, Freddie Mac packages them into securities. Freddie Mac works with its network of securities underwriters to structure and issue private label securities backed by pools of multifamily loans. As illustrated in figure 10, Freddie Mac issues a guarantee on the senior portion of the structured security and then issues pass-through certificates, known as K Certificates, which are publicly offered by placement agents to investors. Subordinate bonds and mezzanine bonds covering the balance of the structured pool of these commercial mortgage backed securities (CMBS) are not guaranteed by Freddie Mac and are sold by Freddie Mac through its placement agents to private investors.

Figure 10: K Certificate Transaction

Figure 10: K Certificate Transaction

Source: Form 10-K for the fiscal year ended December 31, 2013, Freddie Mac, page 12.

Freddie Mac recently announced a new Small Balance Loan (SBL) program designed for multifamily loans ranging from $1 million to $5 million on properties with five or more residential units.8 Six Program Plus lenders are approved to sell small multifamily loans to Freddie Mac.

Borrowers must be one of the following: a U.S. citizen, a limited partnership, a limited liability company, a single asset entity, a special purpose entity, an entity that holds as tenancy-in-common with up to five unrelated members, or a trust (irrevocable trusts and revocable trusts with a “warm body” guarantor). The borrower must have a net worth equal to the loan amount with liquidity equal to nine months of principal and interest.

Fixed-rate loans are available with five-, seven-, or 10-year terms and amortization up to 30 years. For fixed-rate and hybrid adjustable rate mortgage (ARM) loans, the maximum LTV for small balance loans is 80 percent, but the required minimum amortizing debt coverage ratio (DCR) varies depending on location of the property. The minimum amortizing DCR for loans in specified top small balance loan markets is 1.20x, and the DCR is a higher 1.25x for loans in all other markets.9 Full-term interest-only loans are available with a minimum amortizing DCR of 1.40x and a maximum LTV of 65 percent. Loans are available for existing properties with a minimum 90 percent average occupancy rate over the trailing three-month underwriting period. Yield maintenance provisions governing prepayment penalties apply to both fixed-rate and hybrid ARMs. Small balance multifamily loans are non-recourse with standard carve-out provisions (e.g., fraud).

SBLs are securitized using the K-Deal securitization technology. In the case of SBLs, however, the lenders agree to buy the unguaranteed slice of the security or place it with another investor, taking a first-loss position to absorb any credit losses.

Depository institutions that are not Program Plus correspondents but would like to sell small multifamily loans can approach Freddie Mac to evaluate a seasoned pool of multifamily loans. Freddie Mac evaluates the loans, which generally must be seasoned for at least a year. If Freddie Mac approves the loans, it purchases, credit enhances, or swaps a security for the pool of mortgages.

Providing Liquidity to Small Multifamily Finance: the Future Role of the GSEs

In the past several years, the Federal Housing Finance Agency (FHFA), which regulates the GSEs, has held divergent views on how much support these institutions should offer in the multifamily market. In 2013, the FHFA directed the GSEs to reduce multifamily volume by at least 10 percent. FHFA Director Melvin Watt, however, included no plans to reduce multifamily production levels as part of FHFA’s “The 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac.” Although Director Watt noted that the FHFA expected less GSE multifamily activity in 2014, he stressed that the “FHFA will not mandate that the Enterprises [i.e., the GSEs] prematurely shrink their multifamily footprint.” Watt added, “Consistent with safety and soundness, our affordability focus will include multifamily lending for small properties.”

In fact, the FHFA has proposed regulation requiring that the GSEs increase their future small multifamily residential property financing activity. For the first time, the FHFA has proposed a specific sub-goal target for small multifamily properties serving low-income individuals (defined as having incomes of 80 percent or less of area median income) in the GSEs’ 2015 through 2017 affordable housing goals (see figures 11 and 12). In the proposal, the FHFA defines small multifamily property as five to 50 units.

Figure 11: Proposed GSE Low-Income Small Multifamily Housing Goals 2015–2017

Figure 11: Proposed GSE Low-Income Small Multifamily Housing Goals 2015–2017

Source: Federal Housing Finance Agency 2015–2017 Enterprise Affordable Housing Goals , 79 Fed. Reg. No. 176, pages 54481 and 54498, September 11, 2014.


Figure 12: GSE Funding of Low-Income Units in Small Multifamily (Five- to 50-Unit) Properties

Figure 12: GSE Funding of Low-Income Units in Small Multifamily (Five- to 50-Unit) Properties

Source: Proposed GSE Low-Income Small Multifamily Housing Goals 2015–2017 , table 4, Federal Housing Finance Agency 2015–2017 Enterprise Affordable Housing Goals, 79 Fed. Reg. No. 176, pages 54481 and 54497, September 11, 2014.


Lenders interested in learning more about the GSEs’ small multifamily programs can visit Fannie Mae and Freddie Mac’s Web sites.

For more information, e-mail Sharon Canavan.


1 Monthly rents in properties with fewer units tend to be lower, so smaller multifamily properties offer a more affordable housing option for lower income individuals. The mean monthly rent receipts per housing unit on mortgaged properties are $658 for five- to 24-unit properties, $826 for 25- to 49-unit properties, and $919 for properties with more than 50 units. See the 2012 U.S. Rental Housing Finance Survey, U.S. Department of Housing and Urban Development and U.S. Census Bureau, Selected Characteristics by Mortgage Type, Tables 2b, 2c, and 2d at pages 39, 57, and 75.

2 Wayne Archer and David Ling, “Toward an Understanding of Fannie Mae’s Penetration of the Multifamily Housing Market,” University of Florida, September 2012, at page 3.

3Fannie Mae’s Role in the Small Multifamily Loan Market,” first quarter 2011, page 7.

4 Mortgage Bankers Association, “Annual Report on Multifamily Lending,” 2013.

5 Ibid.

6 Fannie Mae, “Multifamily Term Sheet, Small Loans Program.”

7 Freddie Mac provides a list of Program Plus lenders.

8 Freddie Mac, “Multifamily: Small Balance Loan At-a-Glance,” December 2014.

9 Ibid, page 2. The top small balance loan markets include the following Metropolitan Statistical Areas: New York, Newark, Jersey City; Boston, Cambridge, Newton; Philadelphia, Camden, Wilmington; Washington, Arlington, Alexandria; Chicago, Naperville, Elgin; Los Angeles, Long Beach, Anaheim; San Francisco, Oakland, Hayward; San Jose, Sunnyvale, Santa Clara; and San Diego, Carlsbad.

GSE Financing for Two- to Four-Unit Properties

Sharon Canavan, Community Relations Expert, OCC

Both Fannie Mae and Freddie Mac offer financing options for two- to four-unit properties, which are underwritten using single family guidelines. The eligible loan amount depends on both the number of units in the building and the location of the property; in high-cost areas, loan purchase limits are appreciably higher.

Fannie Mae

Fannie Mae’s standard single family eligibility and underwriting guidelines treat two- to four-unit properties as single family properties. Financing for two- to four-unit properties accounted for 3 percent of Fannie Mae’s single family conventional guaranty book of business in 2013 and through June 2014. Moreover, Fannie Mae financed almost 32,000 owner-occupied two- to four-unit properties in 2013, totaling about $8.7 billion.

Depending on the loan type, certain additional eligibility requirements apply to two- to four-unit properties, such as a more stringent loan-to-value (LTV), debt-to-income ratio, and credit score, and minimum reserve requirements. A 1 percent loan-level price adjustment applies to two- to four-unit properties. Owner-occupant borrowers can use rental income from the other units to qualify for the loan. Under standard underwriting guidelines, Fannie Mae permits up to four loans to the same borrower/investor. Borrowers holding five to ten properties must meet additional eligibility, underwriting, and delivery requirements.10

Freddie Mac

A number of Freddie Mac products expand financing options to include two- to four-unit properties.11 Additional eligibility requirements apply to these properties, such as a more stringent down payment, debt-to-income ratio, and credit score, and minimum reserve requirements. Although more stringent LTV requirements apply to two- to four-unit properties,12 the Home Possible and Home Possible Neighborhood Solutions products allow down payments as low as 5 percent for two- to four-unit properties.13 Rental income from the other units can be used to qualify the owner-occupant borrower. Post-settlement delivery fees ranging from 1 to 2 percent, depending upon the LTV, apply on two- to four-unit properties.

For more information, e-mail  Sharon Canavan.

Articles by non-OCC authors represent the authors’ own views and not necessarily the views of the OCC.