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Community Developments Investments (May 2015)

What Community Banks Are Saying—A Review of Four Community Banks’ Small Multifamily Lending Programs

This photo shows three small, brick, tenement-style apartment buildings..Source: Shutterstock.
This photo shows three small, brick, tenement-style apartment buildings.

William R. Reeves, Community Development Lending Manager, OCC, and
Letty Ann Shapiro, PhD, Community Development Expert, OCC

Our district community affairs officers (DCAO) provide a conduit between OCC Headquarters staff, local bankers, and examiners. These colleagues support the OCC’s mission to ensure a safe and sound banking system. DCAOs help national banks and federal savings associations (collectively, banks) to become better leaders in providing financing, investments, and retail services to underserved communities and consumers; provide community development expertise to support examiners; and help bankers and examiners better understand community development financing needs in communities across the country.

Through the DCAOs, the authors have heard about issues related to small multifamily rental properties that may be limiting the bank financing available to preserve these valuable affordable housing units. The authors also have heard similar concerns voiced by community development financial institutions in areas that were hard hit by the economic downturn of 2008 and that have experienced increased pressure on rental housing and high unemployment.

What’s the Story?

Small rental properties with five to 50 units provide the largest source of unsubsidized multifamily rental units in the country. Anecdotally, over the past 12 months, we have heard conflicting stories about a lack of financing available for these small multifamily affordable rental properties. One story line described frustrated borrowers unable to find loans to purchase, refinance, or improve these small rental properties. This was supported by a nonprofit lending consortium telling us how large bank lenders once active in this line of business have since left it, leaving many neighborhoods with financing gaps. In contrast, we also have heard that community banks are increasingly interested in making loans to small multifamily affordable rental properties.

To sort out the details, we decided to go to entities that we readily can access—community banks—to hear what they had to say.

To determine whether community banks have an appetite for small multifamily rental financing (SmMF), which is a subset of commercial real estate (CRE) lending, we contacted four community banks to gauge their level of interest and involvement in this product, and if they offered SmMF loans, to learn about their respective products. We limited our interviews to community banks because we knew that while many large banks continue to be significant players in financing the CRE industry, they typically look for loans on larger properties that can be sold in the secondary market, usually in amounts greater than $3 million. For more information about this product line, see the article by Elizabeth La Jeunesse titled “Small Multifamily Property Ownership, Management, and Financing Issues.”

The community banks we interviewed were not scientifically selected, nor do they reflect a national survey or picture. The banks are lending in the SmMF niche in different urban areas, and they are in markets that have a substantial stock of small multifamily properties.

What We Learned

In response to our fundamental question as to whether these community banks have a healthy appetite for SmMF loans, all four indicated that they were actively seeking out this type of business. The banks reported that the SmMF loans in their portfolios were well matched with their funding sources and performed as well as or better than other types of CRE loans. The banks all reported significant competition for these loans. This information matches our understanding of how the overall multifamily rental property market is generally performing. As figure 8 illustrates, multifamily rental properties (the dark blue line) are outperforming the three other CRE asset classes: office, retail, and warehouse.

Figure 8: Net Operating Income Index at All-Time High for Apartments

Source: Property and Portfolio Research, third quarter 2013 baseline forecast.

Note: The net operating income index (NOI) represents the change in the total net operating income for each property type over time. The NOI is simply the cash flow generated by properties (rents) minus expenses but before payments of principal and interest. The indices are set to 100 at the pre-recession high. In 2014, net operating incomes were at an all-time high for apartment properties and projected to continue moving upward, while the other property types were bringing in 90–95 percent of what they were before the recession.

As a starting position, all four banks that we interviewed offered an initial five-year fixed-rate loan with amortization periods stretching out over 20 to 30 years. After this initial five-year term, however, the products’ terms varied. In fact, two of the banks we interviewed described their loan product as having a 10-year maturity with the interest rate being reset at the end of the initial five-year fixed-rate period and a balloon payment at maturity. The other two banks indicated that the second five-year term would be a variable interest rate based on an index. One of these two banks indicated that, in some cases, it would extend the initial fixed-rate term to seven years. Both of these banks also required a balloon payment at the end of the term. All of the banks indicated a willingness to entertain loan refinancing at maturity.

All four banks utilized an index, either from the start of the loan, in the case of the variable rate loans, or at the initial fixed-rate reset. The indexes mentioned ran the gamut: the Federal Home Loan Bank advance rate; the five-year Treasury bond rate; a swap index; and the prime rate or the London Interbank Offered Rate. Each of the banks then added a margin, from as low as 200 basis points to as high as 350 basis points, depending on the index used and the loan’s term. Three of the banks hedged their interest rate risk with various prepayment premium schedules that reduced as the loans seasoned.

Loan-to-value (LTV) ratios were fairly standard, with all four banks reporting a maximum range of 75 to 80 percent. One bank indicated that its LTV ratio was 80 percent, while another indicated that it had the authority to go up to 80 percent, but typically kept its loans at a 75 percent LTV. Likewise, debt service coverage ratios were standard, with the four banks reporting their minimum coverage requirements range from 1.20x to 1.25x of the annual debt payment, with higher coverage ratios required for larger properties.

The banks indicated that they offered loans in amounts ranging from $250,000 to $1 million or more. 

From an underwriting perspective, all four banks agreed that the following are fundamental to the success of this line of business: operating cash flow, collateral value, and borrower guarantees. Because the debt service on these loans is supported by only a small number of units, just one or two vacancies in a five- to 25-unit property can be the difference between a performing and a nonperforming loan. While adequate (or appropriate) collateral value (supported by documented appraisals) is always considered the second source of repayment, all of the banks noted that the recession had confirmed that what goes up (like a property’s value), can, and will, come down. The banks indicated that they were looking for borrowers with deep pockets to support the guarantees and reserves required.

Most SmMF loans are secured by properties located in older metropolitan neighborhoods. The properties themselves are typically older; in many cases they were built in the 1920s and 1930s, and in almost all cases, they were built before the 1970s. Therefore, asset management and unit maintenance also are important factors for bankers to consider when making loans secured by these buildings.

When we asked the banks to tell us what they were looking for in a quality borrower, some spoke about borrower character and pride of ownership. They also said that no “slumlords” need apply and that investor owners needed to show proper maintenance, which results in satisfied tenants and more consistent cash flow. Some banks indicated a desire to lend to experienced rental property owners who knew what is expected of them both on the asset preservation side as well as the banking relationship side. To reinforce what was said earlier, each of the banks sought borrowers with good liquidity to help themselves and the bank if the property rent rolls needed support.

During our interviews, we asked how the banks performed their own asset management due diligence. The bankers all indicated that they conducted annual account reviews in some manner. Most frequently, the reviews relied on financial statements (business and personal) and rent rolls to indicate the financial stability of the properties. Additionally, the banks reported that they conducted site visits and inspections prior to closing. And most of the banks indicated that they completed a site inspection at least annually, and more often when the borrowers’ financials raised concerns.

We learned from these banks that the SmMF borrowers do not have typical profiles. Depending on the property size, borrowers could be full-time professional real estate investors, or alternatively, could be young professionals with full-time jobs who are investing in real estate on the side. In all cases, however, the banks were cautious when it came to borrowers who indicated they would be doing their own plumbing and electrical repairs. Not surprisingly, the banks looked more favorably on borrowers who had appropriate experience, and whose portfolios reflected that they could afford to hire appropriate management teams to keep their properties in good condition.

When we asked the banks to describe how they originate these loans, we again heard a variety of answers. One bank relied heavily on commercial real estate brokers to bring in business. Other banks indicated that their branch system, reputation, and word of mouth were sufficient to gain a good market share. With intense competition for this business, all four banks indicated a willingness to be aggressive if the transaction offered the chance to establish a new business relationship, or if approving it was important to maintain an existing customer relationship.

All of the banks that we interviewed keep their SmMF loans in portfolio. The banks indicated that the structure and pricing of these loans worked well for them as a portfolio asset.

It has been suggested that the availability of an established secondary market for these SmMF loans could further the availability of credit to this market by providing liquidity and long-term fixed-rate financing. Importantly, all of the banks that we spoke with indicated that they are highly liquid and do not need to look for opportunities to sell the product in the secondary market. They also valued the shorter-term loans and the fees these loans generate.

What Does It Mean?

As the economic downturn put many former homeowners out of their homes and into the rental market, the demand for rental properties increased. In addition, new data on the younger population cohort, the older baby boomer cohort, and the new wave of immigrants forecasted, indicate that these groups are likely to expand over the next 10 to 20 years and are more interested in rental housing than previous generations. Pressure from these groups is likely to lead to an increasing demand for rental units, especially affordable rental units. In addition, the aging of these properties increases the need for renovation, including energy efficiency and structural improvements. Thus, the demand for loans on SmMF properties is likely to continue to gain traction. And, as we reported earlier in this article, competition for this business is high.

These bankers also indicated that if the economy weakened, or their liquidity positions changed, an established secondary market might be helpful to them, such as when credit is tight or long-term fixed-rate financing is the preferred loan product. Based on our interviews, for now it appears that community banks specializing in SmMF financing appear willing to make loans to creditworthy borrowers.

For more information, e-mail Letty Shapiro.

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