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Community Developments Investments (May 2015)

Underwriting Challenges of Financing for Small Multifamily Rental Properties

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

James A. Stiel, CRC, Risk Specialist, OCC

Small multifamily rental properties fill an important need in many communities; such properties provide housing that is affordable and offer relatively short-term housing solutions when needed. The OCC encourages national banks and federal savings associations (collectively, banks) to make soundly underwritten and prudently administered loans, including loans to finance smaller multifamily properties, that help provide needed affordable housing and promote economic development in the communities the banks serve.

Good loan underwriting and seasoned judgment help minimize a lender’s losses and help ensure that the borrower is successful and that the property continues to serve the community’s housing needs. The OCC’s “Commercial Real Estate Lending” booklet of the Comptroller’s Handbook provides supervisory guidance to examiners for commercial real estate lending, which includes multifamily housing. This article is not intended to provide supervisory guidance, but instead discusses a few of the unique challenges the financing of smaller multifamily properties (five to 49 units) can present.

Although the underwriting for loans that finance these smaller properties is similar in many respects to the underwriting for loans that finance larger properties, there are important differences that are useful to consider. The biggest difference is often the borrower. These borrowers often have less experience and fewer resources than investors in larger properties. The available financial information may also be quite different for these borrowers, with financial statements prepared by the borrower or bookkeeper, rather than prepared, reviewed, or audited by a certified public accountant. Adequate and clear financials are what an examiner or banker needs to be confident in the financial information and borrower. The property and its condition are other considerations. Maintenance of smaller properties is commonly performed by the owner or a trusted hired helper rather than a dedicated maintenance staff who may have access to more resources. The ultimate tests of the property are its condition on inspection and whether the borrower has adequate resources to maintain property quality.

The Borrower

In some cases, those who borrow to invest in smaller properties may have only one or possibly a few properties, and these borrowers often manage the properties themselves. Effective management is critical to the success of multifamily properties, and poor management is a primary cause of failure. Particularly where the primary source of repayment is the income from the property, it’s important to understand how well prepared the borrower is to successfully manage the investment and the collateral.

If the borrower has other properties, a review of these properties’ performance helps to gauge his or her management ability. If the borrower is relatively new to being a landlord, assessing his or her ability requires some additional sensitivity. A lender can use the interview with the borrower to assess how well prepared the borrower is. How well does the borrower understand the business? Has the borrower analyzed all the important factors, such as rental and vacancy rates for similar properties? How does he or she plan to screen tenants? Is he or she prepared for the challenge of collections (those of us who are former newspaper carriers remember that delivering newspapers was the easiest part of the job—it was collecting that determined if you made any money)?

Does the borrower have another full-time job that requires his or her attention? If so, how will the borrower handle urgent calls from tenants about a stopped-up toilet or leaky roof? Will the borrower have the time to manage and maintain the property if he or she performs these duties?

If the borrower’s plans are to turn an underperforming property into a successful one, experience becomes even more critical. The lender will want to know if the borrower has done this before and make sure that he or she has a plan that is well supported. What are the borrower’s plans and expectations? Are they realistic? How will the borrower improve the property? Will he or she reduce vacancies? Increase rents? Increase collections? How will the borrower make the property successful? A new owner sometimes comes to understand why the previous owner couldn’t do this only once the borrower is in the previous owner’s shoes—when it’s too late.

Financial Information

A careful review of the financial information that the borrower presents tells the lender a lot about the borrower’s understanding of the business in addition to the performance of the property.

Has the borrower included all likely expenses in the pro forma? Small property borrowers may do a lot of the work, such as management and maintenance, themselves. Although borrowers may sometimes view this work as “free,” it still represents an investment of time and materials that should be accounted for in the pro forma.

Has the borrower made realistic assumptions about vacancies and credit and collection losses? These are items that inexperienced borrowers and lenders may underestimate. What kind of resources does the borrower have? Does he or she have some source of liquidity aside from retirement funds that can be used to pay for unexpected repairs or other expenses?

For a small multifamily property, maintenance, repairs, and the replacement of capital items require a larger share of a property’s cash flow than most other property types. The borrower’s assumptions about required capital replacements should be reviewed, and the pro forma and historical information should demonstrate that the property can be reasonably expected to generate sufficient cash flow to maintain the property and fund replacements over time.

Is the income expected to provide an adequate rate of return or, instead, does the borrower plan to forgo income and expect to receive his or her return through appreciation? In the latter case, such properties may be unable to absorb inevitable fluctuations in income and thus be more likely to face default. The borrower or guarantor needs sufficient wherewithal to support the property. Properties should generate sufficient cash flow to cover expenses and upkeep.

If the borrower owns other properties, a review of these properties’ statements can tell the lender not only how the properties are performing but how good a manager the borrower is. Does the borrower maintain current rent rolls and collection records, and can he or she show month-by-month or quarter-by-quarter what his or her profit or loss is? Or is the borrower a “seat-of-the-pants” type who waits until April 15 to find out how much he or she has made or lost when giving checking statements and receipts to an accountant to figure out the taxes? While tax returns can be useful to verify information, they are not sufficiently detailed or current to provide a good basis to manage a multifamily property or underwrite a loan.

Revenue should be closely analyzed. Comparing rent rolls with deposit records helps to determine the true revenue and effectiveness of the borrower’s tenant screening and collection programs. Expense statements should be carefully reviewed to ensure that all appropriate expenses are included in the statements and that the expenses are reasonable. Statements prepared on a cash basis show only the expenses that have been paid; they do not show the expenses that should have been paid but were not. The same is true of tax returns prepared on a cash basis. Items such as real estate taxes and maintenance are commonly deferred when cash flow is tight. For this reason, the tax returns should be carefully evaluated. Expenses presented in appraisals of similar properties can provide useful comparisons. A cash-basis income statement that shows positive cash flow may actually be hiding negative cash flow if necessary expenses were not paid and were therefore excluded from the statement. It’s not enough to determine if the borrower can pay the lender; the lender needs to be assured that the borrower can, and does, pay everyone else too.

The Property

Property condition is a major factor in a property’s ability to attract and retain tenants, and this is particularly true with residential properties. It’s critical for the lender and the borrower to have a good understanding of the condition of the property. When financing the purchase or refinance of smaller properties, it’s tempting to forgo having a professional inspection done in order to keep the borrower’s transaction costs down. Most of us would, however, never think of purchasing a home without an inspection; the same should be true of investment properties. In addition to describing the property and its overall condition, the inspection report should identify any deferred maintenance that may have accrued and estimate the cost to remedy it. A good practice is to make sure that any needed work is done before closing, or to hold back sufficient loan proceeds to ensure the work is done. Postponing work that needs to be done now to fund it out of future cash flow is rarely a good idea. The inspection report should also note major repairs or replacements that are not needed now but will be needed in the near future, and a realistic plan should be developed to pay for them.

When new improvements are part of a plan to improve property performance and the improved performance forms the basis for the underwriting assumptions, the construction budget should be closely reviewed to ensure that it accurately represents and includes all costs. The expenditures should make a commensurate contribution to the overall value of the property and be supported by the prospective (as-complete or as-stabilized) value. The “Commercial Real Estate Lending” booklet of the Comptroller’s Handbook provides examiner guidance for underwriting and administering loans that finance construction.

It is a good practice to inspect the property at least annually to determine whether it is being adequately maintained. Monitoring the condition of the property can be as important as monitoring the cash flow; doing so helps determine if the property is generating enough cash flow to cover all of the expenses, since maintenance is one of the first items to be cut if the property or borrower is experiencing difficulty. Regular inspections can also help to protect the value of the lender’s collateral.

For more information, e-mail James Stiel.

Thumbnail-sized cover of the OCC’s Comptroller’s Handbook  booklet titled “Commercial Real Estate Lending,” published August 2013Source: OCC
Thumbnail-sized cover of the OCC’s Comptroller’s Handbook booklet titled “Commercial Real Estate Lending,” published August 2013

The OCC's 'Commercial Real Estate Lending' Booklet of the Comptroller’s Handbook

James A. Stiel, CRC, Risk Specialist, OCC

The OCC recently revised the “Commercial Real Estate Lending” booklet of the Comptroller’s Handbook to replace the “Commercial Real Estate and Construction Lending” booklet issued in 1995. The revised booklet also replaces sections 210, “Income Property Lending,” and 213, “Construction Lending,” of the former Office of Thrift Supervision’s Examination Handbook, issued in 2009 and 1994, respectively. The revised booklet provides guidance to examiners for multifamily as well as other types of properties.

The “Commercial Real Estate Lending” booklet reflects examiner guidance issued subsequent to the release of the now replaced 1995 booklet. The new guidance includes a variety of topics, including prudent loan workout strategies; management of concentrations; stress testing; updated interagency appraisal guidelines; and statutory and regulatory developments in environmental risk management. Discussions of statutes and regulations governing federal savings associations have also been incorporated in the revised booklet.

In addition, expanded examiner guidance addressing acquisition, development, and construction (ADC) lending is found in the revised booklet. Issues unique to ADC and income-producing real estate lending are discussed in separate sections. Other topics found in the booklet that are either new or expanded include project feasibility, investor-owned residential real estate, amortization, debt yield, owner-occupied real estate, and specific underwriting considerations for various property types, including multifamily and affordable housing.

The booklet also enhances the agency’s guidance for supervisory loan-to-value (SLTV) limits that were established in appendix A to subpart D of 12 CFR 34, “Interagency Guidelines For Real Estate Lending.” The limits under the updated guidelines for multifamily properties are 80 percent for construction financing and 85 percent for completed properties. The guidelines do not prohibit loan-to-values in excess of these limits. Rather, they provide that the sum of these loans in excess of the limits at origination should be no greater than 100 percent of a bank’s capital. Within that aggregate limit, total loans to finance commercial, agricultural, multifamily, or other non-one- to four-family residential properties should not exceed 30 percent of the bank’s total capital.

For a loan exceeding SLTV limits, the entire outstanding balance should be included in the bank’s nonconforming basket, not just the portion exceeding the limit. If the bank holds a first and second lien on a parcel of real estate and the combined commitment exceeds the appropriate SLTV limit, both loans should be reported in the bank’s nonconforming loan totals. Further, the bank should include all loans secured by the same property if any one of those loans exceeds the SLTV limits. A loan need no longer be reported as part of aggregate totals when reduction in principal or senior liens, or additional contribution of collateral or equity (e.g., improvements to the real property securing the loan), brings the LTV into compliance with SLTV limits.

The booklet also provides examiner guidance in selecting the proper value for measuring SLTV. The value used in calculating the SLTV can be as-is, the prospective market value as completed (“as-completed”), or the prospective market value as stabilized (“as-stabilized”). An as-is value would be appropriate for calculating the SLTV for raw land or stabilized properties. For an owner-occupied building or a property to be constructed that is preleased, the as-completed value should generally be used. An as-stabilized value would be appropriate for an existing property that is not stabilized or a property to be constructed that is not preleased to stabilized levels. For a further discussion of as-completed and as-stabilized values, see the “prospective market value” entry in the booklet’s glossary (page 124).

The LTV ratio is only one of several important credit factors to be considered when underwriting a real estate loan. Additional credit factors to be taken into account are discussed in the “Underwriting Standards” section of the booklet (pages 8–10). In light of these additional factors, the establishment of the SLTV limits should not be interpreted to mean that loans underwritten to these limits are automatically considered sound.

The booklet also provides property-specific underwriting considerations for various property types, including multifamily. The booklet stresses that management ability is critical to the success of multifamily properties; inept or inexperienced management is a major cause of difficulty for loans financing multifamily dwellings. Mitigating tenant turnover requires a constant marketing effort, and management must retain tenants when possible by being attentive to their needs. In addition to attracting and retaining tenants, management must do an effective job of collecting rents. Although a review of the rent roll might indicate a high rate of occupancy, actual collections should be examined to determine the true economic occupancy and to evaluate the competency of management and the effectiveness of its collection efforts. Whether properties are self-managed or managed by a third party, the manager’s ability and experience should be carefully evaluated.

Lack of proper maintenance can pose a significant risk to the viability of multifamily properties. Undercapitalized borrowers may neglect needed maintenance when cash flows are inadequate, which can result in increased turnover and vacancies. Deferred maintenance can significantly affect loan losses and expenses in the event of foreclosure. An inspection of the property should determine how many of the vacant units are rentable in their current condition; cash-strapped borrowers sometimes “cannibalize” vacant units of appliances, heating units, and other items when replacements are needed. It is important that banks monitor property maintenance and improvements to ensure they are timely and appropriate. Banks should ensure that the property’s cash flow is adequate to provide for necessary replacements and upgrades over time. In addition, the property’s operating expenses should be carefully analyzed to ensure that replacements and upgrades actually were made.

Multifamily rental properties fill an important need in many communities; they can be more affordable than owner-occupied housing and offer relatively short-term housing solutions. These properties have historically been one of the most stable property types, and, when prudently underwritten, and properly managed and maintained, they can provide profitable opportunities for lenders while improving the communities they serve.

For more information, e-mail Jim Stiel.

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