Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA) sustained the multifamily industry in the darkest days of the recession. But as fundamentals continue to improve, questions have naturally arisen as to whether the agencies are crowding out the private sector in the race to finance apartment deals.

More than five years into the housing downturn that presaged the broader recession, the moribund state of the market for homeownership remains a powerful tailwind in support of apartment demand, as recent statistics show. Effective-rent growth, for example, was 4.4 percent across the nation in 2011, according to Dallas-based market research firm Axiometrics.

The national occupancy rate, which had climbed to just below 94 percent at year's end, will tighten further under the coming quarters' constrained-supply conditions. As a result of higher occupancy and rising rents—even in the absence of robust job growth—the apartment sector's fundamentals trajectory will strengthen ahead of the first signifi- cant additions to inventory in 2013.

The Agencies As Stabilizers

Buoyed by a near-term fundamentals outlook that will go largely unmatched by other commercial asset classes, investors have elevated the apartment sector to the apex of the investment hierarchy. Apart from supportive fundamentals, the resiliency of agency financing has been an equally important facilitator of the sector's investment recovery.

In late 2008 and 2009, disengagement by a broad range of lenders starved investment in the other commercial property sectors. But the availability of credit through Fannie, Freddie, and the FHA ensured that apartment credit dislocations were relatively less severe, even in submarkets where the sector's occupancy rates and income trends were deteriorating.

Today, nonagency lenders' assessments of the apartment sector and its risk profile have clearly improved, as has their capacity to engage in new lending. On the margins, the brighter outlook for apartment income and loan performance has fueled an increase in lending activity across a range of financing sources. In addition to domestic banks, life companies and private lenders have become more active. In 2011, listed apartment REITs raised a further $1.8 billion in unsecured debt. Meanwhile, commercial mortgage- backed securities (CMBS) remain the most observably absent source of funding, largely as a result of competitive imbalances with agency securitization.

In the case of domestic banks, new lending has slightly outpaced maturing balances and the amortization of seasoned loan balances. During the third quarter of 2011, for instance, banks reported a net increase in multifamily mortgage balances of $1 billion. That gain coincided with the banks' lower multifamily default rates, which had fallen from a third-quarter 2010 peak of 4.7 percent to 2.9 percent as of our most recent analysis of bank balance sheets.

As a larger number of private entities have sought to make apartment loans, questions have arisen concerning the government- sponsored enterprises' continued participation in the market. In cardinal markets like New York City, Washington, D.C., and San Francisco, even the most aggressive nonagency lenders report challenges in matching agency terms.

Crowding out, which in the language of economists can refer to a reduction in private lending because of government or quasigovernmental lending, is generally viewed as inefficient. And yet it remains evident that the agencies and their lending partners are competing for lending opportunities in segments of the market that might be well-served in their absence. In the extreme, for core assets in markets such as New York and Washington, D.C., spreads on new originations have narrowed to a degree that indicates greater risk-taking by lenders and higher lifetime default rates.

An Uneven Landscape

The appropriateness of agency financing in the handful of cardinal markets where lenders are competing most actively warrants debate, especially as loan quality weakens under competitive pressures. Elsewhere, however, the broader landscape of secondary markets and relatively smallerscale properties reveals the channel's ongoing importance for the balance of the apartment sector. In many secondary and tertiary markets, the data show a paucity of engaged nonagency lenders.

Absent a clear path to normalization in the CMBS marketplace—and in light of predictable shifts in bank lending once apartment fundamentals slow to a sustainable pace— smaller markets and noncore assets still rely on agency channels for the robustness of credit flows. Irrespective of the long-term direction of the nation's housing finance reform initiatives, smaller markets' nearand medium-term apartment price stability and capital flows remain functions of agency lending and will be acutely sensitive to disruptions in the activities of these institutions.

A change in the agencies' mandate is improbable in the near to medium terms. As a result, the principal risk facing apartment lenders relates to the very optimism that has allowed underwriting standards to ease amid heightened nonagency competition to finance new deals. Current market structures are working to the benefit of borrowers, but history shows that very low-cost credit carries serious risks, as well.

SAM CHANDAN, Ph.D., is president and chief economist of New York–based market research firm Chandan Economics. RON JOHNSEY is founder and president of Dallas-based Axiometrics.