Just a year ago, it was hard to find money if you wanted to buy and rehab an apartment building. But as rents have recovered, the opportunity for rehab has regained validity.

“There was a time when rehab really didn't make sense financially,” says Kevin Smith, a director at New York–based Centerline Capital Group, which opened its Alternative Capital Markets division to source nonagency money for its clients. “That's changed dramatically since last year.”

Rising rents plus the availability of capital and the need to fix deferred-maintenance issues have helped drive rehab's re-emergence. “There are opportunities to go in and do a minor rehab or a major rehab and see a decent return on your investment,” Smith says.

Bridge loans that will carry value-add buyers until they can get long-term debt are becoming more prevalent. Both banks and debt funds are offering increasingly more competitive terms, and pricing has “come in dramatically,” Smith says. “The bridge funds tend to be more aggressive, and there's more and more of these funds coming out of the woodwork.” Terms are anywhere from three to five years on loans with extension options that cover the cost of rehab through a draw schedule.

And life insurance companies such as Northwestern Mutual will sometimes lend on substantial rehab deals as a way to wrest more multifamily borrowers away from the agencies and capture the longterm permanent-debt business.

“We generally stick to major markets, and our leverage levels are more in the moderate range, but for the right deal, the right sponsorship, we'd absolutely do it,” says David Clark, who leads the commercial real estate lending arm of Milwaukee-based Northwestern Mutual. “Our niche in the market is taking a little bit of construction risk, or leasing risk, or repositioning risk as a way to compete with the agencies.”

Agency Engagement

Many agency lending shops offer a proprietary bridge program for properties that need a little more seasoning before they can qualify for an agency permanent loan. And in some cases, borrowers are even accessing agency loans for the rehab itself.

Gary Mozer, principal and managing director at Los Angeles–based George Smith Partners, is seeing some people eschewing the bridge lender and going directly to Fannie Mae or Freddie Mac for debt if they have cash flow from day one. “You have to look at your blended cost of capital,” he says.

Once upon a time, Fannie and Freddie had mezzanine programs that often served valueadd repositioning deals. Those programs were suspended during the downturn but were reintroduced in 2010 with a new purpose—they are now reserved only for defensive refinancings.

But Fannie and Freddie are starting to grow a little more active in the rehab space, as more borrowers eye their adjustable-rate mortgage (ARM) executions, according to Charles Halladay, director in the Irvine, Calif., office of Holliday Fenoglio Fowler (HFF).

“As value-add deals become available, a lot of borrowers have recently opted for the agencies' ARM executions, which allow for a low pay rate today [approximately 3 percent to 3.25 percent], flexible prepay, and the ability to fix their rate down the road post-rehab and -stabilization,” says Halladay.

The Big Three

The Federal Housing Administration never really stopped doing rehabs throughout the downturn. The main advantage of its Sec. 221(d) (4) program is that you can lock in construction debt and permanent financing all in one fell swoop. Plus, the program is nonrecourse, goes out 40 years, and is fully amortizing.

“If your project is 18 months long, it allows you to lock in today's rate,” says Trevor Smith, director at Columbus, Ohio–based Red Mortgage Capital. “When you convert to a permanent loan 18 months later, you can still get a 4 percent rate, for example.”

The ability to lock in today's fixed rates is a huge advantage on the back end of a deal. But on the front end, timing issues can work against the borrower—Sec. 221(d)(4) loans can take 10 months or more to close.

Meanwhile, Freddie Mac is working on revamping some of its existing programs to capture an expected wave of value-add deals. Specifically, the company is looking at how it might use its credit-facility line of products to transition floating-rate debt to longer-term, fixed-rate mortgages. The GSE is hoping to roll out these enhancements later this year.

Freddie's ARM is a five-, seven-, or 10-year execution, and the company also offers partial and, sometimes, even full-term interest-only.

Not to be outdone, Fannie Mae rolled out its ARM 7-6 last year. The loan includes embedded caps and an option to convert it into a fixed-rate mortgage in the second year. Leverage goes up to 80 percent loan-to-value. The company says the most common rehab deals it sees are basically in-place, one-for-one rehabs, where borrowers with solid occupancies are upgrading units as they're turned over.