Call it the aftershock refi.

Several other names have been kicked around lately: defensive refis, higher loan-to-value (LTV) refis, and even “nochoice refis,” in that the lender has no choice but to re-up the original loan. But another name for the seismic dilemma currently facing multifamily owners and lenders is the “aftershock refi.”

First came the earthquake—soaring unemployment rates in the fourth quarter of 2008 that continued into the first quarter of 2009. Since the multifamily industry is a lagging indicator of the economy, those jobless rates take a while to show up as vacancy rates, and longer still to translate into delinquency rates. Hence the ripple effect. While multifamily delinquency rates are currently low, they are climbing. The number of Fannie Mae loans at least 90 days past due was 0.34 percent in May, up from 0.27 percent in January. And while Freddie Mac's rate is even lower, at 0.10 percent, the company also expects a coming wave of more troubled loans.

“We've seen it steadily rise: Our watch list has gone up, our stressed properties have increased, and our delinquencies have increased,” says Mike May, senior vice president of multifamily for McLean, Va.-based Freddie Mac. “In the fourth quarter, job losses just exploded, and that had a big impact on our portfolio.”

But it's not today's numbers that are causing sleepless nights. “It's more a question of what's coming,” says David Durning, senior managing director for Newark, N.J.-based Prudential Mortgage Capital Co. “Apartment values have fallen 30-plus percent, delinquencies will rise, and that's the gathering storm.”

Indeed, market-research firm Real Estate Econometrics currently predicts a multifamily delinquency rate of 5.5 percent by the end of 2010. Meanwhile, as Fannie and Freddie struggle to grapple with these current and future delinquencies, the real horror show concerning securitized loans is only beginning to get underway. About $171 billion of commercial/multifamily loans are set to mature this year, and another $120 billion will mature in 2010, according to the Mortgage Bankers Association. Of the $171 billion in total nonbank loans coming due in 2009, about 53 percent is in commercial mortgagebacked securities (CMBS), collateralized debt obligations, or other asset-backed securities such as short-term, aggressively underwritten loans.

“When things started to deteriorate in 2007 and the first part of 2008, we didn't really have any issues,” says Al Brooks, president of New York-based Chase Commercial Term Lending. “Our issues now are happening pretty hard, and they'll remain that way at least six to nine months after the general economy starts to improve.”

As a result, lenders and owners are bracing themselves, wondering what happens if and when those loans can't find the capital to refinance. How many of those maturing loans will go south and flood the marketplace with more distressed assets, further depressing apartment values? And what is the industry doing to proactively prevent the flood gates from opening? Here is a look at four avenues being pursued by lenders and owners today.

1. Work out a workout with the GSEs.

For government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, the best defense against the looming wave of distress is a good offense.

The GSEs are working on several strategies to get out ahead of the potential wave of distress and help their troubled borrowers ride through the downturn. While the workouts will be decided on a case-by-case basis, some of the tactics being considered include extending maturities, providing favorable refinancing rates, and lowering the balance of an existing loan. None of these programs had formal names as of late June as details were still being ironed out.

“We're eager to work with lenders who need help to do refinancing and loan modifications,” May says. “We're considering all the different aspects of loan workouts and refinances and financing of defaulted properties.”

Freddie Mac plans to unveil a refinancing program this summer that gives its borrowers more options for refinancing higher LTV maturing loans—providing more flexible market-rate refinance terms at maturity, for instance.

The programs won't be available to just any borrower. Freddie Mac needs to see an owner who is keeping the property in great shape and whose property is performing as well as the rest of the market. “And we're looking for skin in the game,” May says. “We expect them to be willing to put some equity in to make the deal work.”

Fannie Mae has also increased its asset management staff this year, and plans to add more staff as the watch list grows. The first phase of the company's new asset management strategy is to identify maturing loans and determine whether they meet current underwriting standards for a refinancing. To help comb through its portfolio, Fannie Mae will make its site inspection protocols more stringent. And while annual financial statements have always been par for the course, Fannie Mae will likely up that requirement as well in order to get a more recent read on a borrower's financial health. “We're carefully evaluating whether we want to move to a quarterly financial statement requirement,” says Michele Evans, vice president of multifamily corporate affairs at Washington, D.C.-based Fannie Mae.

The second phase of Fannie's portfolio management strategy is to institute a set of guidelines, scheduled for release in July, which will direct lenders on how to deal with loans that don't meet the current standards.

“We're developing a formalized strategy around how we're going to address these requests, but it's not yet fully baked,” Evans said in late May. “Will we be doing modifications, interest-rate reductions, lowering the balances on the mortgages? We haven't determined exactly what the path will be.”

2. Stop the bleeding and close the equity gap.

For balance-sheet lenders, the biggest concern as consumers look to refinance is the equity gap: Borrowers with maturing loans may have to put more equity in to make the deal whole, for instance, but questions linger about where all of that equity will come from.

To address this, KeyBank Real Estate Capital is doing something it's never done before: The lender is exploring the idea of raising an equity fund just to clear some loans out of its own books. “We're looking at forming our own fund with third-party investors to put the equity into these types of deals, to move them off the balance sheet and into Fannie and Freddie,” says Dave Shillington, director of agency lending at the Cleveland-based firm.

In short, the lender isn't inclined to grant long-term extensions. “If I've got a deal at LIBOR plus 150 [basis points] on my balance sheet, a lot of borrowers felt like we would just extend the loans at maturity,” Shillington says. “We don't want to extend loans; we want to shrink the portfolio.”

Most of KeyBank's refinancing deals have been for existing short-term bank loans, typically construction or interim bridge loans, coming from another institution's balance sheet. “The banks are all furiously looking for capital relief,” Shillington says. “They're bringing deals to us, and we're seeing capital gaps anywhere from 10 percent to 20 percent of the notional amount.”

And it's not just balance-sheet loans: Those aggressively underwritten shortterm CMBS loans coming due also loom over the industry. That's partly because, during the high-flying days of the CMBS market, many deals were underwritten at up to 90 percent LTV, with a full-term interest-only (IO) period. “If you did a full-term IO deal five years ago, with the increasing cap rates out there, you're in trouble,” says Will Baker, a vice president at Bethesda, Md.-based Walker & Dunlop. “It's going to get messy.”

When those CMBS deals seek refi- nancing, many will likely be turned away. “There's an enormous equity gap, and the market needs to figure out how to fill it,” says Freddie Mac's May. “A lot of CMBS, because of the way they were underwritten, just won't work for us, unless somebody's coming to the table with a lot of cash.”

Lenders are seeing the equity gap increasingly being filled by institutional equity funds looking to take a preferred equity stake in a deal—basically, a jointventure arrangement. And there are a number of opportunity funds sitting on the sidelines, waiting for this avalanche of maturing loans out of the CMBS market in 2010 and 2011.

Similarly, most of the refirequests coming to Walker & Dunlop are for properties that have CMBS loans maturing. “A lot of it doesn't even get anywhere close to the existing balance,” Baker says. “And we're not going to change our terms to accommodate them.”

3. Consider cashing out—while the terms are still good.

A cash-out refinancing—when a property is refinanced for more than it owes, and the owner pockets the difference—is a critical strategy for many multifamily owners, especially now. At a time when many markets have seen declines in rent and rising vacancy rates, owners are looking to find the kind of strategic liquidity that can help prop up underperforming assets. With a cash-out refi, they can take equity from a strong property and balance their portfolio by investing the cash in a weaker one. Unfortunately, the GSEs have significantly tightened their credit standards on cash-out refinancings, dropping the leverage levels down five or 10 basis points, and upping the debt service coverage ratio (DSCR) by the same amount. So more borrowers are turning to the FHA's Sec. 223(f ) program, where cash-out refiterms feature 80 percent LTV and a 1.17x DSCR.

With borrowers finding equal or better pricing from the FHA, while achieving better leverage, the choice is clear. “Anything that would have historically gone to a conduit because of higher leverage seems to be falling to the FHA,” says Jeff Patton, a senior vice president at Charlotte, N.C.-based Grandbridge Real Estate Capital. “They're the only ones allowing 80 percent LTV.”

There's a growing sense in the industry that the GSEs will further tighten standards on cash-out refis as the year goes on. Many borrowers were scrambling to do cash-out refis through the GSEs in the first half, sensing that their window of opportunity was slipping way.

The concern in the industry is that any further tightening would severely limit an owner's ability to ride out the downturn. “It's the real estate's business to recycle cash —that's what we do,” says John Cannon, who oversees agency lending efforts for Horsham, Pa.-based Capmark Finance. “So I think this prohibition against cash-out refis is a fairly short-term phenomenon.”

4. Whatever you do, avoid the falling knife.

Though the strategies that owners and lenders are employing should go a long way toward reducing the amount of distressed assets on the market, the aftershocks of the distressed asset shakedown will be felt for some time. That's why many companies are focusing on asset management—to make sure that doesn't happen.

Grandbridge, for one, has reallocated staff to focus on asset management. The company currently only has two Real Estate Owned (REO) properties, both of which are Fannie Mae deals, but expects more in the next year.

“We're trying to extend deals to allow people to work through the current environment, so long as we expect them to be able to right-size the debt,” Patton says. “If we feel like we're just delaying the inevitable, we're dealing with that today.”

As of late June, Freddie Mac's Web site listed just six REO multifamily properties, four of which are in Georgia. Should the level of REO properties rise in the coming months, the GSE hopes to entice new buyers with favorable financing, a strategy Fannie Mae is also likely to employ for its 38 REO sites.

Meanwhile, Chase Commercial Term Lending (formerly Washington Mutual) has about 40 REO multifamily properties. While that number may seem high, it's relatively low: WaMu was a high-volume small-loan specialist. In 2007, for instance, the company processed 7,632 multifamily loans (more than double any other lender), with an average deal size of just $1.4 million. But the company expects more pain on the horizon. “We're anticipating it will be obviously much larger than it is now,” Brooks says. Brooks is probably right, if you consider the aftermath of the savings and loan scandals of the early 1990s, after which distressed assets were still hitting the market in 1994 and 1995 due to the lengthy settlement process. And since the capital stack of CMBS deals today is complex, it will also take time for troubled assets backing these loans to hit the for-sale market.

“I would guess 2010 is when a signifi- cant volume of assets will hit, and the second half is where it will peak, even while the markets recover in the middle of the year,” Durning says.

While the multifamily industry is in a better spot than other commercial real estate classes, thanks to the GSEs, the wave of loans coming due for overleveraged borrowers will only add to the level of distressed assets on the street.

“Lenders are going to have to make some hard choices; they're doing a lot of extending now because they can't or don't want to take them back,” says Ryan Krauch, a principal with Los Angelesbased Mesa West Capital. “We haven't seen a lot of distress yet at the regional bank level yet, but that's coming. It's going to get worse before it gets better.”

The Best Candidates for a Workout

Lenders don't want to be property owners. That's especially true in today's market.

WITH OCCUPANCIES DECLINING and sales prices depressed, most lenders are doing everything they can to amend and extend troubled loans. Their goal? To keep the keys in the pockets of the current owners.

Lenders across the nation are bolstering their asset management staff and taking a magnifying glass not only to a borrower's financial statement, but also to the assets themselves. Prudential Mortgage Capital Co. is inspecting more properties than ever before to determine the best candidates for a workout.

“One of the main concerns that the agencies have, and that we have, is deferred maintenance,” says David Durning, senior managing director for Newark, N.J.- based Prudential Mortgage Capital Co. “One of the most important factors in making a decision about showing some flexibility is whether the physical quality of the property is being maintained.”

In the past, many portfolio management techniques were asset-centric, but lenders are taking a much closer look at the borrower these days. And a property's appearance can mirror a borrower's financial health. Prudential looks for evidence that the property's cash flow is being reinvested into the community, or whether that cash is being used to pay off other corporate bills—a possible sign that the borrower is in trouble.

For amendments and extensions, the company likes to see borrowers with some skin in the game. “Lenders like to know that borrowers have put additional capital at risk—repaving the roads, putting on new roofs, whatever,” Durning says. “Those are important signals to a lender of going forward.”

One of the largest balance-sheet lenders in the business, Chase Commercial Term Lending (formerly Washington Mutual), is also trying to get in front of the issue by expanding its asset management capabilities. “We're reaching out more than people are reaching out to us,” says Al Brooks, president of New York-based Chase Commercial Term Lending.

Owners who are keeping the property up—through maintenance, landscaping, and graffiti abatement—are at the top of the list for workouts. “During a difficult period is when people really earn their stripes as property owners,” Brooks says. The company is particularly sensitive to good owners in bad markets—cases where a specific market's fundamentals are roiling a normally solid property, Brooks adds.

So, keep your properties humming, continue to service your debt as best you can, and be upfront with your lender if you feel things are heading south. Honesty really is the best policy, lenders say.

Divining Value

One of the biggest issues facing refinancing transactions is determining the “V” in LTV.

EVERYONE KNOWS THAT asset values are falling in most, if not all, markets. But how can you measure the rate of descent for that falling knife?

“No one knows what loanto- value [LTV] is because there are no sales comps,” says Will Baker, a vice president at Bethesda, Md.-based Walker and Dunlop. “The appraisers are pulling their hair out, trying to figure out what a cap rate is.”

In the past, lenders could turn to the acquisition market to get a current read on valuations. But since there are very few acquisitions this year, lenders have nothing to measure against: In the absence of a trade, there's no market-determined value. But even if there was a recent transaction in a local market, it may not really be comparable. Today's cap rates just can't be trusted. “You have to really dive into cap rates and see why the sale happened,” Baker says. “Was it a distressed sale? Did they have to sell? Or was this a normal deal? You can't just look at a cap rate anymore.”

Appraisers are expanding the box to get a read on the economy, especially in secondary and tertiary markets. To determine the value for a deal in Springdale, Ark., for instance, the appraiser may have to look to recent transactions in Little Rock, Ark.—200 miles away—for a comp to support a given cap rate.

Most lenders are taking a closer look at the trailing and current collections numbers to determine a trend. “That's why cash flow is so important,” says Mike May, vice president of multifamily at McLean, Va.-based Freddie Mac. “We get appraisals now, and there are no comps, or the comp is two years old, or three counties away. So cash flow is king.”

But scouring the past three months of collections data won't make it easier to see where things are headed. “In a lot of markets, we are seeing collections where the most recent month is not as strong as the past three,” says David Durning, senior managing director for Newark, N.J.-based Prudential Mortgage Capital Co.

As apartment values continue to descend, the LTV ratio of existing debt gets skewed. A loan that was made at 75 percent LTV two years ago may now be at 85 percent LTV or higher.

“We're left to estimate where cap rates are today,” says Jeff Patton, a senior vice president at Charlotte, N.C.-based Grandbridge Real Estate Capital. “And if we can't figure out the true value, and a borrower wants to pull out cash through a refi, that makes us nervous. And that has led to Fannie and Freddie being more of a 70 percent or 75 percent LTV player on refinance transactions.”

It's a tricky proposition, and the process can sometimes feel as precise as reading tea leaves, lenders admit. “In many cases, we can see declines but we can't see the bottom, so we don't know how much further we're going to go,” says Don King, head of national agency lending at Needham, Mass.-based CWCapital. “It's extremely difficult.”