Before Fannie and Freddie jumped into the multifamily arena, the private sector owned the apartment debt market. And the market may be headed back that way again, depending on how GSE reform plays out.

So what would a fully private market mean to multifamily owners and investors? Interest rates would take a hit, but only a modest one, according to the American Enterprise Institute (AEI). The conservative think tank issued a proposal that mirrors the first option of the Obama administration’s white paper—a fully private market.

“We believe option one could end up with very modest increases in interest rates over time,” says Ed Pinto, a scholar at Washington, D.C.-based AEI and a former chief credit officer for Fannie Mae. “We think our pricing ends up being perhaps 40 basis points (bps) higher than Fannie and Freddie today. And we think that shrinks over time as liquidity increases in the marketplace.”

A fully private market would also increase competition—for years, smaller lenders have complained that the GSEs had an unfair advantage through its implicit government guarantee. “We think this approach actually levels the playing field legitimately for small lenders and community banks,” Pinto says.

Industry veterans believe that, when the market is booming, the impact on interest rates wouldn’t be too severe. But what happens when the market suffers a downturn?

“When the markets are bullish, your cost of capital is going to go down,” says Mitch Kiffe, co-head of origination at Los Angeles-based CB Richard Ellis Capital Markets, and a 17-year executive at Freddie Mac. “The real risk is when there’s a shock to the system, an event which nobody predicts, but always happens. Then, private capital goes to the sidelines and maybe you can’t get a loan at any cost.”

Even in good times, financiers have their preferences, and that appetite usually doesn’t include tertiary markets or affordable housing assets. Yet the GSEs provide capital for a broad menu of communities. So if the private sector were the only game in town, the strongest assets and markets would see plenty of capital—but what about the rest of the country?

“There will be a significant liquidity premium in some markets, which means not every loan can get done,” says Shekar Narasimhan, managing partner of McLean, Va.-based Beekman Advisors and a member of the mortgage finance working group at the Center for American Progress. “A loan in parts of Alabama is going to cost 250 bps more, and loans in Washington, D.C., will cost 50 bps more than they do today. We’ll end up with a truly bifurcated market, and that’s not good public policy.”

And cap rates will follow. Since the GSEs make capital available across all asset classes and markets, the multifamily industry doesn’t see the same kind of cap rate disparity from one market to another that other real estate sectors see. “But if you get an exit of the GSEs, all of a sudden, mortgage financing costs and cap rates start to look more like what you see in other sectors,” says Sam Chandan, global chief economist for New York-based Real Capital Analytics.

Investors weighing opportunities in secondary and tertiary markets, or B-minus assets and below, should keep this possibility in mind. If the characteristics of a property don’t warrant the attention of a broad array of lenders and investors, you could have a problem a few years down the road.

“You’ve got to anticipate that there will be a narrower spread between your underlying costs of capital and the cap rates of the market,” Chandan says. “There are going to be buy opportunities today that may look attractive, except that, as the degree of liquidity in the market changes, that won’t necessarily remain the case.”

Meanwhile, one of the biggest concerns about a fully private market is whether there’s enough capacity in the private sector to pick up the slack left by the GSEs. The entire non-recourse multifamily debt market is expected to be around $60 billion this year, and the GSEs are on pace to do at least half that volume.

Life insurance companies have grown aggressive of late, but multifamily is just a percentage of their overall commercial real estate activity. Last year, life insurance companies originated about $30.7 billion in commercial real estate mortgages. Multifamily assets accounted for just a fraction of that, around 15 percent, according to the American Council of Life Insurance Companies. 

Life companies aren’t wedded to the multifamily mortgage business; it’s just a means to an end, a way to get a fixed income return. And a life company’s appetite for multifamily changes depending on the attractiveness of alternative investments. “A life company book is a fickle book,” says David Durning, senior managing director of Newark, N.J.-based Prudential Mortgage Capital. “And in terms of capacity, the life company book of business is a fixed nut.”

The CMBS market is still dusting itself off, though it too has grown more aggressive. Total issuances this year are expected to be around $35 billion to $40 billion, yet multifamily assets will make up just a small percentage of that volume, probably less than 10 percent.

And commercial banks are every bit as inconsistent as life companies and CMBS. Even as the life insurance and CMBS sectors saw big gains in multifamily volume last year, commercial banks lent less than they did in 2009, according to the Mortgage Bankers Association.