In the debate over the future of our nation's housing financesystem, a lot of lofty concepts get thrown around. At the heart of the debate is a philosophical quandary over how involved the government should be in supporting the nation's housing finance system. But in practical terms, apartment owners and borrowers just have one question: What does it all mean for me?
Three paths have been laid out by the Obama administration's white paper on the future of Fannie Mae and Freddie Mac, all of which are being debated in Congress: a fully private model; a fully private market with an “emergency” government guarantee in times of crisis; and a market with an “always-on” government guarantee for select portions of the industry.
Some consensus is forming around a few principles, including that the private sector should dominate and the government's role should be constrained. But many in the industry believe that interest rates will rise regardless of which option is chosen. “The cost of capital is going up no matter what model gets implemented,” says Mitch Kiffe, co-head of origination at Los Angeles–based CB Richard Ellis Capital Markets and a former 17-year Freddie Mac veteran. “It's not just GSE reform, but financial reform in general, and risk-based capital rules, that will have an impact."
An uncertain future awaits, and industry observers are anxious to understand how each option will affect interest rates, cap rates, and investor risk. Here, Apartment Finance Today analyzes the impact on both financing and dealmaking of the many roads that lie ahead.
Option 1: Fully Private
Who's in support: Conservative think tank American Enterprise Institute (AEI) wants the government completely out of the mortgage business. Its own proposal for reform 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."
Pinto says a fully private market would also increase competition— for years, smaller lenders have complained that the GSEs had an unfair advantage thanks to their 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 under this scenario wouldn't be too severe. But when the market suffers a dislocation, “private capital goes to the sidelines and maybe you can't get a loan at any cost,” Kiffe says.
What it means for you: A fully private market would likely have a significant impact on the types of deals that see traction. 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. “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 City–based Real Capital Analytics.
Investors weighing opportunities in secondary and tertiary markets, or B-minus assets and below, should keep this possibility in mind. “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. If the characteristics of a property don't warrant the attention of a broad array of investors and lenders, that's potentially problematic for you."
Option 2: Not Mutually Exclusive?
Who's in support: The second option hasn't gained much traction. The idea that the government can act as a fireman in standby mode, scaling up during times of crisis, doesn't seem plausible: Where would all of that sudden infrastructure come from?
“It's an interesting, esoteric, academic idea that has no bearing at all in the real world,” Narasimhan says. “It's the least viable option."
But maybe that second option is simply a piece in a larger puzzle. To Doug Bibby, president of the Washington, D.C.–based National Multi Housing Council, the white paper laid out a continuum, a road map that starts with option three and progresses eventually to a market that more closely resembles the fully private model in option one.
“Option three could carry us for maybe five years, to a period where the private sector becomes much more robust, and then you'd have the federal government stepping in on an emergency basis," Bibby says. “And maybe 10 years down the road, you'd have a market truly dominated by private capital, with some function performed by the government."
What it means for you: Borrowers can expect to see the same rise in interest rates and cap rates presented under option one. But the greatest value of option two would be in providing counter-cyclical liquidity—when the market suffers a dislocation, interest rates and cap rates would remain fairly steady thanks to the sudden presence of a government guarantee. This latent backstop—invisible until times of crisis—would allow owners to refinance or make an acquisition throughout a recession, acting as a placeholder until the private sector returned.
Option 3: Always On
Who's in support: Where conservatives have coalesced around the fully private first option, most housing industry groups have huddled around the third option of an “always-on” federal guarantee. The Center for American Progress (CAP) and the Mortgage Bankers Association (MBA) also advocate the “always-on” guarantee for select portions of the market. In their view, government involvement is instrumental in assuring a free flow of liquidity through good times and bad.
“If it ain't broke, don't break it,” says David Abromowitz, a Bostonbased partner at law firm Goulston & Storrs and a senior fellow at CAP. “The government involvement has provided liquidity in a time of credit freeze; it brought private capital into the market; and if you look at the default rates for the GSEs, the track record shows that it's been working."
The federal guarantee would be given to privately capitalized companies—the MBA calls these companies mortgage creditguarantor entities; CAP calls them chartered mortgage institutions. That guarantee would be explicit, paid for, and limited—the resulting mortgage-backed securities would be guaranteed, but the corporate debt and equity of the institutions would not be.
What it means for you: Borrowers can expect a 40 bps rise in interest rates, estimates CAP, but that cost of capital would be fairly steady throughout the ups and downs of the market. Option three would provide a free flow of liquidity to assets that are less palatable to the private sector—Class B assets and below, and secondary and tertiary markets, would enjoy the same access to credit that they do now. This option presents the least risk to investors—the cap-rate disparity between asset classes, and from market to market, would remain muted (relative to other types of commercial real estate).
That government charter would also likely mandate a responsibility to serve the workforce housing market. Under CAP's proposal, half the units financed annually should be for rents affordable to those earning 80 percent or below of the area median income. Of course, the main argument against such a scheme is recent history: It sounds awfully familiar.
“No matter how you structure the new entities, they all end up having the same flaws as Fannie and Freddie,” AEI's Pinto says. “When you start describing affordable housing, income limits, expectations, that gets right back to the GSEs. And all of a sudden, the market says, ”˜I don't think the government is going to let those fail.'"
FHA CORPORATION?
The future of multifamily housing finance may have been proposed 17 years ago.
IN 1994, PRESIDENT CLINTON floated the idea of taking the FHA and making it a governmentowned corporation that would behave more like a private company. The FHA would remain part of HUD but would have more independence— maintaining its own funds, for instance, as opposed to being subject to the appropriations process—to hire top talent and invest in technology.
The proposal didn't get very far, but then again, the political motivation to re-engineer the agencies wasn't as strong in the mid-'90s. Now, there are some influential voices calling for a similar framework. “The FHA is essential to the system—the left, right, and center seem to agree on that,” says Shekar Narasimhan, managing partner of McLean, Va.– based Beekman Advisors. “Option one is FHA, option two is FHA, and option three is also FHA. One way or another, the government, in a guaranteed form, will continue to have an entity that provides some type of assistance to affordable rental housing development."
How It Would Work
As it's currently framed, the FHA is a model of inefficiency— just ask anyone who's closed an FHA loan lately. But by freeing it from its bureaucratic chains, a functioning, self-sufficient FHA corporation could generate profits for the government while spreading the risk around.
The idea is basically to mirror Fannie Mae's Delegated Underwriting and Servicing model. A regulated private intermediary market—a network of well-capitalized private lenders—would risk-share with the FHA, much as DUS lenders do with Fannie Mae now.
Unlike Fannie Mae, the FHA Corp. could also provide construction financing, sharing the risk with banks. Multiple entities will likely emerge—community banks may create a consortium; larger banks will need a charter, too; and private equity firms will see a great opportunity to get in on the ground floor and capitalize one entity just for multifamily.
The Obama administration's white paper offered some clues that it may be inclined to give the option a try. The white paper talks about expanding the FHA's capacity to support multifamily lending, including risk-sharing with private lenders, giving the FHA more flexibility to adjust fees and programs, and goes on to say the “FHA should also have the technology and talent needed to run what should be a world-class financial institution."
Multifamily First
The problem with some congressional proposals is that they either want to eliminate the GSEs very quickly—throwing the housing markets into chaos—or not quickly enough. If Congress continues to debate the issue for another decade, the GSEs will wither on the vine.
“People don't wait around in dying places; they don't hang around a funeral home after a funeral; it wouldn't hold together," Narasimhan says. “We can't just suddenly end the GSEs, and we can't say let's keep thinking about it for another 10 years. The answer is really somewhere in between."
To Narasimhan, the rallying cry is “multifamily first.” The multifamily industry should try the FHA corporation model first to prove that it could be done. The agencies' multifamily divisions are already profitable, the markets are recovering, and more new construction capital is now needed to meet rising demand.
“I believe that the framework of a plan—multifamily first—can be achieved in 2011,” Narasimhan says. “There is a basic agreement that we've desperately got to have a functioning FHA, and that we've got to have private capital ahead of any government resources. Can we do a pilot? Can we see if we can raise capital? Let's go out and try."
BE PREPARED
Here are three ways you can get ready for a post-GSEs world.
THE NATIONAL MULTI HOUSING Council believes that it will take five to seven years before a solution for the next generation of housing finance is enacted. But borrowers shouldn't be lulled into complacency by that time line—you should start preparing now to live in a world with no GSEs or, at best, a market with more limited GSE participation. Here are three things you can do today to prepare for the inevitable changeover.
1. Diversify
If the first or second option is enacted, then the private market will absolutely dominate the multifamily lending arena. So borrowers who have been singularly using the GSEs as their financing vehicle should begin cultivating more relationships with banks, life insurance companies, and CMBS lenders in order to protect themselves and their investments.
Like many multifamily borrowers, Lincoln Property Co. has grown increasingly dependent on the GSEs. The company had about 10 percent of its outstanding permanent debt with the agencies in 2000. By the end of 2010, agency permanent loans accounted for nearly 80 percent of the company's debt portfolio.
“As an industry, we have to be prepared to have a significant downsizing in that source of financing,” says Brian Austin, vice president of finance for Dallasbased Lincoln. “We all have to do a better job of rounding out the table to make sure we're talking to everybody."
2. Go Long
Behringer Harvard, one of the biggest buyers of assets in the past three years, has made a conscious decision to favor only long-term debt—seven to 10 years—to mitigate the interest-rate risk presented by the upcoming new world order. And the company's prudence in taking a long-term view can sometimes be painful.
“I'm going more long term in my thinking. That interest-rate risk moving forward, with the potential elimination or reduction of impact of the GSEs, is a huge risk to me,” says Mark Alfieri, executive vice president and chief operating officer of Addison, Texas–based Behringer Harvard. “We're more long-term, fixed-rate thinking today than probably we should be, given where adjustable-rate financing is today."
3. Underwrite Conservatively
Even if the third option, the always-on guarantee, is enacted, it will still have ramifications for the upper end of the asset class spectrum. As life insurance companies grow more aggressive in pursuing Class A luxury deals, the GSEs are becoming a shrinking presence in that space. And less competition ultimately means higher interest rates.
“If you're an owner or developer of Class A real estate, you've got to keep that in the back of your mind," says John Cannon, executive vice president with Horsham, Pa.–based Berkadia Commercial Mortgage. “What if Fannie and Freddie pull away from Class A? What's that going to mean to you from a cap-rate perspective and from an exit strategy perspective?"
Under such a scenario, the caprate disparity between Class A and Class C assets may begin to flatten a bit. The fear is that, while life insurance companies will step in to the void, their rates will certainly not be as low as they are now. So owners should be prepared for higher rates and model a worst-case scenario when underwriting exit strategies.
