Small apartment properties like these, in the Prospect Heights neighborhood of Brooklyn, N.Y., are often targeted by investors eager to renovate and raise the rents.
Bendix Anderson Small apartment properties like these, in the Prospect Heights neighborhood of Brooklyn, N.Y., are often targeted by investors eager to renovate and raise the rents.

Though they may not be large, small apartment buildings are a big piece of the affordable housing puzzle. But they can also face some big challenges.

For one, it’s often difficult to find financing for these assets to keep them well-capitalized and operating smoothly. Many multifamily loan programs won’t make loans of less than $5 million, though in recent years Fannie Mae and Freddie Mac have both created programs that originate small apartment loans. Additionally, in urban neighborhoods where rents are rising quickly, existing apartment communities have become attractive targets for “value-added” investors eager to buy the properties and raise their rents.

Small Properties Are Often Affordable
With the exception of the occasional “boutique” small rental building, small apartment properties are typically older buildings whose rents are significantly less than those at new multifamily buildings. “There's a high correlation between these smaller apartment properties and Class C rental properties,” says David Brickman, executive vice president of Freddie Mac Multifamily.

The challenges that face small apartment building are very different in different places. In neighborhoods “rediscovered” by luxury apartment developers, rents are rising quickly. “There's a spillover effect,” says Barbara Byrne Denham, an economist for Reis.

In these gentrifying neighborhoods—such as Williamsburg or Harlem in New York City—many small apartment buildings have been bought by investors. Mission-driven affordable housing developers have also attempted to buy properties like these, but, unlike their market-rate counterparts, affordable developers seek to preserve the properties' affordable status, though these buyers tend to favor large apartment properties where they can achieve some economies of scale.

In other, quieter housing markets, rents are also rising, but within limits. “There are spots where owners and operators are hesitant to push pricing much further, simply because we’re at the limits of what the renter base can handle,” says Greg Willett, chief economist for MPF Research, a RealPage company. Rents grew an average of 2.8% at Class C properties overall over the 12 months that ended in the second quarter, according to MPF.

Many of these small properties, because of their age, need some repairs to continue their useful life as apartments. Most are decades old, as developers have been building fewer small apartment properties over the years. The rising costs of land and construction press multifamily firms to create larger developments that offer economies of scale. “If you're going to build, you're going to build big,” says Brickman.

In the late 1990s, developers started construction on roughly 20,000 new apartments a year at small properties—those with 10 to 20 units apiece. Today, developers are building new small apartment communities at half that rate while building large communities at a very fast pace.

Every year, the housing market loses 125,000 rental apartments to old age and obsolescence, with the average life of an apartment property being just 70 years, according to recent research from the National Multifamily Housing Council (NMHC).

Apartment buildings can often be forced to close if they have capital needs—like a leaking roof or failing heating systems—that the owners can’t find financing to repair, even if the demand for apartments is high and rising in their market.

Small-Balance Loans Can Help
Small-balance loans may be the answer for some of these undermaintained properties. Fannie Mae and Freddie Mac both offer financing tailored to fit small apartment properties. “There was a great opportunity to support workforce housing,” says Stephen Johnson, vice president of Freddie Mac Multifamily’s Small Balance Loan business, in explaining some of the thinking behind the program's creation.

Details of Freddie Mac’s lending program show that the small apartment properties that tend to take out small-balance loans also tend to provide workforce housing. The vast majority of the loans made by Freddie’s Small Balance program, in fact, have gone to apartment properties where the rents are low enough to be affordable to people who earn less than 80% of the area median income, going up to 100% in a few high-cost markets. “Almost 70% of the loans are to properties that qualify as affordable,” says Johnson.

That affordability is important to Freddie Mac because federal regulators don’t limit the volume of loans the company can make to properties that are affordable to low-income people. Ever since Fannie Mae and Freddie Mac were seized by the federal government during the Great Recession, the Federal Housing Finance Agency has set a cap on how much the two GSEs can lend in total to apartment properties. But loans to affordable housing aren't included in the cap. So Freddie’s Small Balance Loan program can grow to meet the demand—and the demand has been very strong.

As summer comes to a close, Freddie's program has already made more small-balance loans than it closed in all of 2016: 1,641 loans totaling $4.1 billion so far this year versus 1,534 loans totaling $3.72 billion for all of last year.

These small properties are located in cities and suburbs, though the program also reaches rural areas. “[The properties] are older, and they’re located in inner-ring suburbs and cities,” says Brickman.

The properties in Freddie Mac’s Small Balance Loan program range in size from as small as five apartments to properties with 50 units, with the average at about 40 units. The average loan in the program is just $2.4 million, though the loans can be as large as $7.5 million. Fannie Mae’s program, which has provided more than $12 billion in financing since 2009, focuses on loans of less than $3 million apiece, or $5 million in a few high-cost markets.

The money provided by these loans can help apartment owners make vital repairs that in the past might have been deferred. “Some of these buildings may have some deterioration,” says Johnson. “We're not against cash-out refinancing.”