Multifamily housing is a 3-trillion-dollar industry—that’s about 14 percent of GDP—and provides more value and jobs to the economy than even the tech industry. There is no question that multifamily housing is a critical piece of the country’s infrastructure. It provides residences for millions of families and individuals. That’s why we all have an interest in supporting it and why it’s a great investment in good economic times and bad.

Two government-backed financial institutions, Fannie Mae and Freddie Mac maintain the stable stream of funding that supports multifamily housing. Loans from financial institutions enable buyers—developers, investment firms, and so on—to purchase properties. Because multifamily housing is critical infrastructure and a good investment, it’s worth understanding some of the underlying financial details.

Fannie Mae and Freddie Mac

Much of the capital that finances multifamily housing is agency debt from Fannie Mae and Freddie Mac. They are private companies that Congress chartered in 1938 and 1970, respectively.

The funds Fannie Mae and Freddie Mac loan are called agency debt because these financial institutions can borrow from the US Treasury, although there is no guarantee that the US Treasury must lend to them. In simplified terms, Fannie Mae and Freddie Mac buy mortgages from commercial lenders and other financial institutions and guarantee that the principal and interest on those mortgages will be paid. The funds they supply when they purchase mortgages enable financial institutions to make more loans. This buying and selling of mortgages creates a cycle that keeps funds in the mortgage market liquid.

Although Fannie Mae and Freddie Mac are government-chartered and government-backed organizations, they are financially self-sustaining. Fannie Mae bundles the mortgages it buys from lenders into mortgage-backed securities and sells those as bonds. The bonds pay interest to investors every month. Fannie Mae funds itself by buying the original mortgages at a lower interest rate and selling the bundled mortgage-backed securities at a higher interest rate. The difference in rates is its profit. In return for that profit, Fannie Mae bears most of the risk on both ends of the deal.

Non-recourse Loans

Multifamily real estate investments depend on non-recourse loans. The asset—for example, a 300-unit apartment complex on 15 acres of land—serves as collateral that guarantees the loan. In the case of default, the lender can take the property and any cash flow it generates. The value of the property and its cash flow cover the principal and interest on the loan.

A non-recourse loan protects an individual’s personal assets. If the value of the property and its cash flow are less than the principal and interest on the loan, the lender cannot recover the balance from the borrower. The individual bears less risk in this arrangement, and investors and the bank or financial institution bear greater risk. Because financial institutions bear greater risk, non-recourse loans usually come with higher interest rates.

There are, however, conditions that protect the lender’s interests. When these conditions are met, the lender can recover the principal and interest on the loan directly from the borrower. Called “bad boy” carve outs, these conditions consist of unethical or illegal business practices, like fraudulent financial reports or tax returns or obtaining additional financing (over-leveraging) without the original lender’s permission.

In the multifamily industry, Fannie Mae and Freddie Mac loans act as a backbone for the financial institutions that make these non-recourse loans available. Individual borrowers are not affected by circumstances, like a major economic meltdown, that create default unless they commit gross mismanagement or fraud.

Non-recourse Loans Mean You Can Scale

Beyond protection from personal liability, why do non-recourse loans make good business sense? The answer is that they provide non-contingent liability. And non-contingent liability gives you the ability to scale. When a bank evaluates a contingent loan, it looks at global cash flow, which includes the individual borrowing the funds. They will assess the person’s liability against the person’s income and reject the request to borrow if the person has too many liabilities. But in the case of non-recourse loans, each property supports itself based on its cash flow (the bank calls this “debt service coverage ratio”). Because each property has a cash flow and supports itself, a real estate investment firm can get more than one loan, buy more properties, and scale its business.

Financial institutions, however, don’t just hand out loans for real estate investment deals. A firm must have some equity in the investment to make the deal happen. In commercial real estate, closing a multimillion-dollar deal means bringing several million dollars to the table. With the loan and the equity in place, a firm buys the property.

Most of the time American Ventures® invests in properties that generate cash flow. If we underwrite the deal well and meet our performance expectations with efficient management, usually there is no need for further investment, no need to raise multiple rounds of capital, and no need for public offerings. The project sustains itself, generates a profit, and provides a service that people need.

More than simply sustaining itself, paying for operating expenses, the original debt, and taxes, the property pays a yield on the investment, and this is what makes it desirable to investors. Although other types of commercial real estate also pay a yield, multifamily deals are easier to execute because of the financial institution’s access to non-recourse capital from Fannie Mae and Freddie Mac.

A Case Study

Suppose you are buying an apartment complex in the suburbs of Dallas, Texas, for $10,000,000. Financial institutions are willing to lend $6,500,000. The balance of $3,500,000 is the down payment or equity you must raise to acquire the property. An investment firm might put $2,450,000 into the deal, providing nearly 25 percent of the required capital or 70 percent of the down payment, and will do no more. But the deal is still short about $1,050,000. American Ventures® or any real estate investment firm has only so much funds available and typically invests 10 percent or more of the required equity capital or down payment. For the difference, I might call a group of friends, who then put in $100,000 to $250,000 each. This is called syndicating a deal and is a typical way to create a real estate investment opportunity. In a case like this, we create a single-purpose entity (SPE), typically a limited liability corporation (LLC), which acts as the entity that owns the asset. All the investors become members of the LLC, which protects their interests in the deal.

Fannie Mae and Freddie Mac Helped Multifamily Weather the Pandemic

The multifamily real estate industry thrives on non-recourse financing. Fannie Mae and Freddie Mac back that financing and keep it stable.

If enough renters become unemployed and cannot pay rent, as happened during the pandemic, multifamily housing complexes lose their ability to generate cash flow to cover operating expenses, including loan payments and a return to investors. When an industry that makes up 14 percent of the US economy defaults on the loans that sustain it, the financial institutions making those loans will also suffer losses. The economy was already in a deep recession because of the public health measures in place to control the pandemic. A wave of bankruptcies in a major industry closely tied to the financial industry would have been devastating.

In response to the looming financial disaster, Fannie Mae provided $1.4 trillion to support the mortgage industry. These funds helped lenders establish forbearance programs with borrowers. For example, borrowers could make mortgage payments at a lower interest rate, make partial payments, forgo immediate payments and spread them out over twelve or twenty-four months, and so on. Multifamily borrowers were able to pass these arrangements on to renters.

The COVID pandemic showed just how important Fannie Mae and Freddie Mac are to the smooth working of the multifamily housing industry. Without their lending programs, the industry would have unraveled through multiple bankruptcies.

3 Tips For Investing In Multifamily Real Estate

1. Discover Your 50%! The best way to navigate through potential deals is by crunching the numbers and figuring out how much a specific multifamily property can make you as an owner. It’s all about calculating the difference between expected income (like rent payments, storage fees, parking fees) and expenses (repairs, maintenance, etc.).

2. Calculate Your Cash Flow Now let’s calculate your estimated monthly cash flow by taking into account the mortgage payments. This step will help you determine how much money you’ll have in your wallet. Simply subtract the monthly mortgage from the property’s NOI to get your cash flow estimate. It’s a handy calculation that will give you an idea of whether or not the investment is worth it.

3. Figure Out Your Cap Rate A third critical calculation to memorize is the capitalization rate, or cap rate for short, which indicates how quickly you will get a return on your investment. It’s important to remember two things. First, the cap rate for a “safe” investment, like a certificate of deposit (CD), is usually between 1-2%. Second, this cap rate you’re about to calculate doesn’t account for many factors. You should also consider property value increases, monthly NOI boosts, or the tax breaks afforded to owners of multifamily properties.

Read More Tax Benefits for Passive Real Estate Investing

Author

Shravan Parsi

CEO & Founder | American Ventures

Connect with Shravan on LinkedIn 

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