Underwriting Guidelines For Freddie Mac Apartment Loans

At Raisal, our loan advisors are often asked to assist real estate brokers and investors “size” up a deal to evaluate max leverage.

There are many misconceptions about what underwriters will look at and how to properly view the deal from the lender’s perspective. Below are a few key factors you should consider when evaluating a multifamily acquisition and how to size it up like a pro.

Current Income Versus Proforma Income

Investors naturally think “in the future.” They look at the upside potential of a property and evaluate based on what future rents will be. But lenders think “in the now.” So, when considering how much debt you can obtain, you need to underwrite based on current performance, not proforma – i.e., potential.

For example, we were recently underwriting a 19-unit apartment building where total Gross Potential Rent was $364,800 based on average market rent of $1,600 per unit. Actual rent was $1,450 per unit, providing monthly actual rent of $27,550 or $330,600 in annual gross rent.  The property was underperforming by over $34,200. With some slight improvements to the property, rents could be (theoretically) increased to market to get to an average of $1,658 per unit, which annually would be $378,000. An investor would obviously be purchasing this property with the strategy of realizing this additional income – nearly $48,000.  However, a lender is going to lend only on the current income.



A pretty stark contrast here between Current and Proforma income, which is even more pronounced when you calculate Net Operating Income (“NOI”) and apply a Cap Rate to determine a value.



When you consider how much leverage you can add, you need to focus on the current income, not the proforma.  This will help keep you from chasing an overpriced deal. Lenders are naturally more conservative. You should be too.

Replacement Reserves

Agency lenders will underwrite with a replacement reserve, regardless of whether it is actually required. Replacement reserves are funds to be used to maintain the property, such as normal wear and tear.  Typically, you are looking at $250 to $350 per unit, per year. Basically, for underwriting purposes, the replacement reserves are treated like an expense and deducted from NOI, which provides the Cash Available to Service Debt (“CASD”).  So, in our example, assuming we go with a $250 per unit replacement reserve, you’d have to deduct $4,750 from the NOI, producing CASD of $154,320.



Calculating Debt Service Coverage

Freddie Mac has minimum debt service coverage ratio (“DSCR”) to qualify for financing. Stated differently, the property must produce a surplus of income after payment of loan payments. In effect, it has to be profitable.

The DSCR is the ratio of cash available to service the loan payments. Lenders will want a ratio in excess of 1.0x.  A ratio of 1.0x means that the property is breaking even. For example, a property that is generating $10,000 per month in NOI, but the loan payments are $10,000 has a 1.0x DSCR.  A property that is generating $15,000 per month in NOI with the same $10,000 monthly loan payment has a 1.5x DSCR.  The minimum DSCR is 1.20x for Freddie Mac multifamily loans. The NOI is based on the LTV and the market.  See below grid:



For example, suppose that in our example above, that the buyer pays $2,800,000 for the property.  Based on current NOI, that is 5.68% Cap Rate (159,070 / 2,800,000 = 0.0568).  Based on proforma NOI of $199,100, that’s a 7.11% Cap Rate. It sounds like a good buy if the purchaser can realize that higher NOI.  However, the lender is going to underwrite this based on the current income, not the proforma income.

Let’s presume we want 80% financing (loan amount would be $2,240,000) and we go with the Freddie Mac Small Balance 10-year fixed, which has a rate of 4.22% and a 30-year amortization. Let’s also assume that this property is in a “top market”, which would explain the low Cap Rate, and thus a 1.20x DSCR will be required. The monthly loan payment is $10,980, which annually is $131,760.  DSCR would be:



Unfortunately, this deal does not support 80% financing.  To get to a 1.20x DSCR, the total annual debt service must be less than $128,600, meaning the monthly loan payment must be less than $10,716.

At 78% LTV, for example, which would be a loan amount of $2,184,000, the monthly loan payments would be $10,706, which annually is $128,472. That would produce a DSCR of 1.20x.

Other Factors To Consider

There are a few other issues to consider, such as the monthly liquidity requirement and rate adjustments based on changes to the prepayment penalty. Agency lenders require that you have 9-months of principal and interest payments socked away in a bank account. This is called the “liquidity requirement.”  Also, Freddie Mac has adjustments to the rate (all of them increases to the rate) if you elect to change the prepayment penalty from a “yield maintenance” provision to a graduated declining balance structure.  Changes to the rate will obviously affect the monthly payment, which will affect DSCR.

All in all, there are many factors to consider with multifamily financings or any commercial financing for that matter.  There are some great resources out there and we strive to provide our clients with the information that they need to make informed decisions.

Raisal.com provides commercial real estate investors direct access to hundreds of institutional lenders, including local and national banks, credit unions, Fannie Mae and Freddie Mac correspondents, CMBS conduits, life insurance companies, and bridge lenders.

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