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Evolution of multifamily small balance loans

| January 31, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Freddie Mac Small Balance Loan program has undergone some structural changes over the past year in response to investor feedback: the number of deals in 2018 was one per month, down from frequently two per month in 2017, and the average deal size grew to $535 million from $290 million. The reduced deal frequency has benefited smaller investors who often lack the bandwidth to conduct deep dive analysis of the collateral on a bi-weekly basis. The larger deal size has started to attract the institutional investors who need better liquidity and buy in significant size. The multifamily small balance loan program is expected to continue growing in 2019. The January deal was $622 million, and the monthly deals may reach $750 million in size. The additional liquidity may ultimately tighten spreads, while the additional yield over K-FRED deals and shorter average weighted lives of the FRESB securities continues to attract new investors.

Background

The Freddie Mac Small Balance Loan (FRESB) program has financed +7,200 loans and securitized over $18 billion of that collateral across 58 deals as of January 2019. A growing investor base composed primarily of banks, money managers, insurance companies and pension funds. The agency guarantee means the securities benefit from the same favorable risk-based capital treatment as agency debt and mortgage backed securities. CMBS investors can increase portfolio diversification, as FRESB deals have separate fixed-rate and hybrid classes of loans across 5-, 7- and 10-year tenors, resulting in securities with shorter weighted average lives and a broader choice of cash flow profiles than available in other CMBS structures. The additional spread compared to K-FRED deal bullet structures compensates for the greater prepayment optionality in small balance loans. Involuntary prepayments (defaults) are historically lower for small balance loans than larger commercial mortgages.

Growing securitization volume of small balance loans

The Federal Housing Finance Agency (FHFA) includes multifamily lending goals in for both Fannie and Freddie in their yearly scorecard. There are special carve-outs for multifamily properties with 5-50 units since research revealed that 80% of lower-income renters live in these smaller buildings, and this section of the multifamily market was historically underserved.

Excerpted from the FHFA’s 2019 Scorecard for Fannie Mae, Freddie Mac, and Common Securitization Solutions.

Appendix A: Multifamily Definitions

Market share target and quarterly review of market size

The 2019 Scorecard establishes a $35 billion cap on the multifamily purchase volume of each Enterprise (the “capped category”). Loans in affordable and underserved market segments are excluded from the cap (the “excluded category”). FHFA will review its estimates of the multifamily loan origination market size on a quarterly basis. If FHFA determines that the actual 2019 market size is greater than was projected, it will apply an appropriate increase to the capped category. If FHFA determines that the actual 2019 market size is smaller than was projected, it will not reduce the capped category.

Loans on small multifamily properties

Small multifamily properties are properties that have 5 to 50 units. FHFA will exclude the pro rata portion of the loan amount based on the percentage of units affordable at 80 percent of AMI or below in standard and cost-burdened renter markets, 100 percent of AMI or below in very cost-burdened renter markets, and 120 percent of AMI or below in extremely cost-burdened renter markets.

Freddie Mac added the small balance loan (SBL) program to its lending platform in 2014 and began securitization in 2015, known as FRESB deals. FRESB volume as part of Freddie’s multifamily securitization program has grown over time (Exhibit 1) and has attracted a greater number of investors.

Exhibit 1: Freddie Mac multifamily securitization volume (2009-Q3 2018)

Source: Freddie Mac Multifamily Securitization Overview (page 32).

FRESB deals typically contain a selection of securities with shorter weighted average lives, since the tranches correspond to 5-year, 7-year or 10-year fixed-rate or hybrid ARM underlying collateral. The FRESB securities also can offer additional spread compared to K-deal bullet structures to compensate for the greater prepayment optionality in small balance loans (Exhibit 2).

Exhibit 2: Example structures of recent FRESB vs K-deal multifamily agency CMBS

Source: Freddie Mac, Amherst Pierpont Securities

A comparison of the fixed tranches of a recent FRESB versus a K-FRED deal is shown in Exhibit 3.

Exhibit 4: FRESB 2018-SB56 fixed versus K-FRED fixed

Note: Indicative prices as of 12/7/2018. Source: Bloomberg, Amherst Pierpont Securities

Prepayment restrictions have evolved

For the first few years of the FRESB program, prepayment restrictions on the underlying loans were predominantly in the form of a declining points system. For example, a “54321 1%” prepay penalty refers to a penalty that is 5% for year 1, 4% for year 2, 3% for year 3, and so on, then 1% after 5 years for the remainder of the term of the loan. Over time more small balance loans have incorporated yield maintenance prepayment penalties, similar to traditional K-FRED structures which only utilize defeasance or yield maintenance for prepayments. Yield maintenance prepayment provisions are usually in the form  of “YM or 1%”, meaning the borrower pays the higher of the yield maintenance or 1% of the loan balance. Yield maintenance prepayment penalties covering the underlying loans have grown gradually from 0% in the early years of the program to as much as 50% of the loans originated in some recent months (Exhibit 4). Over time the growth of yield maintenance provisions could result in slower prepayments on some small balance multifamily loans.

Exhibit 4: Declining points vs yield maintenance prepayment provisions for small balance loans

Note: Prepay provisions shown as a percentage of the total original loan balance originated on a monthly basis for loans underlying FRESB deals. Source: Intex, Amherst Pierpont Securities

Investor base growing more diversified

Freddie Mac reports in their latest Multifamily Securitization Overview that in 2018 there were on average 38 different accounts investing in FRESB deals per transaction, with 5 new investors per transaction. Banks comprise 64% of investors and insurance companies / pension funds make up another 16%, with the remaining 20% of investors money managers (19%) and hedge funds (1%). No doubt the favorable risk-based capital treatment for agency guaranteed securities attracts the banks and insurance / pension companies, and a broader selection of cash flow  profiles increases diversification opportunities for money managers and other traditional CMBS investors.

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