GSEs revise approach to eminent domain
admin | December 20, 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.
Both Fannie Mae and Freddie Mac have recently revised their multifamily loan guidelines to address issues created this year when the King County Housing Authority near Seattle used eminent domain to seize properties financed through agency CMBS. The seizures triggered prepayments without requiring prepayment penalties. The revised approaches give the GSEs slightly different abilities to collect penalties in the future. Although unlikely to get triggered, the differences nevertheless may create obstacles to easing investor concerns.
The origin of the confusion
In 2019, the King County Housing Authority (KCHA) used eminent domain to acquire multifamily properties and preserve workforce housing stock. There were three properties taken, two of which had mortgages securitized in Fannie Mae DUS pools, and one which was in a Freddie Mac K-deal (Exhibit 1). Multifamily loan documentation for both Fannie and Freddie categorize an eminent domain taking – also called a condemnation action – as an involuntary prepayment, and explicitly do not require prepayment premiums as a result of those actions.
Exhibit 1: Agency CMBS deals containing the properties taken by KCHA
The two Fannie Mae DUS pools which had previously been priced at a premium, were prepaid at par and the pools underperformed, since no yield maintenance penalty was required or collected. The owner of the property securitized in the Freddie K-deal voluntarily defeased the loan, despite the fact that the prepayment premium was not required, resulting in no performance impact on the deal.
Agency CMBS with exposure to properties in King County – particularly Fannie Mae DUS pools, which have undiversified risk – are trading 10 bp to 20 bp back of equivalent pools or securities without such exposure.
Differences in state law add to the confusion
Oddly enough, Washington state law includes provisions that prepayment penalties on existing mortgages be paid by the acquiring agency in a condemnation proceeding (RCW 8.26.200 excerpted in full, emphasis added).
Expenses incidental to transfer of right, title, or interest to the acquiring agency.
As soon as practicable after the date of payment of the purchase price or the date of deposit in court of funds to satisfy the award of compensation in a condemnation proceeding to acquire real property, whichever is the earlier, the acquiring agency shall reimburse the owner, to the extent the acquiring agency deems fair and reasonable, for expenses the owner necessarily incurred for:
(1) Recording fees, transfer taxes, and similar expenses incidental to conveying such real property to the acquiring agency;
(2) Penalty costs for full or partial prepayment of any preexisting recorded mortgage entered into in good faith encumbering such real property; and
(3) The pro rata portion of real property taxes paid which are allocable to a period subsequent to the date of vesting title in the acquiring agency, or the effective date of possession of such real property by the acquiring agency, whichever is the earlier.
Eminent domain laws vary by state and local jurisdiction. California state law includes provisions that prepayment penalties will not be paid in eminent domain takings (excerpt from California Code of Civil Procedure § 1265.240):
Where the property acquired for public use is encumbered by a lien, the amount payable to the lienholder shall not include any penalty for prepayment.
However, Fannie and Freddie’s previous multifamily loan documentation did not incorporate individual state law, even in jurisdictions where the law provides for the remittance of mortgage prepayment penalties when the property is subject to eminent domain.
Fannie Mae updates its collection policy in King County
Fannie Mae was first to announce a modification of its multifamily loan documentation for properties located in King County (excerpt below, emphasis added, announcement dated November 4, 2019):
In order to address the heightened risk to borrowers and investors of a multifamily property located in King County being taken by eminent domain, we are announcing a modification to our Multifamily Loan and Security Agreement and to our Multifamily Mortgage-Backed Securities (MBS) prospectus for new transactions with properties located in King County. These modifications provide that:
- If state law requires the acquiring agency to reimburse the property owner for any prepayment premium, that prepayment premium is due. This aligns Fannie Mae’s revised loan documents with the benefits allowed under the Revised Code of Washington Section 8.26.200, which requires an acquiring agency to make such a payment to the property owner.
- If no such law exists at the time of a taking, a prepayment premium is due to the extent that the amount received exceeds the unpaid principal balance (UPB), accrued interest, and any other amounts due under the loan documents, other than the prepayment premium.
Fannie Mae’s approach is straightforward, if somewhat incomplete. They have amended the documentation to incorporate the existing state law for properties located in King County only. The modification is prospective only, and will not apply to existing loans. For any pools issued on or after December 1, 2019, Fannie Mae will collect prepayment penalties in King County, and will otherwise only pursue collection if there are sufficient funds remaining once the mortgage balance has been paid.
It seems odd to amend the documents to incorporate state law for a single county in one state, instead of amending the documents to collect penalties in every jurisdiction that provides for their payment. It’s possible that maintaining a uniform approach throughout the rest of the country will be less confusing for investors and was a priority for the GSE. If eminent domain actions remain rare, the amount of investor money left on the table will be relatively small. If the strategy of using eminent domain to preserve affordable housing does spread, this could be the first amendment of many to pursue payment, and pricing in the agency CMBS market would discriminate between states and counties that required remittance.
Freddie Mac follows suit, with a twist
Freddie Mac announced on December 5th, 2019, that they are making changes to their multifamily loan documents in order to address eminent domain issues (excerpted below, emphasis added):
Freddie Mac’s multifamily loan documents will continue to provide for prepayment relief when a traditional condemnation proceeding is undertaken by a governmental agency (such as a taking of a portion of a property for street widening, installation of turning lanes or sidewalks). To avoid any confusion, however, when a non-traditional use of eminent domain occurs, Freddie Mac is making the following clarification to its multifamily loan documents.
With respect to prepayments made in connection with a condemnation, no prepayment premium will be required unless the condemnation is intended to result in the continued use of the condemned portion of the property for residential purposes or if the condemning authority is required by law to reimburse for any prepayment premiums, in either case, a prepayment premium will be due.
This clarification specifies that we will continue the historical treatment of not requiring a prepayment premium in connection with traditional exercise of the power of eminent domain. It also ensures compliance with applicable laws and uninterrupted provision of cost-competitive and reliable liquidity to the multifamily housing market.
The changes will be effective for all loan applications as of January 1, 2020, and is effective immediately for loans currently under application in King County.
Freddie’s modifications attempt to draw a line between those traditional eminent domain actions and the strategy being deployed in King County. However, the pledge to require prepayment premiums in eminent domain cases based on the purpose of the taking is somewhat hollow, because it can’t be enforced in states or jurisdictions that legally do not provide for such payments, like California. It also introduces a level of discrimination that may rarely be used outside of King County, but could deepen investor confusion if it were to become more widespread.
Takings of viable multifamily properties via eminent domain are relatively unusual, and the KCHA appears to be the first to employ it as a strategy. Arguably it’s a strikingly creative, effective and efficient method for state and local governments to preserve affordable housing in areas where both the cost and space available for building new housing are significantly constrained. The issue for property and CMBS investors is that it can forcibly alter their investment horizon and impact returns. The uncertainty alone results in the market pricing in a discount. The modifications of loan documents announced by Fannie and Freddie attempt to address the issue for investors and assure collection of penalties in King County. A more holistic and unified approach could have prevented some of the initial confusion. The differences in the latest modifications, though hopefully minor in practice, may not ease ongoing concerns.