Multi-Family Investors Beware: Keep an Eye on GSE Reform

By Bob Dougherty, Executive Vice President, Buchanan Street Partners

Penn State football fans can well appreciate the debate that is simmering in the arena of U.S. housing finance.  Joe Paterno, PSU’s revered 83-year-old head coach has chalked up more wins over his 45 seasons than any coach in major college history, winning 3 NCAA championships for the school.  Yet, even as he notched his 400^th career win this month, many – even those in the legion of Nittany Lion faithful – wonder aloud if the legend has outlived his prime.  With the team struggling to an uncustomary 6-4 record, maybe the game has passed him by?

So it is with Fannie Mae, Freddie Mac, and the other so-called “agencies” of housing finance.  The multi-housing market owes an extraordinary debt of gratitude to these government-sponsored enterprises, whose outsize presence in the market has been monumental in fueling its growth and, more recently, its revival from the depths of the credit markets crisis.  Yet while the GSEs have never played a larger role in financing apartment communities, many are questioning their usefulness, the necessity of their mandate for the future, and whether we as a nation can afford the costs of a federal hand (or handout) in housing finance.

Few would debate how essential the GSE’s have become to multi-family mortgage finance.  In 2005-2007, they accounted for just 30 percent to 40 percent of multi-family mortgage originations, while in 2008 and 2009, the GSE’s were responsible for over 70 percent of new originations through their repurchase programs.  Today, estimates are that the agencies account for approximately 90 percent of new apartment loans, filling the void left by the ruination of commercial banks and the CMBS market.

Proponents argue that this recent injection of mortgage liquidity when private lending sources have dried up is exactly the mandate that the agencies were intended to fulfill.  Ensuring a functional lending market, even in times of crisis, has allowed multi-family rental housing to remain affordable for those most in need of housing, especially during their time of most dire need for affordability.

Conversely, critics make several competing arguments.  Some point out that providing government-subsidized (the debate over whether the GSE’s were implicitly backed by Uncle Sam is now moot) financing for $7,000-per-month Manhattan apartments seems to have strayed from the original affordable housing intent of the GSE’s.  Free-marketers argue that private markets are the only appropriate way to match risk against return and finger the implicit guaranty as a root cause for the current crisis.  Finally, budget hawks contend that, with the cost to taxpayers of the Fannie Mae and Freddie Mac conservatorships already at $148B and potentially more than doubling to $370B, we can ill afford to support rental housing across the board and risk another such large-scale bailout tab.  Some favor instead a more explicit guaranty for truly affordable housing while leaving owners of renters-by-choice apartments at the mercy of the private capital markets.

However, apartment industry lobbyists argue that housing affordability will be negatively impacted by a withdrawal of GSE financing that tends too far towards “cold turkey.”  To date, the stimulus-minded Obama administration seems to be abiding this admonition.  Despite calls for the GSE’s to eventually shrink their mortgage holdings, current portfolio limits, in the case of Freddie Mac, actually allow for an increase in loan assets of nearly $100B, a 13 percent increase over current holdings of $716B.

Furthermore, industry advocates maintain that GSE-financed communities which cater to Upper East Side investment bankers are the exception to the rule and that fully 90 percent of agency-financed apartments are affordable to the median wage-earner.   Furthermore, they contend that America is becoming increasingly a nation of renters due to demographic trends and tattered credit scores and battered financing markets for home ownership.  They argue that aiding multi-family finance is as important as promoting home ownership.

Finally, industry advocates cite nearly $400B of apartment loans coming due by the end of 2014 as a risk to the system if these maturing notes are not met with adequate replacement debt capital.  They maintain that reform of the GSE’s must be deliberate but not hasty to avoid shocking a still fragile patient that relies upon the $200B+ of agency paper currently sustaining it.

Like admiration and respect for “JoePa,” the sentiment for reform of the GSE’s is universal . . . yet both changes are inevitable.  The argument, in each case, centers upon how and when.  The recent mid-term elections diverted political focus from the issue of GSE reform, and political will typically lacks in election years, anyway.  However, expect the issue to return to the spotlight in 2011.  Advocates for overhauling the housing finance agencies exist on both sides of the aisle, although their proposed solutions undoubtedly differ substantially.

What is beyond debate, though, is that the stakes in this debate are very high for apartment owners.  The GSE’s are the lifeblood of multi-family finance at present, so any significant and sudden changes to this supply could have dramatic impacts on asset returns and valuations.  Prudent owners are advised to stay closely tuned to these very important deliberations which will resume with the new Congress.