In all my years in real estate, one of the most common questions I get is, “What is Freddie Mac and Fannie Mae, why do I need them, and how do I know which one to choose?” In this article, I will discuss what Fannie and Freddie do, what the main differences are between them and how their pricing works. You will learn how agency lenders make their money and by the end of the article, you will know how to negotiate the best terms for your loan. In a separate article, I will go over the different types of terms that Fannie and Freddie offer and how to choose the best ones.
GSE’s: Who Are They and What Do They Do?
Freddie Mac and Fannie Mae are known as “Government Sponsored Entities” (GSE’s), established by Congress to promote stability, increase affordability, and provide liquidity to the U.S. mortgage markets. Together, they have a combined balance sheet in excess of $5 Trillion, which is roughly the equivalent of if JP Morgan Chase and Bank of America decided to merge their respective firms. You wouldn’t be alone if you weren’t aware that they control at least half of the multifamily debt (and significantly more of the single-family debt) in the United States. Their significance in all things related to housing cannot be overstated. In 2020, they are expected to buy over $160B in new multifamily loans from a small circle of banks and mortgage lenders that brand themselves as Optigo (Freddie Mac) and DUS (Fannie Mae) Seller-Servicers (collectively known as “agency lenders”). Over the last decade, if you own a multifamily asset, it is almost certain that you have been in contact with one or more of these Seller-Servicers. Yet even with all of that contact and volume, there is still a lot of confusion regarding what Freddie and Fannie do and how agency lenders operate and differentiate themselves.
In a nutshell, the biggest difference between Fannie and Freddie is that Fannie delegates credit and pricing to their Delegated Underwriting and Servicing (DUS) lenders and securitizes their loans in a one-off transaction. Freddie does not delegate their credit decisions and pools their loans into mortgage-backed securities (MBS bonds). Freddie tends to be better on floaters and I/O, and has better pricing in a declining rate market. Fannie is really good at “off the run” terms (like 12 and 15 years) and tends to have better pricing in a rising rate market. However on any given day, one or the other might win when it comes to proceeds, price and terms, so it’s best to spread your business around. Always get bids from both and pit one against the other.
In originating a FNMA loan, the agency lender takes on some of the risk (delegation), with a split of 1/3 lender, 2/3 FNMA. For example, if a borrower defaults on $3M loan and asset sells for $2M, the lender will take a $330,000 loss and FNMA will take $660,000 loss. In order to fund the loan, the lender sells FNMA-backed bonds to institutional investors looking for fixed rate investments for a certain duration (the term of the loan). The bond is guaranteed by the underlying asset and by FNMA so it is a very secure investment. Fannie bonds are issued per loan so one loan = one bond. The bond is 100% guaranteed by Fannie (and by extension, the U.S. government).
Here is a summary of FNMA loan terms:
- Duration: Though terms vary from 5yr to 30yrs, 75% of FNMA loans are for 10 years (though amortization may be up to 30 years).
- Rates: Either fixed or floating.
- Max Leverage: 80% LTV on purchases, 75% LTV on refi’s. (See my other articles on GSE’s for help on selecting the optimum leverage and duration for your project.)
- Recourse: Both recourse and non-recourse are available
- Interest Only: available on fixed rate products.
- Capital Reserves: Required for most properties over 65% LTV, especially older properties with deferred maintenance. Please note that as a result of Covid, Fannie is now asking for 6 – 18 months of debt service (PITI) in reserve on all non-affordable deals. This is in addition to any capital reserve requirements.
- Assumable: Yes, with pre-approval and payment of an assumption fee (usually 1%).
- Prepayment Penalty: Yes, loan has yield maintenance so bond investor gets the same yield they would have gotten if the borrower had paid the loan until maturity.
- Additional Requirements: Assignment of rents is required. Assignment of rents from HUD is required for HUD properties
Fannie is the older and historically larger of the two GSE’s. Their business model relies on delegated credit and pricing to their approximately 25 or so DUS lenders. Fannie primarily makes its money by charging a guaranty fee on mortgage bonds secured by single loans. Fannie tends to be better than Freddie on longer term loans (greater than 10 years) and tends to have a one-size fits all pricing, so a loan in Topeka KS will receive similar pricing than a loan in Jacksonville, FL.
Freddie makes all the decisions on loans so there is no lender discretion as with FNMA. Freddie pools loans into $1 billion mortgage-backed securities (MBS) bonds which are then broken down into tranches from “AAA” to “unrated”. In addition to the value of the underlying assets, Freddie further “wraps” (guarantees) the AAA bonds, which makes them very safe investments. Because of this extra guarantee, Freddie sells “AAA” at a premium, while “unrated” bonds are sold at a discount. Please note that Freddie only guarantees the top 85% of bonds – those that are rated AAA. All of the other bonds do not carry a Freddie or government guarantee. Freddie holds 10% of mortgages in their own portfolio and sells 90% of mortgages to bond investors. Freddie holds 10% of mortgages in their own portfolio and sells 90% of mortgages to bond investors.
Here is a summary of FHLMC terms:
- Duration: usually 5 – 10 years. Mortgages held in FHLMC’s portfolio can go up to 30 years, though the amortization period depends on various factors
- Rates: fixed or floating
- Maximum Leverage: 80% LTV
- DSCR: Minimum debt service coverage ratio is 1.25x
- Recourse: Non-recourse with standard carve outs (ie borrower fraud)
- Interest Only: available on fixed and floating
- Capital Reserves: Required. Furthermore, as a result of Covid, Freddie is asking for 6 – 9 months of debt service (PITI) reserves, depending on the debt service coverage ratio. This is in addition to any capital reserve requirements.
- Assumable: Yes, but assuming borrower must qualify by meeting original underwriting standards. Assumption of the loan avoids defeasance or other pre-payment costs.
- Prepayment Penalty: Yes, yield maintenance and defeasance. Both include a 2- year lockout period. (I will discuss ways to negotiate the prepayment penalty in another article.)
- Yield Maintenance: the loan is actually paid off and the mortgage note is cancelled.
- Defeasance: a substitution of one source of collateral (the property) with another, typically treasury bonds, are transferred to a special purpose entity (SPE) called a “Successor Borrower.”
- Both of these can cause the borrower to incur significant monetary penalties if the loan is prepaid well before the maturity date or if the US treasury bonds fall substantially. Therefore, anticipated hold time and consideration of future markets should be taken into consideration when contemplating the term for this type of loan.
- Additional Requirements: Assignment of rents is required. Assignment of rents from HUD is required for HUD properties
- Loan servicing: The agency lender or a third party may service the mortgages, but the Master Servicer is responsible for major loan servicing decisions including approving borrower consent requests.
Freddie is the younger of the two GSE’s having only been established in the early 70’s. Freddie does more in multifamily loans than Fannie. Even so, Freddie tends to offer more “vanilla” loan terms given that most of their loans end up in a REMIC structure. (REMICs consist of a fixed pool of mortgages broken apart into tranches, repackaged, and marketed to investors as individual securities.)
Freddie tends to be better at simple 7-year and 10-year terms and can offer more nuanced pricing based upon Sponsor strength and market dynamics. That means a loan in Manhattan, Kansas will absolutely get a different price than a loan in Manhattan, New York.
Profit Centers for GSE’s
How do Freddie and Fannie make money? Well, there are several profit centers for each:
- Spread – the GSE’s add a spread over an index, such as the 10-year treasury or 1-month LIBOR. The spread includes the servicing fee for the loan servicer and the GSE’s profit.
- Guarantee and sale of bonds
- Fannie Mae – 50 bps per annum
- Freddie Mac – 2 points when they successfully aggregate loans into pools + 10 to 15 bps as an annual guarantee fee.
As mentioned above, an agency lender is licensed or authorized by FNMA, FHLMC or FHA (collectively, the “Agencies”) to offer their products according to standardized underwriting. While the underwriting and servicing guidelines make quotes from agency lenders who tap into the same programs very similar, there will be differences in actually applying deal and market data to the models. So, two or three agency lenders can come back with slightly different quotes. Worst case scenario is that the lender you select as an intermediary to Freddie or Fannie only adds minor value such as a few bps on the spread, a longer i/o period or slightly higher leverage. In the best-case scenario, the lender will maximize the property’s NOI for presentation purposes and take the time to fully understand the Sponsor’s financing strategy in order to advocate for the optimal bid from Freddie and Fannie.
Please note that you cannot choose two agency lenders for the same GSE. Once you sign a loan commitment, you’re locked to that lender unless you have them release your application. The release is easy to do, but keep in mind that you will likely not get your application fee back (see “The Loan Process for details.)
How Lenders Make Their Money
In order to negotiate the best loan possible, you first need to know how lenders make their money. Here are the lender’s profit centers:
- Origination fee
- Servicing fee
- 6 – 15 bps (usually around 10 bps) for Freddie loans
- 50 bps for Fannie loans because the lender takes on some of the risk
- P&I float – lender collects payments on the 1st but doesn’t pay GSE’s until the 15th
- Escrow float – lender collects property taxes & insurance monthly, but pays these out biannually.
- Spread – extra bps mark up to the rate obtained from GSE’s. These are often hidden from the borrower.
- Undisclosed premiums/buyouts – additional bps on top of the spread, which can add up over the life of the loan. (Ex: 10 bps over 10 years = 75 bps of the loan)
- Miscellaneous fees
How to Choose an Agency Lender and Get the Best Deal (Very Important)
- Demand transparency: Ask the lender how they make their money – you can negotiate origination fee, servicing fee, premium and miscellaneous fees.
- Ask to see copy of the wholesale quote from Freddie and Fannie. This quoted is actually an index + margin (spread) not an actual interest rate, from the GSE to the agency lender. If your agency lender refuses to give this to you, you’re working with the wrong lender. Please note that you will not know your actual rate until the rate is locked. It is impossible to guess which way the underlying index is going to go so rate lock when you’re ready to close. Of course, if you see rates trending down during the process, rate lock at that time. Note: Freddie offers an index lock option but it costs an extra 5bps per year.
- Find out who is the #1 salesman in the office you’re applying to. Rates can vary dramatically based on who you work with. You don’t want to use the guy who originates $20 million in loans a year; you want the guy who originates $1 billion in loans a year.
- Make sure the lenders selected have experience in the region and asset class of your project.
- Try to exert some control over the loan terms by asking to meet the decision makers at Freddie and Fannie. In my experience, you get better terms when you meet face-to-face because the best advocate for the deal is you, the Sponsor, not the mortgage banker.
- Now that you know how these loans are priced, you should dictate the rate you’re willing to pay, rather than have them quote you a rate. Many lender reps will tell you that’s not possible, which means you’re working with the wrong people. It’s possible if you work with the right people (see item #3 above).
- Tell the agency lender you want a fixed price on the lender’s legal fees. Most lenders will balk at this and say “we can’t do that” or “we have no control”. If so, find another lender. The legal fee should range from $8,500 – $12,000. You don’t want to encourage their lawyer to pad the bill and spend unnecessary time looking for things to go wrong.
- Once you get through the process of letting a few FNMA lenders and a few FHLMC lenders beat each other up, you may find that a bank is actually your best option. Or a credit union. People always forget about the credit unions! After all, FNMA and FHLMC both securitize these loans, so they are more restrictive than a local institution who will keep a loan on their balance sheet. Very often a bank will be able to provide a more customized approach than Freddie or Fannie can. The interest rate may not be that different, but the loan may have shorter prepayment period or no prepayment as well as an easier loan process.
The Loan Process
After signing your loan commitment letter, the lender will request that funds be wired in for 3rd party reports. The amount varies from $16K – $25K to cover the cost of an engineering report, an appraisal, a title report, an environmental report (you’re not going to get a loan if the property is built on an old gas station or dry cleaner) and the legal fee for the lender’s council. Please note that if the loan doesn’t close, it is unlikely you will get any of these funds back.
You will be submitting financial data (income and expenses) every month from the time the process begins until the loan is ready to close. This is because the lender wants to make sure there have been no changes in occupancy or sudden increases in expenses. As a result of Covid, many buildings are currently experiencing a 10% or greater decrease in collections. In this case, I recommend waiting until the building stabilizes before closing your loan.
Please contact me at [email protected] if you need any help with this.
What to Ask a Lender?
Once you’ve selected a lender, here are some of the questions you’ll want answered:
- How long is the spread good for?
- When can the spread be locked?
- What is the exact time frame involved (including key milestones)?
- Exactly how is the mortgage banker getting compensated?
- What are the estimated closing costs (including legal fees)?
- When you can expect a commitment?
- What are the insurance requirements? If you’re used to bank financing, the insurance requirements for a GSE loan are significantly more complex. As a result, your premiums will probably be higher. From my experience, this is a good thing because most people are under insured.
- Can you preview/discuss key loan document terms with the lender’s counsel?
- Who orders the appraisal and 3rd party reports?
- Is the lender going to sub-contract out the underwriting?
- Who will you deal with if there are post-closing issues?
Regardless of whether the lender is big or small, don’t be afraid to ask the tough questions and demand that answers be put in writing.
A Word About Supplemental Loans
If the value of your asset increases and you want to take additional money out, you cannot get a second loan behind a FHLMC or FNMA first. You also can’t refinance the loan because of the prepayment penalties (yield maintenance and defeasance). So what to do? GSE’s have answered this dilemma by offering supplemental loans, which can be obtained through the same agency lender that arranged the original loan.
- Freddie Supplemental Loan: Loan amounts are $1 million+ and may include interest-only options. Maximum 80% LTV and minimum DSCR of 1.25x. Freddie supplemental loan can take a long time to fund because all tranches (AAA to unrated) of the bond holders must approve the extra loan (could be up to 8 bond holders)
- Fannie Supplemental Loan: Original loan must have been in place for a minimum of 12 months and only be approved by Fannie. Maximum 75% LTV and minimum DSCR of 1.30x. New 3rd party reports may not be required. Early rate lock is available for a fee.
Important: you can ONLY go through the Freddie and Fannie first mortgage lender for your supplemental loan. So recognize that if you are not a good customer, you will literally be at their mercy in terms of fees and rates. This is where the trust factor comes in.
- Helpful Hint 1: If you think the mortgage banker/lender is a smart, responsive, honest, and yes…. even nice, then Freddie and Fannie will likely feel the same way. If you are dealing with someone who is a bit of a jerk…then it’s highly likely that Freddie and Fannie will feel the same way and not bid aggressively so as to avoid doing business together.
- Helpful Hint 2: Unless you really, really, REALLY trust your lender, split the assignment up. Award the right to get a Freddie Optigo bid from lender “A”, and get a Fannie DUS bid from lender “B”. Getting bids for both GSE’s from one lender is the lazy way of doing it. You will get a better execution by creating competition.
- Helpful Hint 3: SEE HELPFUL HINT 2…. seriously.
WHAT NEVER TO DO
NEVER USE A BROKER FOR A FREDDIE OR FANNIE LOAN – Don’t ever go through a broker to access one of the Freddie Optigo or Fannie DUS lenders. You will be paying for an extra layer of fees whether you see them or not. Also, you won’t have transparency regarding what’s happening with the loan or the loan process. I have used brokers and found the process to be very frustrating. Furthermore, since the agency lender doesn’t know you, you’re not building a relationship with them. If you want to hire a consultant, by all means do so, but don’t have them be paid by the Optigo or DUS lender. It’s better to pay them yourself and control the cost.
NEVER USE A HUD LOAN UNLESS ITS ABSOLUTELY NECESSARY – HUD loans can take from 6 months to 2 years to close, and you never know if you’re actually going to close until the very end. Then once you have the loan, you are subjected to onerous annual inspections and need to spend $5K – $15K a year for accountants to conduct financial audits. Though the prepayment penalties are less than Freddie or Fannie, HUD loans are typically for 35 years and there is no interest only option. Furthermore, there are no supplemental loans available through HUD so if your property appreciates, you have no way to pull extra money out. The only people who do HUD loans are for affordable-housing tax credit deals where they need get 93% to 94% leverage to make the deal work. HUD is also the only option for funding the construction or purchase of assisted living facilities.
NEVER ACCEPT A RECOURSE LOAN – If the deal is so sketchy that it would require a recourse loan, you may want to consider not doing it. In the last year, I have personally lost two structures – one to a fire and one to a hurricane. Most people don’t insure for a complete loss, which means you would need to personally pay for any loan deficiency not covered by your insurance payout. Just note that while Freddie and Fannie loans are technically non-recourse, there ARE carve outs. Very rarely do Freddie and Fannie negotiate the carve outs.
DON’T SUBMIT UNREALISTIC EXPENSES TO MAKE THE PROPERTY LOOK BETTER – Fannie and Freddie underwrite to industry norms and underwrite tens of thousands of buildings per year. Though a good agency lender should catch this at the beginning, often, the unrealistic expenses won’t get brought up until the end of the process, which will change the loan proceeds. At that point, there is very little you can do. Here’s an example of what I’m talking about: Let’s say you need a $7M loan for a $10M purchase. The lender agrees to fund the $7M, so you release a non-refundable deposit to the seller, thinking you have the loan he needed. However, 30 days later after the underwriting is complete, the lender comes back and says they can only fund $6M because the expenses were unrealistic. Now, the math on the transaction doesn’t work and you’ve already committed to the seller (non-refundable), you’ve paid the 3rd party application fees (non-refundable), and you can’t switch lenders. I’ve seen this happen many times. This is another reason not to use a loan broker, because they don’t usually catch this.
DON’T ACCEPT ANY LENDER THAT IS NOT WILLING TO FIX LENDER LEGAL FEES – I already discussed this in item # 7 above, but it’s worth repeating.
To summarize, GSE’s provide the mortgage market with stability, affordability and liquidity. GSE’s buy mortgages from lenders and either hold these mortgages in their portfolios or package the loans into mortgage-backed securities (MBS) that can be sold. By packaging mortgages into MBS and guaranteeing the timely payment of principal and interest on the underlying mortgages, Fannie and Freddie appeal to the secondary mortgage market investors who may not otherwise invest in mortgages, thereby expanding the pool of funds available for housing.
It is my opinion that because of the way that Freddie and Fannie loans work, with the interest rates subsidized by the government, the rates would be higher for apartment borrowers if Freddie and Fannie didn’t exist. The fact that they do exist is the main reason why apartments are the best real estate investments.
As discussed, you will not know your actual interest rate until the rate is locked, which means the quote you get at the beginning will not be what you end up with. If you’ve done a good job in choosing a lender and have all the pertinent information in writing, you can ensure that the lender stays honest and that you get the same margin you signed up for.
You now have a more thorough understanding of Freddie Mac and Fannie Mae, as well as the agency lenders that act as their intermediaries. Armed with the knowledge of how the GSE’s and the agency lenders make their money, you are in a much better position to negotiate the terms of your loan.
For more information about how to invest in multifamily properties, please check out Marc’s website at www.marcmenowitz.com.
(special thanks for John Cannon for his time and insight)