Cityscape: A Journal of Policy Development and Research strives to share HUD-funded and other research on housing and urban policy issues with scholars, government officials, and others involved in setting policy and determining the direction of future research.

Cityscape focuses on innovative ideas, policies, and programs that show promise in revitalizing cities and regions, renewing their infrastructure, and creating economic opportunities. A typical issue consists of articles that examine various aspects of a theme of particular interest to our audience.

Edward J. Szymanoski, U.S. Department of Housing and Urban Development.

The U.S. system for financing multifamily rental properties (those of 5 or more dwelling units) has changed considerably since the early 1980s, and the changes are ongoing. For example, depository lenders such as banks and thrifts, which held multifamily loans in their own portfolios, once dominated loan originations. Now these depositories are being joined by other types of lending institutions, such as mortgage banks, State housing finance agencies, and community-based lending consortia, which have greater access to broader capital markets and often sell their loans in the secondary market.

Although its financing has changed, ownership of multifamily properties remains varied. Individual owners and partnerships can still be found, but there is a growing trend toward ownership by large, publicly traded real estate investment trusts (REITs). The Federal Government's role has changed as well. Government-backed mortgage insurance through the U.S. Department of Housing and Urban Development's (HUD's) Federal Housing Administration (FHA) programs once accounted for a sizable share of multifamily originations. However, absent project-based rent subsidies, these programs are far less in demand than they were in the 1970s and early 1980s. Low-income housing tax credits have instead become the Federal Government's principal program for affordable housing production, mostly without FHA financing.

The secondary market for multifamily mortgages has been enhanced by the activities of government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. Wall Street, too, has developed a secondary market for multifamily mortgages following a big boost in the early 1990s by the Resolution Trust Corporation, which liquidated the assets of failed thrifts using innovative securitization techniques. The secondary market for multifamily mortgages is not as well developed as that for single-family mortgages, but it continues to evolve.

Current Issues in Multifamily Finance: Key Unanswered Questions

These changes in the multifamily finance system raise many questions about the direction in which the market is headed. The questions presented below illustrate some of the major issues. Not all of these questions are directly addressed by the articles in this issue of Cityscape. Nonetheless, the questions do provide a contextual framework for this diverse collection of articles.

• What will the U.S. system of multifamily finance look like in 5 years? In 10 years? If a cyclical downturn comes, will the cast of characters change again?
• Can multifamily finance ever become as well integrated into the broader capital markets as single-family finance? If so, would this reduce cyclical highs and lows in the market?
• How do renters benefit from secondary market access for multifamily mortgages? Do benefits differ by income?
• What are the special problems to be overcome in financing affordable multifamily properties? To what extent are these problems due to lack of financing or lack of subsidies?
• Is sufficient capital available to preserve the existing, largely unsubsidized multifamily stock?
• What are appropriate roles for Federal, State, and local governments in the financing of multifamily housing? For government-sponsored enterprises?

The Articles in This Issue of Cityscape

Donald S. Bradley, Frank E. Nothaft, and James L. Freund begin this issue with a discussion of the most recent changes in the multifamily finance system. The authors note that the roles of traditional players such as thrifts, commercial banks, and insurance companies have diminished relative to that of new players with lower cost access to the capital markets. The rise of secondary market conduits, GSEs, REITs, and State housing finance agencies in the multifamily arena is already bringing new efficiencies into the market, such as reducing regional disparities in the availability of capital and lowering its cost. The outlook for continued growth of securitization and REITs is good, particularly in the current economic climate. Yet the authors caution that underwriting discipline must be maintained to avoid a cyclical downturn reminiscent of the late 1980s in the multifamily market.

Bradley, Nothaft, and Freund also suggest that the increase in secondary market access has uncoupled servicing and investment decisions from the underwriting process, which has increased the use of third-party due diligence, or "layered" underwriting. Specifically, portfolio lenders with detailed knowledge of the local market once controlled the entire underwriting process. Increasingly, underwriting is being performed by many parties. The new loan originators often have less at stake than a portfolio lender and are less familiar with the local market. Conduits that buy the loans as collateral for securities, security rating agencies, security traders, and investors, are now each reviewing or supplementing the originator's underwriting on a single transaction.

Jean L. Cummings and Denise DiPasquale present two case studies that illustrate why layered underwriting can be particularly problematic in the area of affordable housing. Their detailed account of how the underwriting process worked (or failed) with regard to two affordable housing initiatives -- one between Freddie Mac and the Local Initiatives Managed Assets Corporation and the other between Fannie Mae and Enterprise Mortgage Investments, Inc. -- suggests a need for more industry leadership efforts to fully develop the secondary market for affordable multifamily mortgages. Because neither initiative has met expectations, Cummings and DiPasquale point to improved standards based on better understanding of the determinants of default risk and investment return as the goal for the industry with a challenge to both HUD and GSEs to provide leadership. The next two articles discuss recent efforts by HUD and GSEs that support the financing of affordable multifamily housing.

Drew Schneider and James Follain document a case study of how FHA developed its small projects processing initiative. The initiative targets FHA mortgage insurance programs to an affordable housing "niche" market without the use of project-based rental subsidies. The small projects case study is of interest for several reasons. First, it addresses a market segment that experts say is not being adequately served because of the sweeping changes that have occurred in the multifamily finance industry. Second, it presents market research by FHA that addresses the question of why small affordable properties are not adequately served. Third, it details the changes that FHA made to its underwriting process and delivery system to make FHA more attractive to small projects. Finally, the entire FHA process -- from identifying a need in the market to conducting research into the reasons for its existence to modifying its programs to address the need -- serves as a good case study and model for future efforts to reinvent FHA.

Next, William Segal and Edward J. Szymanoski present a discussion of the role that Fannie Mae and Freddie Mac have come to play in the multifamily market. These two GSEs, while private corporations, are federally chartered and receive numerous public benefits. Congress has mandated that these GSEs allocate resources to the affordable sectors of both the single-family and multifamily mortgage markets and, accordingly, HUD has established affordable housing goals for them. The authors use a recently available public use database and other publicly available information to show the performance of Fannie Mae and Freddie Mac with regard to multifamily housing in general and affordable multifamily housing in particular. They find that total multifamily mortgage volume has increased at both GSEs since the establishment of HUD goals.

Further examination shows that both GSEs deal in the middle of the market with regard to affordability. Also, through various risk-mitigation techniques, GSEs protect their shareholders and the public from concerns over the safety and soundness of their multifamily portfolios. Yet, by doing so, GSEs may be concentrating on loans that would be made in the marketplace without their participation. This suggests that the public policy debate over the relationship between HUD's GSE housing goals and the affordable housing market is likely to continue.

Lawrence Goldberg and Charles A. Capone, Jr., complete this issue of Cityscape with an examination of a question that crosscuts all market segments of multifamily finance: What are the determinants of multifamily mortgage default? Using data from more than 7,000 conventionally financed multifamily mortgages, the authors develop an innovative default model. The model is based on option theory, which is often used to model single-family mortgage defaults, but differs with the addition of a second default trigger, negative cash flow (the traditional option model default trigger is negative equity).

Goldberg and Capone also provide empirical evidence of the tension between underwriting flexibility and default risk. Specifically, they show that extending so-called standard conventional underwriting ratios -- such as allowing debt coverage ratios below 130 percent or loan-to-value ratios above 70 percent -- increases the probability of default. The authors suggest exercising caution in relaxing underwriting ratios for affordable housing. However, the authors also show that properties underwritten at conventional ratios can withstand a considerable amount of economic distress because they start with solid financial cushions.

The resilience that Goldberg and Capone found with regard to properties underwritten at conventional ratios suggests that underwriting flexibility for affordable properties may result in higher, but not necessarily unacceptable, default risks. Cummings and DiPasquale have argued that there ought to be some flexibility with regard to underwriting of affordable multifamily properties, particularly if standards for affordable housing can be developed based on better information about default risk.

The Future of Multifamily Finance

The articles in this issue of Cityscape are intended to help readers understand the direction in which multifamily finance is headed. Clearly it is a market in transition. Many unanswered questions remain, particularly those involving the provision of affordable housing. The issues are complex, and the articles presented here contribute to the discussion of the complex but promising evolution in multifamily finance.