Fixing federal financing for Main Street buildings

Federal lenders are slowly seeing less risk in financing mixed-use buildings.

Back in March, we covered a report from the Regional Plan Association entitled “The Unintended Consequences of Housing Finance,” which makes the case that federal housing finance rules are impractical for financing the types of three and four-story mixed-use buildings that are common in older urban downtowns.

At a session at the recent Congress for the New Urbanism conference, federal officials from Freddie Mac and HUD signaled they’re aware of those issues, and discussed some recent steps they’ve taken to address them.

Richard Oram of the Oram Foundation, who funded the RPA report and has made this his pet issue for the last three years, organized the session, bringing in Kelly Brady and Corey Aber of Freddie Mac to discuss some recent movement at the federal level with the development wonks at the conference.

How the feds shape the private lending market

The problem is complicated, but the central issue is that until recently the Department of Housing and Urban Development’s housing finance rules have said no more than 20 percent of a building’s square footage can be commercial space, and no more than 15 percent of the building’s revenue could come from commercial space. That means — assuming commercial use of the ground floor — that buildings need at least five stories to qualify for financing.

Sarah Serpas of RPA pointed out that these rules don’t just affect federal loans and financing, but actually echo throughout the private lending market because Freddie Mac and Fannie Mae, the government-sponsored enterprises, buy those mortgages, and their policies impact what kinds of financial products private lenders offer.

“We are like the car manufacturers, and they are like the car dealers,” said Brady, Vice President, Underwriting & Credit at Freddie Mac, explaining how federal finance rules shape the private market, “We have a network of lenders and sellers who make loans based on the products that we create.”

Small changes for small development finance

Traditionally HUD had viewed mixed-use buildings as risky prospects for lending, but that view is changing.

Oram said advocates recently won some concessions from HUD, but stressed that there’s still more work to be done, from his perspective.

In September 2015, FHA quietly increased the non-residential square footage allowed for a standard 30-year mortgage to 49 percent, which applies to homes with between one and four units. And earlier this year, HUD raised the commercial cap slightly to 25 percent for some other loan products, though they left the allowable income from the commercial portion capped at 15 percent. Oram has proposed a pilot where that cap would be lifted for buildings under 50 units. He said some members of Congress have been supportive of the effort to lift the caps, and are planning to introduce a bill next year, nudging HUD to go further.

This is all a bit wonkish, but the basic dynamic to keep straight is that a higher commercial cap means a mixed-use building needs fewer stories to qualify for federal financing, and a lower cap means it needs more.

HUD has traditionally been resistant because mixed-use loans have been viewed as riskier, though the RPA report argues that mortgages in mixed-use communities have actually performed better than those in more single-use areas.

A problem of marketing

A year ago, Freddie Mac rolled out a more robust commercial lending program that Brady said many developers and lenders aren’t aware of yet. The Small Balance program can go up to 40 percent commercial income for projects under $5 million, and they have a conventional loan that can go up to 50 percent.

She gave a few examples of projects in Atlanta and Chicago where 3 and 4-story developments had already taken advantage of the new products, but mentioned that they were all renovations of existing mixed-use buildings.

“We’ve done projects that were newly constructed, but we just don’t see them very often, which I guess is why we’re here,” Brady said.

She pointed out that Freddie Mac also offers other financial products, like Small Apartment Loans, which allow 25% commercial for space and income, and which can be used for 4-5 story buildings.

But judging by the number of clued-in development and finance professionals at CNU who were unaware of these products, she was convinced a better marketing effort is needed.

Both Brady and Aber, Freddie Mac’s Business Design Manager in the Multifamily Finance Division, said they would be supportive of more flexibility and tailoring loan products to finance more 3-4 story buildings.

“We do have the ability to get very creative, and provide different capital solutions for different types of properties,” said Aber.

The changing view from Washington

What’s behind the new experimental mood?

“It was the change of the FHA [Federal Housing Administration] director,” said Brady. “Mel Watt [the new director] has a very different take than Ed DeMarco.”

Since the financial crisis, when Fannie Mae and Freddie Mac entered federal conservatorship, FHA director Ed DeMarco’s goal was to contract the Government-Sponsored Enterprises, and he prohibited them from creating any new loan products that could potentially be seen as risky. Watt is more open to experimentation, particularly now that housing has substantially rebounded.

“We are chartered by Congress,” said Brady. “We have to provide affordable housing, but we also are only allowed to purchase mortgages that are ‘in whole or in part residential.’ That’s it. It doesn’t say ‘only 15 percent of the square feet, or only 30 percent of the income. It says ‘in whole, or in part.’ And historically Fannie and Freddie have been very conservative in interpreting that.”

When Brady came to Freddie Mac in 2008, she said there was no credit policy for how to underwrite commercial income.

“I would ask underwriters why they were doing this or that, and they would say ‘we just halve the income by 50% and call it a day.’ The perceived risk is about lack of knowledge. They just didn’t know how to underwrite it.”

Scott Bernstein, director of the Center for Neighborhood Technology, asked if Freddie Mac would be willing to work with CNT and others to replicate the studies cited by RPA showing there is no additional default risk from 3-4 story mixed-use buildings.

Brady responded that loan performance data is public information, down to the loan level and the property level, so outside groups are capable of doing this analysis on their own, although she was open to partnering on research and other policy approaches.

Michael Freedman of HUD, who does not work directly on this issue but happened to be in the audience, said that while he sees a gap in the marketplace, he wants more studies on how large that gap is.

“It does appear there is a gap in the marketplace for lower-rise mixed-use properties,” he said, “The RPA study is a good start, but it would be helpful to get a better read of how big of a problem it is, and where it is a problem. It appears to be the problem is older, existing communities, where you have older existing spaces on the first floor and two stories above that.”

Overall, the housing advocates in attendance seemed cautiously optimistic about what they heard from federal officials.

“I think the move they’ve made isn’t place-based or really even market segment-based, but what they said was that they’re willing to experiment with loans that are of a certain size,” said Bernstein, “It’s a step in the right direction. What some of the folks here are saying is, it’s a good start but towards what?”