Small-Balance Market Shows Resilience

Despite pressure from rising interest rates, valuations on properties securing small-balance multifamily loans have shown clear resilience, said Arbor and Chandan Economics.

Cap rates at mid-year were essentially unchanged from a year ago, the firms’ Small Balance Multifamily Trends report said. “While debt yields have increased slightly, the small balance market’s liquidity and borrowing capacity has not weakened,” it reported.

Volume of new multifamily loans between $1 million and $5 million totaled $49.9 billion during 2017, the most activity since the financial crisis. Volume declined 5.8 percent in the first half of the year to a $47.0 billion annualized rate, but the report predicted full-year lending volume to be on par with 2017 after seasonal adjustments.

“As the macroeconomic and real estate cycles lengthen, the [small-balance] multifamily sector is generally expected to outperform other property types, both in terms of liquidity and the stability of operating fundamentals,” the report said. “Healthy operating income, a structural diversity of capital sources and elevated demand for refinancing from the sector’s higher indebtedness will support a critical mass of lending activity.”

The report noted changing policy priorities in Washington could lead to a disruption to the sector. Specifically, congressional reform of Fannie Mae and Freddie Mac–two important sources of small-balance financing–could cause an “adverse shock” to multifamily liquidity. But the report called this scenario “exceptionally unlikely” in the near- to medium-term.

National average cap rates for multifamily properties backed by small-balance loans increased less than five basis points during the second quarter, taking them to just over 6.1 percent, the report said. Cap rates have increased by 23 basis points since the 5.89 percent apparent low point for this cycle in second-quarter 2016.

Small-balance cap rates peaked at 7.60 percent just after the financial crisis. “While small-balance cap rates have increased over the last two years, they remain low by historic norms,” the report said. 

That limited increase in small-balance cap rates contrasts with the underlying interest rate environment, the report said. The 10-year Treasury has increased by nearly 140 basis points from its most recent quarterly low of 1.6 percent during third-quarter 2016. Meanwhile, the spread between small balance cap rates and the Treasury declined to its lowest level since 2008.

Leverage on small-balance loans has declined somewhat this year, reflecting the impact of mortgages held on balance sheets by regional and community banks, the report noted. The loan-to-value ratio on small-balance loans originated in the second quarter equaled 67.5 percent, down 70 basis points from a year ago, while LTVs for larger multifamily loans increased by 50 basis points, reflecting higher competitive pressures for larger assets. As a result, the LTV spread between small-balance loans and the larger multifamily market has increased since 2014, it said.

“While the broader real estate market has shown signs of softness, small-balance investment activity and liquidity have improved in part by this cycle’s increase in aggregate agency support,” the report said. “Barring a downturn in the economy (inevitable but not in the immediate future) or a policy misstep by the administration, the overall lending environment for small-cap properties is projected to remain healthy.”