Inside The Underwriting Policy Reforms of Fannie and Freddie.
This year Fannie and Freddie updated their underwriting policies in an effort to combat the mortgage fraud being revealed by contracting multifamily market conditions. These updates aim to codify more stringent verification processes, enhance due diligence, limit partnerships, and ensure appraiser independence. According to the WSJ, these updates “represent some of the biggest recent changes in the way Fannie and Freddie monitor these loans” (1).
These policies will undoubtedly have a cooling effect on the multifamily market. This is good. Over the last three or four years, multifamily valuations have been allowed to ignore reality. When reality is ignored, people get hurt. And so, as usual, a return to viable market conditions means that the top players will do better, and that the marginal or ethically dubious players will exit the market. Investors will be safer. Long-term multifamily market health will improve.
Policy Reform Elements
Increased Lease Verification Measures
To ensure the legitimacy of lease agreements and tenant payments, the following measures have been implemented:
Increase in the Number of Unit Inspections: Regular inspections will be conducted to verify the occupancy and condition of rental units.
Higher Lease Audit Sample Sizes: A larger sample size of leases will be audited to detect any irregularities or fraudulent activities.
Additional Documentation Requirements: Landlords will now need to provide extra documentation to verify that the payments reported are actually being made by tenants.
Enhanced Due Diligence for First-Time and Amateur Borrowers
New borrowers, especially those with limited experience, will undergo a more thorough examination process:
Additional Liquidity Verification: Borrowers will need to demonstrate sufficient liquidity, ensuring they have the financial stability to meet their mortgage obligations.
Verification of Real Estate Owned: Detailed verification of any real estate assets claimed by the applicant will be conducted to ensure accuracy and ownership.
Limitations on Multifamily Business with Certain Title Companies
In cases where applicable, Fannie and Freddie will limit their dealings with certain title companies. The specific targets of this change in policy is unknown.
Updated Appraiser Requirements
To maintain the highest standards of appraiser independence, objectivity, and impartiality, updated requirements have been established. This includes stricter guidelines and oversight to ensure that appraisals are conducted without any conflicts of interest.
The Warrant
Fraud becomes fraud when someone gets hurt. When markets are strong, fraud can result in a perverse mutual exploitation. But as markets soften, fraud becomes not necessarily more identifiable but less acceptable. Consequently, underwriting fraud is getting attention as its consequences hurt investors purchasing the loans and MBS purchased and sold by Fannie and Freddie.
Some of the fraud has been manifest in subtly doctored financial statements. There have been instances where financial statements were manipulated to report profits that included income not actually received by the landlord. This could be one-time expenses such as renovations or free rent offered as inducement to potential tenants (2). According to the Journal,
“Griffin, the finance professor, worries that these alterations have got out of hand and that many loans are based on inflated numbers.
In a 2023 paper published in the Journal of Finance, Griffin and co-author Alex Priest studied more than 39,000 commercial mortgages repackaged into bonds. They found that in nearly one-third of these loans, underwritten building profits exceeded actual building profits by at least 5%” (2).
Another manifestation of underwriting fraud has come in the form of unreported vacancies. Some landlords have failed to report vacancies or provided false occupancy numbers, leading to inaccurate assessments of property value and financial stability (2).
As the multifamily market has softened, the large debt packages obtained by landlords have begun to present a serious financial risk that threatens the security of the loan or a connected MBS.
University Courtyard Athens, a multifamily property owned by ROCO Real Estate, LLC who is alleged by federal prosecutors of having engaged in fraud when it gave potential buyer, Cherit Group, financial statements overstating profits by a factor of 2x.
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Impact on Deal Making
These policies come with several inevitable consequences.
Fewer Deals: The increased scrutiny and verification processes will preclude the shaky deals that were taking advantage of lax policies, resulting in a lower volume of transactions.
More Expensive Deal Development: The additional verification requirements and documentation will increase the cost of constructing deals.
Deceleration in Valuations: The market may see a slowdown in valuation growth as fewer deals hit the market with valuations reflecting a market comprised of higher quality projects.
The Silver Lining
While I have serious questions about the inherent moral hazard of large-scale loan guarantors, I view this policy shift favorably, not only because of its effect on valuations and increased protections for downstream investors, but because of how it will reward the truly talented players in today’s market. Appraisers are the not-so-cool kids on the playground. But with the new requirements in place, integrous appraisers with valuation expertise will be highly valued. Truly skilled deal architects will also benefit. The deals that do go through under these enhanced measures will be of higher quality and reliability, attracting capital that was distracted by the sheer volume deals being introduced in the previous era.
To be clear, rules do not always benefit the markets they regulate, and I still harbor doubts about the prudence corporations like Fannie and Freddie as they currently operate. In this case, however, I think policy reforms aimed at strengthening underwriting practices will benefit the multifamily market and the broader economy.
Sources
Wall Street Journal | https://www.wsj.com/real-estate/fannie-mae-freddie-mac-commercial-property-lenders-brokers-rules-116907c2?mod=real-estate_lead_pos2
Wall Street Journal | https://www.wsj.com/real-estate/property-fraud-allegations-snowball-as-commercial-real-estate-values-fall-492d964c?mod=article_inline
Freddie Mac | https://freddiemac.gcs-web.com/news-releases/news-release-details/freddie-mac-multifamily-enhances-policies-strengthen-due?_gl=1*rod4a4*_gcl_au*MjAyMTAxMDY3My4xNzEzMzYzNjg1&_ga=2.146241079.2074179453.1713363685-573847361.1713363685
