Due Diligence Advice for Multifamily Borrowers

There’s been a lot of movement in the world of multi-family lending of late.  Freddie and Fannie are generally pulling back in their lending, taking a more conservative approach with tightened underwriting for their multi-family mortgage loans.  Both agencies recently updated their due diligence policies, including more stringent requirements Property Condition Assessments (“PCA” or known as a Physical Needs Assessment in Fannie’s world).  In light of these changes, now is a good time for borrowers to reassess the best lender to finance their multifamily investment.

A lender’s underwriting policies should be a critical consideration when determining which loan will be the best fit for a deal.  To reasonably weigh up the options, borrowers should have a good understanding of different lenders’ due diligence requirements and how they compare to one another. My colleague Summer Gell discusses this in far more detail in her recent Multi Housing News article titled “Charting a Course through a New Multifamily Lending Landscape”, but here I will quickly summarize Freddie and Fannie’s most important changes to help guide your selection.

What were the key changes to Fannie Mae’s underwriting standards?
Revisions to the Fannie Mae multifamily Selling and Servicing Guide (detailed here) went into effect in February 2014.  The changes relate to many aspects of the due diligence process including consultant qualifications, report format and scope of work.  The recent changes to the guide were substantial and have in several respects pushed Fannie’s requirements beyond industry norms.  Amongst the key changes are:

• Stricter requirements for engineering firms, field assessors and report reviewers qualified to conduct Physical Needs Assessments.
• Fannie-specific Estimated Useful Life estimates (also called Expected Useful Life or "EUL" by other lenders) used during the physical needs assessment
• Increased dwelling unit observation minimums
• New special hazards requirements, including a requirement for seismic hazard search methods to be based on “peak ground acceleration” or “PGA” (which is a measure of seismic intensity.)
• New prescribed report modules based on specific property types, which will determine additional items to be assessed in addition to Fannie’s base Physical Needs Assessment report requirements

Concern has been expressed that the increased complexity of these requirements may affect  PNA and other report cost and turnaround times.  In his blog “Fannie Mae Changes its Multifamily Guidelines – what should you be aware of?” Aaron Kovan concludes that larger companies with high levels of experience and numbers of trained personnel on staff will be able to continue performing physical needs assessments in the Fannie Mae space largely as they have before, but that smaller companies may have to increase their fees and turnaround times in order to keep up with the new requirements. 

What are the biggest changes to Freddie Mac’s Multifamily Seller/Service Guide? 
Freddie Mac announced updates to its Multifamily Seller/ Servicer Guide requirements in 2013.  These changes were not drastic and have not had a significant impact on report cost or time.  Mostly, the changes have brought Freddie's requirements in line with industry standard practice. Key changes were:

• Tighter enforcement of Freddie’s qualification requirements for third-party providers (both for Environmental Site Assessments and for Property Condition Reports)
• Revised seismic risk policy.  Borrowers are now required to go straight to a level 1 Seismic Risk Assessment if the property has certain high risk characteristics.  The professional performing the seismic assessment is now required to have an engineering or architectural degree, and the report reviewer must be a licensed engineering or architect in a seismically active state.  Again, Summer’s article looks at the specific changes made to Freddie’s due diligence policy in more depth.

How Should You Choose the Right Level of Due Diligence?
Whether lenders implement scopes of work that are above or below industry norms (for example, ASTM E2018) is dependent on their internal risk tolerance and management policies, which can vary widely from lender to lender.   When selecting the right lender to finance your multifamily investment – Freddie, Fannie, or other lending institutions like CMBS, HUD, or commercial banks – understanding their respective due diligence requirements matters.  My advice to clients is always that if you’re undecided about which lender you will go with, the best plan of action is to meet the most comprehensive scope of work and assessor qualification criteria (more on this in this Globe St article).   A general rule of thumb is as follows:

• Conduct a Phase I Environmental Site Assessment to Freddie Mac’s standards
• Perform a Physical Needs Assessment to Fannie Mae’s standards
• Conduct a Seismic Risk Assessment to Freddie Mac’s standard
• Use consultants that are qualified based on Freddie Mac’s requirements.

Of course, there are exceptions to the rule, and the appropriate scope of work for your Property Condition Assessment (or any other due diligence assessment) should be determined on a case by case basis, but it’s a good general guideline.  Conducting an assessment to the more stringent requirements may cost a little more initially, but it will prevent unexpected cost overruns and save you a real headache if it turns out that a report needs to meet a lender’s additional scope or qualification standards!