Capped ARM’s a Good Financing Alternative

Low rates, prepayment flexibility attract investorsby Steve Bergsman

It’s been two years since the subprime mortgage market blew up, taking down the residential housing industry and eventually the economy.

While everyone’s hoping the end of the property blues will be reached this year, there are still some sectors, such as commercial real estate, that were late coming into the down cycle and still have a long way to fall.I bring this up because a lot of small investors — after successfully dabbling in the residential markets, picking up forlorn properties cheap and either fixing to sell or holding as a rental units — are realizing it might be time to move up the real estate food chain.

Although the investment market for single-family homes is still vibrant due to all the foreclosures, there’s a lot of competition out there and in many cases the payoff won’t come for many years.

Understanding that new dominoes are starting to fall, smart investors are already moving up, spreading their investment dollars to other forms of residential property such as small apartment buildings or senior family housing.

The problem is, of course, the next level of investment takes a lot more capital. Essentially, you could be moving up from a $200,000 investment to one that’s $2 million. Even if one brings in friends and family, forming some form of partnership or joint venture to help fund this next stage of investment, there probably will be a need to borrow capital.

With the local banks having turned off the lending spigot and locking down the handles, where does one turn for this kind of financing? One of the answers is Freddie Mac, with its “capped” adjustable-rate mortgages.

For many months, I had been noticing a level of investors between institutional buyers and small-time dabblers who had been successfully completing deals using Freddie Mac’s Capped ARM financing program.

Two examples that caught my eye happened earlier this year. I noticed them because both were for dual projects in Florida, a particularly tough place these days to get financing capital for just about anything. Almost the whole state is kind of a ground zero of blown-up real estate developments, so anything that gets financed there immediately draws my attention.

In the first deal, done in January, Capmark Finance Inc. arranged the refinancing on two Florida senior housing properties using Capped ARMs. One of the financings, for Allegro at East Lake, a senior housing project in the Tampa area, was not very big at $7.7 million.

The second also involved two Florida financings, the smallest being an apartment complex in the city of Longwood, for under $10 million.

The second dual set was arranged by Matthew Schoenfeldt, a director at Holliday Fenoglio Fowler LP in Chicago, who has completed in the past year somewhere in the order of $100 million in Capped ARM financings, many down in the $10 million range.

I asked Schoenfeldt what he likes about Capped ARMs, and he responded by saying the two most compelling features in this type of financing were low, current coupons and prepayment flexibility.

“Capped ARMs allow borrowers to take advantage of the low, floating rates today,” he explained. “My clients were able to lock in a spread of about mid-300 basis points over LIBOR (London Interbank Offered Rate), so their coupon was less than 4 percent.”

To which, Schoenfeldt added, “One of the nuances of the Capped ARM is that there is prepayment flexibility. My clients bought these two Florida properties with the idea that they can create value. The prepayment penalty is so light, a client could even put more leverage on the properties or sell them unencumbered.”

I popped on the Freddie Mac Web site to see what it had to say. Basically, the Capped ARM allows for a floating rate for the full term of the loan with an established maximum interest rate; the cost of purchasing this cap is financed by Freddie as part of the spread. Since there is cap protection, Freddie claims it’s not necessary to purchase a third-party interest-rate cap, which eliminates third-party transaction fees, agreements and negotiations.

Some features of the Capped ARM: choices of indices to establish interest rate; options in regard to loan terms, but not longer than 10 years; 80 percent loan-to-value with loan terms of seven years or longer; and an option to convert to a fixed-rate loan at any time unless a lockout applies.

The loans can be used for refinancing, acquisition or moderate rehab, and eligible borrowers can be partnerships, joint ventures, limited liability companies or even individuals.

It should be noted that Fannie Mae has a similar program, but Schoenfeldt prefers Freddie Mac.

“(Freddie Mac) has it down to a science,” says Schoenfeldt. “Freddie Mac has a good track record of setting that maximum note rate appropriately so you are not paying too much for that cap feature that’s embedded in the pricing.”

Although the Florida deals Schoenfeldt was involved in weren’t very big, they still would be larger than those targeted by a lot of people entering the commercial real estate market for the first time. Could they use the Capped ARM program as well?

Schoenfeldt answered to the affirmative, but with some stipulations.

First of all, the minimum loan amount is $2 million.

Secondly, in all commercial real estate transactions today there is intense scrutiny of all the entities — including individual investors and hired management firms — owning and operating the assets.

“If the investor has very little in the way of experience owning and operating a property, it would be very challenging to get this loan,” say Schoenfeldt, “but a small operator with a good track record would get favorable treatment from the agencies (Freddie Mac and Fannie Mae).”

Steve Bergsman is a freelance writer in Arizona and author of several books, including “After the Fall: Opportunities and Strategies for Real Estate Investing in the Coming Decade.”

Copyright 2009 Inman News