FHA was once thought of as the lender of last resort, but now is often is the first and best option for many borrowers. So what changed?

How did FHA get the reputation for being the lender of last resort?

In the pre-1930s, single family homes were financed by banks.  These were 3-5 year loans typically, that caused a family to begin to worry about refinancing them the day the loan closed.  Maturity defaults were always looming.  Banks would extend the loans, add costs in the form of a second and maybe extended for 2-3 years.  This cycle continued, until people were having 4 or 5 loans that were renewing every 6 months.

Things were fine, if cumbersome, during the Roaring ‘20s, but when the stock market crashed and credit dried up, homes began to be foreclosed as there was no liquidity in the mortgage markets.

This is when the Federal Government stepped in with the precursor to the modern single family programs under FHA.  This is when 30 year loans came into existence, with easier qualifying terms.  FHA became the lender of last resort for single family loans.

But what about apartments?  How did FHA get the reputation in the apartment industry? I can only discuss back to 1974 on this one.  I was a Senior at the University of Oklahoma, taking classes in the morning and working construction in the afternoon.

We always had the radio on at work and eventually the music broke for the news. Among the other stories of the day-the pressure on Nixon to resign, the horrible economy and the ending of the Vietnam War-came a message that made a lot of sense to a poor college student.  Congress had voted to approve a new rental program that would limit rents on apartments!  Power to the People, right on!  I remember talking these new programs up to my friends.  Finally, Congress was doing something right for the renter!

Skip ahead seven years.  I had graduated from Law School, practiced law in California and had recently come back to Oklahoma because Penn Square Bank was making oil millionaires of all my friends.  I went to work for the same firm for which I was working in 1974, but now as General Counsel and as a Real Estate Broker.

One day my boss came in and told me that the company had a relationship with a firm out of Washington D. C. to originate FHA Apartment Mortgages.  I was now the President of that division. Congratulations.  Seeing as how I had a new product to sell, I figured I would learn something about it.  It took a couple of days to realize, but these loan programs were the same programs I had heard about 7 years earlier.

It turns out that the rental restrictions which helped sell the programs weren’t the real purpose.  The real purpose was to bail out the Mortgage REITS.  In the early seventies, much of the nation’s commercial mortgage market was handled with Mortgage REITS, which operated much like the Real Estate REITS of today except they were debt, not equity, and took mortgages rather than ownership.  The market in 1974 was the worst commercial mortgage market previous to our most recent debacle, making mortgage money for apartments extremely difficult to find. FHA had become the lender of last resort for apartments through these programs.

The add-on of the rental restrictions, which disappeared with the advent of Coinsurance in 1983, was the method of making a REIT Bailout program more palatable to the citizenry.  The Post-Watergate mentality did not support any kind of legislation that might be helping Big Business or the Government.

Imagine that:  Selling the people a Government program by wrapping it as something different than it was.  Ah well, now we need a TARP to cover these bailouts, as the dollars keep getting bigger.

FHA was the resource to help bail the REITS out.  Over the next 8 years, the delivery of these programs was spotty at best, as other conventional sources arose.

Three big events happened between 1976 and 1985 that promoted the conventional apartment mortgage market.  In 1976, to spur construction, apartment depreciation schedules were reduced from 35 to 15 years in term, accelerating the tax advantages of owning apartments.

Secondly, the phenomena of disintermediation occurred in the Savings and Loan industry.  Basically “disintermediation” was the disdain of investors for passbook savings rates of 5.75% at a time when inflation was creating expected returns of 14-18% in certificates of deposit and other financing vehicles.  Money was leaving the S & Ls in droves, making them illiquid.  A new paradigm, one in which real estate developers could create big returns through real estate to match or exceed the sleepy passbook returns, led to new ownership of the Savings and Loans. Borrowers were now the lenders. Or more cynically, the inmates now had the keys to the asylum.

Fueling the eventual insanity were the tax laws.  Top tax liabilities approached 50%.  The 1981 tax act gave favorable treatment to real estate, allowing for 2, 3, even 5 to one write offs in the first year for real estate investments.

This did several things.  It made every high dollar earner a real estate investor.  It fueled the development of large real estate syndications and it spurred the construction of all kinds of commercial real estate, whether it made economic sense or not.  The key was that it made tax sense to build.

After all, if you made $1,000,000 in Adjusted Gross Income, and were facing a top end tax liability of, say, $500,000 (it would have been less given the benchmarks for percentage increase, but the concept is sound-stay with me) that you knew you would get nothing in return, why not invest $100,000, get a $500,000 first year write-off and pay, say 35% on $500,000?  One way costs you $500,000; the other costs $275,000 and you had the opportunity to maybe make a lot of money on that $100,000 investment.

How did this translate with the S & Ls?  A developer might come to a reformed developer who now owns an S & L and receive 100% financing on his $10,000,000 commercial property.  The   S & L would charge 5 points and a 50% participation interest and lend him $10,500,000 (this assumes the $10,000,000 included a $500,000 developer fee to the borrower).  The property would probably be pre-sold to a large syndicator, who bought it for $13,500,000, allowing the S & L and developer to split $3,000,000.

The real estate syndicator would charge $15,000,000, picking up the $1,500,000 as syndication fees and the balance to the mortgage.  The investors buying the fifty $100,000 units would get a 2-5 to 1 write off in the first year, and even if the deal never made another cent, it worked great to the investor in that tax year.

From 1981 to 1985, these tax motivated syndications got more complicated and sophisticated as everyone got greedier.  What also was a concern was that these pre-sold properties from 1981 assumed they would be the only apartment or office building or shopping center or hotel on that intersection.  Now there were 2 or 4 of the same product type on that intersection and none of them were making money.  Loans were being extended as no one could repay.  Again, all this was for tax purposes, not for true economic realities.

Move ahead to 1986, to the new tax act. Among other things, the tax act took away the benefits to the passive investor.  For the real estate syndicator, the worst thing was the new tax rates, the highest being 28%. What this meant is that the rich, high dollar earning investor no longer was tax motivated as his rate had been nearly cut in half.  Worse, the recapture on that 50% previous investment was at the new rates.  The investor stopped paying into the failing real estate development immediately.

When the investor stopped paying, the syndicator stopped paying.  When the syndicator stopped paying, the S & Ls went insolvent.  When the S & L s went insolvent, the RTC came into place eventually.  At the time the RTC came into place, 30% of the Congress, both House and Senate, had loans in default to the S & Ls.

I remember watching CSPAN around 1990 when this whole process was being explained in a Congressional hearing.  The person laid out how the dominoes fell and the Congressman, incredulous at what he was hearing said, “You mean, we caused all this?”

Yes it did.

Where was FHA financing during all of this? From 1975 to 1983, all FHA multifamily financing under the 223 (f) and 221 (d) 4 was handled through the local field offices.  Some of the deals were great successes.  Many of the household names in large real estate companies that are still around, started with FHA financing.

But FHA’s performance during this time was spotty:  most FHA staff, when a 223 (f) or SAMA submission got to the top of their stack of things to do, simply put it to the bottom of the stack again.  These were difficult deals to do, the rules were voluminous and the forms were exceedingly difficult to type.  “White Out” created mini-mountains on the forms themselves as typewriters completed these forms, not computers.  Deals were taking 24 months to complete in most offices, without knowing until the end whether you are approved or rejected.  No one could do business like this.

The answer was Coinsurance, a Reagan program if there ever was one. The Federal program was put in the hands of the private sector companies who were required to put up money at risk and to add to that risk investment with every deal they did.  The FHA office closed the deals, reviewed the 2530s, but that was pretty much that.  They had no ability to stifle the findings of the private sector company.

How great! Now we can make these deals work! Or so we thought.

Here was the problem:  The deal I described between the S & L and the developer?  It was being done on a 10% rate, 30 year amortization, no recourse, with a 5-7 year call.  Our deals were fixed rate, fully amortizing 35 year deals, with GNMA required returns of greater than 14%.  We couldn’t compete with the S & Ls.

What was the result?  FHA became the lender of last resort for marginal deals that the S & Ls wouldn’t do, with borrowers that were oftentimes shady and almost always shaky.  The programs were marginalized because we couldn’t compete with the cheaper money.

When the S & L s were booming, there were 3 primary Coinsurance companies who eventually probably did 80% of the business done through Coinsurance. By the time Coinsurance was shut down, the nascent industry had perhaps 60-70 firms, but it was too late.  Losses began to pile up in Coinsurance just like with the Savings and Loans.  The program was quashed in 1989 and FHA did not get back to doing apartment deals on a regular program until about 1992.

In the 1990s and early 2000s, FHA enjoyed a renaissance particularly as to 221 (d) 4 properties.  The terms were unmatched:  fixed rate, non-recourse loans at 90% of costs typically, that were assumable and fully amortizing over 40 years.  No one could compete with these terms.  Indeed, it was possible to get 100% financing if the land was free and clear, or if the developer and contractor would subordinate their fees, or both.  Times were good even in difficult interest rate environments.

For then existing properties the pecking order went something like this:  Life Companies got the “A” product, Fannie and Freddie got the “B” product, and the FHA 223 (f) program got the “C” and “D” product.  Why was that?  It was due to the fact that FHA underwriting was a lot more involved than either Life Company or Agency requirements.  Add to that the inability to price on a shorter term (a 7 year loan could garner a lower rate than a 35 year loan) and couple that with the elongated timing of an FHA loan, and we found ourselves doing a lot of loans that had been refused by the agencies.

Since 2008, we have become the lender of first choice because we are the only ones standing. That is now changing as the economy improves and lenders see the effects of no units being built, occupancies going up and rents skyrocketing, but still FHA is doing its share to meet the need.

These programs are a great source of liquidity for the commercial mortgage market.  The men and women who operate these programs within FHA are to be commended for the tireless and effective work that they do.

We all benefit from these programs.