Grasp the complexities of replacement reserves for multifamily loans
Basics of replacement reserves for multifamily properties
- Replacement reserves are built into escrow accounts to fund ongoing maintenance.
- The amount of replacement reserves lenders require depends on the loan amount, the property's age and the number of units.
- Three FHA multifamily loan programs have some form of replacement reserves.
- Fannie Mae and Freddie Mac generally have reserve requirements, determined by a capital-needs assessment.
Replacement reserves essentially serve as financial-insurance tools for commercial mortgage lenders. With multifamily mortgage loans, a lender may require a replacement reserve to cover the costs of irregular maintenance, repairs and upgrades. This can help the property owner or management team avoid using operational dollars, theoretically improving the ability to repay the mortgage.
These reserves are paid as part of the monthly mortgage payment and are held in escrow by a lender or servicer. The amounts vary greatly and generally depend on the loan amount, the age of the property and the number of units. Multifamily investors should know which parts of a property are generally considered regular and irregular maintenance items, though these definitions can vary between loan programs.
- Examples of irregular maintenance (covered by replacement reserves): Appliances, doors, windows, roofs, gutters, sprinklers, siding, plumbing, heating and cooling systems, water heaters, carpets and flooring, cabinets, elevators and parking lots.
- Examples of regular maintenance (not covered by replacement reserves): Interior painting, landscaping, cleaning, pool maintenance, pest control and playgrounds.
When lenders determine the maximum loan amount for a commercial property, they’re likely to include replacement reserves in the net operating income calculations. By attempting to accurately measure the property’s cash flow and the borrower’s ability to repay the loan, the risk to the lender decreases.
Not every lender requires a replacement reserve, however.
There are three multifamily loan programs administered by the Federal Housing Administration (FHA) that require replacement reserves: The Section 221(d)(4) and 221(d)(3) programs that apply to for-profit and nonprofit entities, respectively, for construction and rehabilitation projects; and the Section 223(f) program for acquiring or refinancing multifamily properties.
The 221(d)(4) loan, which is generally for projects valued at $15 million and up — though the minimum loan amount is $2 million — has an annual replacement reserve that’s based on the greater of two values: Either $250 per unit, 0.6 percent of the total project cost for new construction, or 0.4 percent for rehab work. For example, on a new $15 million apartment complex with 200 units, the reserve would be $90,000 a year. A property owner may obtain a waiver if the deposit exceeds $500 per unit.
Multifamily properties that are either three years old, or substantially renovated at least three years earlier, are eligible for a 223(f) loan of $1 million or more. Monthly reserve payments are required and must add up to at least $250 a year per unit, though they can go as high as $1,000 a year per unit on some older properties.
Fannie Mae and Freddie Mac, two major government-sponsored enterprises, or GSEs, have multifamily loan programs.
Fannie Mae has three loan products geared toward multifamily properties. It has a small-balance program that offers loans of $750,000 to $5 million. Replacement reserves are typically required only on properties with higher leverage, meaning a large down payment that decreases the loan-to-value (LTV) ratio can remove the need for a reserve. The program caps LTVs at 80 percent.
Two other Fannie Mae programs have reserve requirements for all transactions. One program is directed toward affordable-housing projects with rent and income restrictions. The other is Fannie’s standard delegated underwriting and servicing program, which provides the bulk of the company’s multifamily loans. The reserve amount is determined by a capital-needs assessment conducted by a professional inspector.
Freddie Mac’s small-balance program, geared toward loan balances of $1 million to $7.5 million, has no requirement for replacement reserves, although they are part of the underwriting process in determining loan size. Its larger-balance programs usually require a reserve. The minimum amount is $250 per unit and the cost can go up based on a capital-needs assessment.