Many real estate investors follow a similar progression. They begin with single-family homes – either to flip or rent. At a certain point, these investors decide to make the jump into multifamily properties to chase higher returns. However, financing can change significantly between single-family homes and an apartment complex. As such, we’ll use this article to provide an overview of multifamily loans.
Specifically, we’ll cover the following topics:
- An Overview of Multifamily Properties
- Multifamily Loans with Residential Financing
- Multifamily Loans with Commercial Financing
- Final Thoughts
An Overview of Multifamily Properties
Broadly speaking, multifamily commercial real estate consists of residential properties with multiple, distinct units. Technically speaking, two- through four-plexes qualify as multifamily. But, from a financing perspective, lenders generally categorize these types as residential real estate, which requires residential financing.
Conversely, when apartment buildings have five or more units, they qualify as commercial real estate. Accordingly, investors typically use commercial lending when debt financing these buildings. While not an all-inclusive list, some of the more common types of multifamily properties include:
- Garden-style apartments
- Mid-rise apartments
- High-rise apartments
- Student housing / dorms
- Senior and assisted-living
In the next two sections, we’ll discuss multifamily loans secured with 1) residential financing, and 2) commercial financing.
Multifamily Loans with Residential Financing
Overview of Residential Financing
Residential financing, typically used to secure loans for two- to four-plexes, entails borrowing in your name. For example, a mortgage loan for one of these properties will be borrowed by John Smith – not 123 Main Street, LLC. Most real estate investors inherently understand residential financing, as you use this to secure a mortgage on a primary home.
While some conventional lenders will issue mortgages for these properties to a company, this is rare. And, when lenders do allow borrowers to use an LLC rather than their own names, they typically have significantly lower loan-to-value (LTV) requirements. In a review of several national banks, only one offered this sort of product and had a 60% LTV requirement. (NOTE: Hard money lenders, unlike conventional lenders, will provide short-term financing for single-family homes in the name of a business – typically to facilitate a flip).
Residential mortgage loans for multifamily properties generally have the same loan terms and amortization periods (e.g. a 15- or 30-year fully amortizing loan).
Applying for Multifamily Loans with Residential Financing
When applying for a multifamily loan with residential financing, lenders will want guarantees about your personal financial situation. That is, a lender’s primary concern will be that you can cover future debt payments. This means that you will need to submit proof of income (e.g. W2s, 1099s, tax returns, etc.) and personal debt schedules to confirm you meet a lender’s maximum debt-to-income ratio, or DTI.
With two- to four-plexes, lenders may factor future rental income into your DTI analysis, but this will likely depend on a couple factors. First, are there tenants with signed leases in place when you purchase the property? Second, do you have an established track record as a property manager, and if not, have you signed a contract with a property management company? If you meet lender requirements, they may include up to 75% of future rental income into your DTI calculations.
With appraisals, residential financing for multifamily properties normally uses the market comp approach. That is, appraisers will review similar properties in the same area that have recently sold to calculate a market value. This approach means that you likely will not be able to use the income-based appraisal approach (used in commercial financing) to argue for a higher appraisal. However, this ultimately depends on the unique situation and the lender requirements.
Multifamily Loans with Commercial Financing
Overview of Commercial Financing
Commercial financing – used to finance multifamily properties with five or more units – entails lending to companies. Continuing the above example, a multifamily loan for an apartment building would be in the name of 123 Main Street, LLC – not John Smith. From a liability perspective, borrowing as a business provides protection to the individual owners. Barring negligence or several other factors that allow “piercing the veil” of an LLC, most lawsuits can only pursue the LLC’s assets – not those of the individual owners. However, despite this liability protection, most lenders will still require a personal guarantee for commercial mortgages, especially for newer investors.
Commercially financed multifamily loans normally have shorter loan terms than amortization periods. For instance, it’s common to see a 10-year loan with a 25- or 30-year amortization period, meaning borrowers must refinance or make a balloon payment at the end of the loan term.
Applying for Multifamily Loans with Commercial Financing
When you apply for a multifamily loan with commercial financing, lenders primarily care about the asset’s rental revenues, operating expenses, net operating income, and debt coverage ratio. That is, when underwriting these loans, lenders seek assurances that the property will be able to cover future debt payments.
To apply for one of these multifamily loans, you’ll need to submit what’s known as a pro forma to the lender. This template outlines the financial aspects of a given deal. At a minimum, pro formas will include the following:
- Sources and uses of contributed capital (i.e. the equity put into a deal)
- Detailed schedule of acquisition and, if required, construction/renovation costs
- Rent rolls for the property (projected or actual, depending on the property’s stabilization status)
- A stabilized operating budget
- Projected debt coverage ratio (to confirm a property’s NOI covers its debt payments with a given margin of safety)
Additionally, lenders will have LTV requirements for commercial mortgages – typically ranging from 65% to 85%, depending on the deal type. However, unlike with residential financing, commercial multifamily appraisals use the income-based approach. With this system, appraisers divide a property’s current or projected NOI by a market- and property-specific factor called capitalization (or “cap”) rate to determine value.
This income-based approach lets appraisers determine property value when no similar properties exist. And, from an investor’s perspective, this appraisal method gives you greater flexibility in A) increasing rents, B) decreasing operating expenses, or C) both to increase a property’s appraised value.
When real estate investors transition to multifamily properties, they face a variety of new challenges. In particular, successfully applying for multifamily loans requires learning the ins and outs of commercial financing, which has significantly different requirements than residential financing.
Fortunately, you don’t have to tackle these commercial financing challenges on your own. If you’d like to discuss different multifamily investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.