You’ve made the decision to purchase an apartment building. You’ve done your research, properly vetted the numbers and came up with a potentially excellent investment. The price is right, and you have investors lined up to help with the purchase. Now the only thing left is arranging financing.
But that might not be as easy as it sounds. Actually, the key to financing an apartment building is finding the right lender. Even though multifamily properties are basically residential, properties with 5 units and above are considered commercial properties to lenders. The reason is obvious: you plan to generate income instead of using it as your residence. And finding the right lender is important not only because commercial loan rates vary from one lender to another, but also because a good lender will work with you in case things go south, while others will rush to take control in case you can’t handle the loan payments.
There aren’t any set rates like with most home mortgages; each lender looks at the strength of the individual deal, the sponsor and the market and evaluates them a bit differently. In order to get the lowest rate, you’ll need a strong net worth and liquidity, solid and proven track record in managing multifamily properties, and have a solid cash flow in a strong market. There are different types of lenders to choose from, so let’s look at what is best for your purchase.
These are the loans that are offered by government agencies - including Fannie Mae and Freddie Mac. The biggest difference between an agency loan and a traditional bank loan is that agency loans are non-recourse loans, meaning that the collateral secures the loan debt, which is the apartment building. This helps to protect your personal liability, since the agencies can’t go after any of your personal assets - even if they weren’t put up as collateral. Bank loans, on the other hand, are usually recourse loans, making you personally liable for the full amount of the loan if you default.
Fannie Mae has a variety of loan programs for purchasing or refinancing different multifamily properties. They include 5+ unit apartments and condos, senior housing, student housing, affordable housing and others. Their biggest program is the DUS (Delegated Underwriting and Servicing program). It partners with private lenders in order to provide competitive rates and faster execution.
The DUS program offers loans from $3 million, with up to 80% LTV (Loan to Value). The LTV is calculated by dividing the amount of money borrowed by the appraised value of the property. Generally, the higher the LTV, the greater risk to the lender, so interest rates will usually be higher.
Freddie Mac non-recourse loans are available for $1,000,000 and up, with 80% LTV and both floating and fixed-rate options up 10+ years and a 30-year amortization. As with Freddie Mae, borrowers must have a minimum net worth equal to the size of the loan. In addition, borrowers must have enough liquidity for 9 -12 months of mortgage payments. Another factor is experience. For agency loans, borrowers must demonstrate extensive prior experience in successfully managing multifamily properties.
CMBS stands for “commercial mortgage backed security,” as these loans are pooled into securities and then sold to investors on the secondary market. For buildings that are not appropriate for agency loans, CMBS financing is often an excellent alternative.
This is particularly true if borrowers are faced with credit or legal problems, including a recent bankruptcy. And for borrowers who need to have a faster closing process than available through agency loans, CMBS is ideal. In addition, the lender tends to focus on the income from the property instead of the borrower’s credit history.
The downside to CMBS loans as compared to agency loans is that CMBS has a rate lock that is only a few days prior to closing. If the borrower’s DSCR (debt-service coverage ratio) falls below 1.25 for two quarters, they will do a “cash sweep,” where all cash is put into an a debt service reserve account and the money will be released to the borrower only after the debt is paid. In some instances, they require tenants pay into the debt service account directly if the DSCR falls below 1.25.
So why is DSCR important? The Debt service coverage ratio is important not only to the lender, but to the borrower as well. Here’s why: it provides a good snapshot of whether the borrower can pay back the loan on time, and with interest. The higher the DSCR is above 1, the better the chance that the loan will be funded.
The DSCR is calculated by dividing the Annual Net operating Income (NOI) by the Annual Debt Payments. It’s good information for the borrower, too. That’s because by determining the result, the borrower can see if the asking rate is too high. It also gives the business an opportunity to increase their DSCR ratio before applying for a loan, so they’ll be in a better position to get a positive response.
An alternative to agency loans and CMBS loans is traditional bank financing for an apartment building, though not very common for investors who purchase multifamily properties. Bank loans are recourse loans, which means that the borrower will be personally liable for the debt, but qualifying is easier than government agency loans.
The LTV (loan-to-value) on most bank loans is up to 80%, which is similar to agency loans, and require a 20% downpayment. The bank loans are also best for having a property manager on premises or a property management company managing the property, so that rents are collected in a timely manner, repairs are noted and made and any tenant related disputes are settled quickly. This helps to ensure that payments will be made in full and in a timely manner.
While banks like to have the borrower set aside cash reserves, there aren’t any strict reserve requirements like there are with agency loans. But for peace-of-mind for the borrower, it’s good practice to have a minimum of nine months’ worth of reserves available to cover monthly loan payments when necessary. Funding requirements for banks are generally a DSCR of 1.25 or higher, a 90% occupancy and 3+ months of stable tenants.
Private or Bridge Loans
There are times when agency loans or bank loans are simply not available to borrowers looking to finance an apartment building. This is due to the need for a fast closing, or when the borrower has credit, legal or financial issues that preclude conventional financing, or if the property is unsterilized (has low occupancy). Another reason is that financing may have fallen through on a property that’s under contract, and money is needed immediately to salvage the deal. Bridge loans are typically between 6-24 months.
The advantage of bridge loans is that the loan amount is determined by the property’s value, and there are limited borrower qualifications required. As mentioned, there is also a fast closing process.
The downside to bridge money loans is the cost. Interest rates are high, along with higher closing costs. Loans are generally short term with a balloon payment. the main reason why I don’t like bridge loans, is the uncertainty that involves with them. Since they are usually short term, investors need to refinance after 1-2 years, which means that they need to take a new loan, but the problem is that nobody knows what the interest rate will be in 1-2 years, and this unknown can significantly affect the projected returns.
What’s the Best Financing Option?
Finding the right property is key to investing in apartment buildings, but finding the right lender is equally important. Government agency loans are non-recourse loans that generally have the best terms and rates, and are non-recourse loans which helps protect the borrower’s personal assets.
While each situation is unique, agency loans are generally the best option, as they offer the lowest rates and best terms. Hence, my go-to loan is an agency loan. CMBS loans are also a better alternative to bank loans or bridge loans, and should be used if you cannot get an agency or CMBS loan.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specializes is multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
Ellie is the host of REady2scale, a podcast that shares true stories from within the industry, and the critical lessons learned, from the most successful real estate investors, innovators, developers, and more from around the globe!
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.