Commercial Loans Blog

Low Cap Rates and Commercial Loans on Small Apartment Buildings

Posted by George Blackburne on Sat, Jan 27, 2018

Small Apartment Building.jpgWhen applying for a commercial loan to buy a small apartment building, you are likely to run into the following problem:  When the lender applies a 1.25 Debt Service Coverage Ratio to the Net Operating Income, the property will only qualify for a loan of 62% Loan-to-Value.  The commercial lender will then insist of a down payment of a whopping 38% of the purchase price!  Remember, purchase money second mortgages, behind bank or conduit first mortgages, are forbidden nowadays.

Who the fiddlesticks has 38% to put down????  What the hellions is going on?

 

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The problem when trying to finance small apartment buildings - I am talking about multifamily properties of 5 to 20 units - is that everyone wants to own them.  The Apartment Game has been played for generations in America.  You buy a four-plex, rent it out, and run it for five years.  In the meantime, the rents go up by 35%.  Then you sell it for a nice profit and use your profits, plus your original down payment, to buy a ten-unit property.  Five years later you sell that 10-unit building and use your big profit to buy a 20-unit project.  By the age of 55, you are ready to retire and live off your rents.  Your success is virtually guaranteed, as long as inflation continues.

 

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Because the Apartment Game is a virtually guaranteed path to a comfortable retirement, everyone wants to play.  If a small apartment building comes on the market, there is a feeding frenzy.  A 15-unit apartment building might have a NOI only $212,000, but the bidding is likely to go as follow:

"I'll pay $2,650,000 for that $212,000's worth of income."  This works out to an 8% cap rate.

"I'll pay $3,029,000 for that $212,000's worth of income."  This works out to a 7% cap rate.

"I'll pay $3,533,000 for that $212,000's worth of income."  This works out to a 6% cap rate.

When the bidding stops on this 15-unit apartment building, the price is likely to end at $4,348,000 - which equates to a cap rate of just 4.875%.  

Then, when the lender takes the $212,000 in NOI and divides it by the 1.25 Debt Service Coverage Ratio, he arrives at a loan amount of only $2,709,000 - assuming he used a 4.75%, 30 year constant.  Constant is just a fancy word for using a 4.75% interest rate on the new multifamily loan and a 30 year amortization.

 

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Quick Review and Summary:

An investor is buying a 15-unit apartment building that has a Net Operating Income of just $212,000 per year.  The bidding to buy the building is fierce.  Everybody and their brother is bidding to buy it.  The investor is forced to pay around $4,350,000 for the building.  The loan officer at the bank working to make the loan can only get the deal to pencil at $2,710,000 - using a 4.75% interest rate and a 30 year term.

The investor has some serious down payment money, but who on earth has 38% to put down?  Does this mean that small apartment buildings cannot get financed, even though small apartments are the most desirable type of income property in the whole world?  Please read this again.  The hottest type of real estate - the best and most secure collateral for any real estate loan - is small apartments.

 

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How Your Bank Loan Officer Must Handle This Situation:

First of all, the investor needs to choose a bank loan officer who is willing to go into Loan Committee and fight for the deal.  Then that loan officer must say:

"Boss, listen.  If we make a multifamily loan on a 100-unit apartment building, we could sit on that foreclosed collateral unsold for months, even though the loan had a 1.25 debt service coverage ratio originally. After all, there is not an unlimited demand for, and an unlimited number of buyers of, a 100-unit apartment building."

"In contrast, if we start to foreclose on a small apartment building (5-20 units), our REO department will have buyers lined up before the foreclosure sale even takes place.  You can verify this, Boss.  Just call the REO Department and ask them how many small apartment buildings we have unsold."

 

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"The truth is, Boss, is that small apartment buildings are the single most desirable class of real estate to own.  The prices get bid up so high (in other words, the buyers are willing to accept very low cap rates), that the numbers don't work for a traditional apartment loan."

"If we want the BEST collateral for our loans, we have to show some flexibility on the debt service coverage ratio on small apartment deals.  We have to be willing to accept a 1.0 debt service coverage ratio, as long as the buyer's global income (salary, interest income, other net rental income) will support a few vacancies."

What I have written above is the absolute truth, and the bank loan officer, in Loan Committee, has to keep pounding the drum.  "Do we want fantastic collateral for our loans in real life or just so-so collateral that looks good on paper."  If the loan officer sticks to his guns, Loan Committee will eventually agree.

 

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Here is one more arrow for the bank loan officer's quiver.  Any small apartment building that does pencil is almost assuredly in a slum.  For a small apartment deal to comfortably pencil for a 70% to 75% loan today, it must be selling at an 8% or higher cap rate.  In other words, in order to attract a buyer, the seller has to offer prospective purchasers a higher yield on the property.   The investor is thinking to himself, "The only way I am going to buy a property in this stinky area is if I am getting a huge return on my money."

So the last arrow in your loan officer's quiver is this:  "Boss, if a small apartment building loan ever pencils, I guarantee you that the area is so seedy that you wouldn't want your wife or mother walking around there at night.  The bank should want to make their apartment loans in good areas.  The reason why this deal doesn't pencil perfectly is because its in a good area."

 

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One final point:  Banks, agency lenders (Fannie Mae, Freddie Mac, etc.), and conduits will not allow the seller to carry back a second mortgage behind their new first mortgage loans.  Blackburne & Sons will allow second mortgages!

 

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Topics: small apartment loans