Unless you hit the lottery or you’re sitting on a massive hoard of cash, you’re going to need commercial multifamily financing to buy properties. As a private multifamily real estate acquisitions and asset management firm we do that, so our investors don’t have to.
Securing financing makes the lender the largest investor / partner in the deal. Active investors need to get comfortable with this topic. But even passive investors should have a basic knowledge of multifamily financing. After all, educated investors make better investment decisions.
For that reason, we’re going to cover the various options for financing in this space. Keep in mind that loan terms change regularly, making it difficult to write a timeless piece on this subject. Rather than discuss current terms, which are subject to change, we’ll focus more on general principles.
But, before we take a deeper dive into the various options, let’s discuss some key metrics and terms
Key Terms and Metrics
Debt Service Coverage Ratio (DSCR / DCR)
DSCR = Annual net operating income (NOI) divided by the annual debt obligations. As an example, if your NOI was $115,000 and your debt obligation was $100,000, then your DSCR = 1.15. A DSCR equal to 1.0 means the property breaks even. Above 1.0 makes money, while below 1.0 loses it.
Loan to value (LTV)
LTV = Mortgage amount divided by the value of the property. Therefore, a property that appraised for and sold at $10 million dollars with an $7,500,000 loans has an LTV of 0.75 (or 75%). The higher the LTV, the more leveraged (multifamily financing) the property is.
Recourse vs. Non-recourse loans
Full recourse loans are those that are personally guaranteed by the borrower. That means the lender could come after the investor(s) and their assets should they default on the loan. With non-recourse debt, the property secures the loan making foreclosure the only recourse available to the lender. Non-recourse debt is preferable to investors as it limits their liability.
Stabilized Properties vs. Distressed Properties
The difference between a stabilized and a distressed property largely comes down to occupancy. Properties with 90% or better occupancy for at least the last 90 days are considered stabilized. Occupancies below 90% for sustained periods of time are typically considered distressed by the lenders. These numbers can vary from market to market and lender to lender, but this is a good rule of thumb.
Multifamily Financing – Variables Lenders Need To Know
When applying for multifamily financing, the lender looks long and hard at several variables.
- Your experience with commercial multifamily real estate
- If the property is distressed or stabilized
- Your financial situation (net worth and liquidity)
- The market, submarket, and property manager
Lenders will want to know your experience investing in multifamily. This doesn’t apply for passive investors; instead, the syndicator or key principals in the deal will be scrutinized. How many projects have they been involved with and what is their current portfolio?
They’ll want to know their track record. Have they been successful investors or is their track record less than stellar?
They’ll also want to know if the property is stabilized or distressed. They’ll ask to see the trailing twelve months of financials (T12), along with the rent roll and offering memorandum. Securing multifamily financing for stabilized properties is much easier than for distressed properties.
Lastly, they’ll ask for the personal financial statements for the key principals. Every lender is different, but the most conservative lenders want those people to have a minimum combined net-worth equal to the value of the loan and at least 10% of the loan in liquid assets like cash.
Therefore, a $10 million property with a $7.5 million loan (75% LTV) would necessitate those key principals have a combined net worth of $7.5 million with $750,000 in liquidity.
Commercial Multifamily Financing Options:
Government Sponsored Entity (GSE):
Government sponsored entities sometimes called “agency lending” often refers to the commercial arms of Freddie Mac (FHLMC) and Fannie Mae (FNMA). While Freddie and Fannie are the two biggest suppliers of multifamily financing in this category, FHA does lend to multifamily as well.
The government often incentivizes behavior they deem beneficial to society. They give multifamily investors some serious tax advantages, so it should come as no surprise that they also offer multifamily loans. They want investors to provide housing for others and will give some of the best terms with the lowest interest rates available to those that do so. And if you promise to lower the building’s energy and water consumption, they will lower your interest rate even further utilizing their “green program.”
In addition to excellent terms, GSE financing comes with extra benefits. They provide non-recourse debt, the ability to acquire supplemental financing, and generous interest only payments for the first 1-5 years of ownership.
Their loans typically take 45-60 days to complete and come with strict underwriting standards. As a result, their distressed loan rates and foreclosure rates are infinitely small.
Be aware that qualifying for these loans is difficult. Inexperienced investors typically won’t qualify and neither will distressed properties, except in rare circumstances.
Like most commercial real estate, Freddie and Fannie will lend for a set number of years with a balloon payment at the end. They also attach pre-payment penalties in the form of defeasance or yield maintenance.
Bank financing may be most appropriate for beginning investors or those looking to purchase a distressed property. Banks often have more flexible qualification standards and terms. In return for that flexibility, it’s not uncommon to see higher fee structures.
Also, banks tend to rely heavily on floating rate structures that are tied to an index. That can work in your favor when interest rates are declining or it can cut into your profitability in rising interest rate environments.
Banks can also move faster, often closing in 30-45 days.
But the biggest downside to bank loans is full recourse lending. Banks typically require full recourse loans, which means the investors have to personally guarantee the loan. That personal liability adds additional risk to the investors.
In the rare circumstance when they do offer non-recourse financing, it typically comes with higher fees and a lower LTV than can be obtained with GSE financing.
Commercial Mortgage Backed Securities (CMBS) or conduit loans are similar to bank loans in that they have more flexible terms than the harder to qualify for GSE loans. They accept less experienced owners and or distressed properties. This flexibility comes with higher fees and interest rates for the borrower.
Unlike bank loans, which typically stay with the bank for the life of the loan, CMBS loans get packaged together into a Real Estate Mortgage Investment Conduit (REMIC) trust and sold as a security to investors.
Their looser underwriting standards, yield higher delinquency rates.
Insurance companies have been providing fixed-term, nonrecourse debt for commercial real estate for decades now. They are a strong player in the industry and their multifamily financing is very competitive to that of GSE lenders. Life insurance companies are the biggest providers of these loans.
Insurance companies often focus on higher-grade properties making it less likely to secure these loans for lower grade properties. They can also provide longer loan term options for those seeking lengthier hold periods.
Life insurance companies typically require a lower LTV than GSE, commonly topping out at 65%.
Bridge Debt / Hard Money
There are some properties and some groups that simply won’t qualify for GSE, insurance company, CMBS, or bank multifamily financing. Often times, the level of distress in these properties is too much even for bank and CMBS financing.
In those cases, there is a place for bridge financing. These are higher risk, short-term, temporary loans intended to allow the purchaser to secure and stabilize the property so that they can quickly turn it around. Once that is done and the property is stabilized, the owner can execute a sale or refinance into a more conventional loan type.
Hard money loans are similar to bridge loans in their purpose, function, and higher fees / interest rates. Bridge loans typically come from banks, whereas private investors finance hard money loans.
A Primer in Multifamily Financing Conclusion
Solid market fundamentals coupled with favorable demographics is driving a healthy commercial multifamily market. Loan originations are up.
Lending remains available and open for multifamily investment, but qualifying for these loans can be challenging. Without a track record of success or the high net-worth and liquidity required to secure multifamily financing, individual investors are frozen out of this lucrative market.
Fortunately, you can invest fractionally with 37th Parallel Properties. As a top syndicator, we qualify for the best lending terms so you don’t have to. If you’d like to learn more about our investment model reach out to us today at [email protected]