Leverage.
It’s one of the pillars of real estate investing. There aren’t many other investment vehicles out there where you can acquire low-interest loans for up to 75% of the asset’s value.
When purchasing multifamily properties, lender financing is a given due to the high value of large apartment complexes in the United States.
Even if you happened to be old uncle moneybags with a few billion stashed away and are capable of buying properties in cash, you’re going to be working with lenders to purchase real estate.
Leverage allows you to maximize the return on your equity in an investment property (check out our Terminology Guide for more details).
As a passive real estate investor, you don’t have to directly engage with these lenders. As we do here at Winterspring Capital, the sponsors of the syndication will acquire the financing for the investment for you.
That said, it’s important for passive investors and aspiring syndicators alike to familiarize themselves with the multifamily lending process. It’s one of the most important steps in multifamily investing and a topic that people overlook far too often.
You may not think of it this way, but your lender is also investing into the deal. They just happen to be investing far more than any other investor!
When framed in those terms, you can see why it’s important to have a healthy respect of debt and lending.
So how do you qualify for financing in the multifamily arena?
If you’re a passive investor, you don’t have to worry about these questions, but for the sponsors in a real estate syndication, the lender will conduct a thorough review of the potential loan.
Their review process will include looking at the property itself, the market it’s located in, and you as the borrower.
The most important part of their review process is their review of the property. The lender will want to see the property’s current rent roll, as well as any financial information from the previous year (known as the T12 or “trailing 12” financials).
They’ll also conduct a review of the market the asset is located in and assess comparable property sales within that market.
For large multifamily purchases, lenders also usually want to vet the property management company as well to be sure of their competency and capability in managing the property.
The other extremely important leg of their review process is in vetting the sponsors. The lender will want to make sure that the sponsors have both the experience necessary in real estate as well as the financial muscle to take on the debt.
They will want to review past deals you’ve been involved with, any tangential real estate experience, and information on other real estate assets you own.
You will need to submit a personal financial statement (PFS) to the lenders that show your entire financial situation.
While lending practices vary, it’s a safe bet to assume that the general partners in the investment must have a combined net worth that’s equal to or greater than the loan amount.
There are also liquidity requirements that stipulate you must have some percentage of the loan amount in cash at the time of the purchase.
To be safe, we recommend you budget for having at least 10% of the loan amount in liquid cash until you find a lender who tells you otherwise.
Okay, so you think your team qualifies for multifamily financing, what’s next?
In today’s article, we’re going to go over the top ten things you need to know about multifamily financing so you have a game plan ahead of time.
Five of the items we’re going to discuss are important financial metrics that lenders pay attention to during their underwriting process.
The remaining five we’re going to dive in to are the different sources of multifamily financing and how each one is different.
The actual terms that lenders will provide you with vary over time based on market conditions, so our focus here is more on giving you a top-down overview of how lending works in the multifamily space, rather than speak too specifically about interest rates, for example, which will become outdated all too quickly.
As stated before, knowledge is power, and even if you’re a passive investor, getting in tune with how things work on the lending side of the equation will equip you with a better working knowledge going into future investments.
Terminology:
1. Debt yield:
Debt yield is a risk measurement metric used by commercial lenders. While every lender is different, this is one of the more popular measures of quantifying how risky a loan is. Using the property’s net operating income, debt yield shows the time it would take to pay back the entire loan if the borrower were to default. Lenders will typically only provide loans on assets with a debt yield of 10% or higher, though they can sometimes go lower for class A properties in tier one cities.
Debt Yield = Net Operating Income / Loan Amount
2. Loan to Value Ratio (LTV):
The amount of debt provided by your lender is determined by the LTV ratio. This will vary based on a number of factors, the most important being the asset type and current market conditions. A common LTV in the multifamily space is 75%. A $20 million property financed with a 75% loan to value ratio will have a $15 million loan, for example.
Loan Amount = Loan-to-Value % x Assessed
3. Recourse Debt:
A full recourse loan allows the lender to seize the assets of the borrowers in the event of a default. This is because these loans require the borrower to personally guarantee the debt.
These loans come with a higher liability to investors when compared to non-recourse loans. Non-recourse loans are secured by the property itself and foreclosure is the only route the lender can go in the event of a default.
As you can probably imagine, investors lean towards non-recourse loans in most circumstances.
4. Debt Service Coverage Ratio:
The Debt Service Coverage Ratio (DSCR) is extremely important to lenders and is one of several variables that will determine the amount of funds they can lend towards the asset purchase.
It shows to what degree the property is capable of covering the annual debt service. The higher the number, the more capable the property is of carrying the debt.
For example, a property with a NOI of $135,000 and an annual debt service of $100,000 will have a DSCR of 1.35.
DSCR = NOI / Annual Debt Service
5. Stabilized:
Whether or not a property is stabilized is also extremely important to lenders.
The actual occupancy rate that is considered stable varies depending on the market and lender, but generally speaking, properties that have consistent vacancy rates of 10% or less for at least three months are stabilized.
If you fall below this threshold, the property would be considered distressed.
6. Bank Loans:
This is the type of financing that the average person is most familiar with for multifamily investing as this is what a beginner solo operator will usually acquire for their purchases.
These are sometimes called “portfolio” loans because banks keep them within their own portfolio rather than selling them in the secondary mortgage market.
Banks are one of the most flexible sources of lending capital, but you’re usually going to end up paying more through higher interest or fees for that flexibility.
Their underwriting process may move more quickly than other sources of financing, though this varies from bank to bank.
Bank loans are usually full recourse debt that require all investors involved to guarantee the loan personally. This element can make bank loans impractical for real estate syndications, depending on the structure of the investment.
7. Government Sponsored Entity (GSE):
Also referred to as agency lenders, the most well-known government sponsored entities are Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA). While Ginnie Mae might be more familiar to the average person because they guarantee FHA and VA loans, but in the multifamily sector, we’re usually dealing with Fannie and Freddie.
GSE loans are particularly attractive to investors in order to stimulate investment into housing. GSE debt is non-recourse and comes with extremely competitive interest rates.
An important component of GSE loans for real estate syndications is the availability of interest only payment periods, which are an important piece of strategical debt structuring to provide passive investors with the most favorable returns.
There are also programs that incentivize property owners to retrofit green energy components to existing property that make their financing even more attractive.
In return for these competitive terms, the underwriting for GSE loans is extremely meticulous and thorough. As a result, these are difficult loans to qualify for.
Plan for around two months for a commitment for a GSE loan.
GSEs exist to keep market liquidity flowing in this important component of the economy.
That’s why they step up big time in times of crisis, such as during the COVID-19 pandemic.
As you can see from this chart, as other lenders temporarily retreated as the pandemic first struck, GSEs stepped up to the plate big time and kept the markets humming along.
8. Life Insurance Companies:
Insurance companies are sitting on a lot of capital that they are trying to grow with minimal risk.
One of the ways they do that is by getting involved in the multifamily lending arena.
In fact, you might be surprised to hear that they’ve been a part of this space for several decades, providing competitive financing rates comparable to the GSEs.
Life insurance companies are more risk-averse, focusing on higher quality assets for lending and providing a lower LTV ratio than other multifamily lenders on average.
On the other hand, they are more amenable to longer loan terms than the other lenders.
9. Commercial Mortgage Backed Securities (CMBS):
Also known as conduit loans, these loans are more flexible than government sponsored loans and the borrower does not have to meet as stringent of criteria. As is the case with bank loans, however, this added flexibility comes with a price tag by way of higher interest rates or fees.
This may be worth it, however, in order for a less experienced operator to qualify, or for properties in extreme disrepair that do not qualify for GSE financing.
In contrast to bank portfolio loans, which remain in the bank’s portfolio for the life of the loan, CMBS loans are sold on the secondary market. This is done by packaging similar loans together into securities known as Real Estate Mortgage Investment Conduits that are then sold to investors.
10. Bridge Loans:
So what do you do if your property doesn’t qualify for any of the traditional means of financing multifamily real estate? Enter the bridge loan. These are short-term loans intended for properties that need to be stabilized over a period of time.
The typical length of a bridge loan is 1-2 years based on the amount of time needed to stabilize the property. The borrower takes on the bridge loan during the period that they are improving the property. They then refinance with one of the other financing options on this list once the property qualifies.
Due to the higher level of risk involved, bridge loans come with higher interest and fees than the other lending options on this list, but they are typically non-recourse, which is a plus.
Conclusion:
The range of options for multifamily financing can seem a little daunting when you’re first starting out, but this list should get you started on the right track.
Understanding how to acquire the best financing and qualifying for said financing is one of the biggest hurdles in the real estate investment world.
Luckily, a lot of the stress involved with qualifying for and obtaining multifamily financing is not relevant to you when you take the passive investment option through real estate syndications.
Syndicators like me have to do that work for you! If you’re new to passive investing through real estate syndications, check out our What is a Real Estate Syndication for Multifamily Investing? article for an introduction to the topic.
