3 Pitfalls to Avoid When Seeking Out Multifamily FinancingPaul Winterowd
“An ounce of prevention is worth a pound of cure” – Benjamin Franklin
Most buy and hold real estate investors get their start in residential markets, and this is often because they are already familiar with the mortgage products that make their investments possible. Residential mortgages can be obtained for properties with up to four units. But once investors cross the threshold to five or more units, they must obtain commercial financing.
Commercial mortgages obviously differ from residential mortgages (a topic for another time). This post highlights three basic pitfalls investors must avoid to in order to successfully obtain a commercial multifamily mortgage:
- The Pitfall of Financial Weakness
- The Pitfall of Limited Experience
- The Pitfall of Poor Record Keeping
1. The Pitfall of Financial Weakness
Multifamily lenders can differ greatly from each other, which is why they will often have different net worth and liquidity requirements for investors seeking a mortgage. Common non-bank funding sources that provide multifamily loans include Fannie Mae, Freddie Mac, life insurance companies (“LifeCo’s”), and the Federal Housing Administration (FHA). Brick and mortar banks have the strictest requirements for borrowers, so I’ll focus on alternatives that aren’t so stringent.
- Fannie Mae & Freddie Mac: Minimum standards for these multifamily loans is: a borrower net worth equal to the loan amount, and liquidity (cash assets) that is 10% of the loan amount.
- LifeCo’s: This will vary from company to company, but typical standards are a net worth equal to one to two times the loan amount, and liquidity of at least a year of debt service payments. A good benchmark is 5%-10% of the loan amount.
- FHA: There can be some wiggle room on these loans, but a good rule of thumb is a net worth equal to 25% of the loan amount and liquidity equal to 7.5% of loan amount. This is definitely a good option for investors with more limited assets.
- Freddie Mac Small Balance Loan: This option requires a net worth equal to the loan amount and liquidity equal to nine months of debt service. For example, on a $4 million loan at 5%, a 30-year amortization would be $193,257 (a monthly principle & interest payment of $21,473 x 9). That is roughly 4.8% of the loan amount, so a good rule of thumb here would be at least 5%—but having 10% would only help your chances.
2. The Pitfall of Limited Experience
Experience matters in the multifamily financing world. Ideally, you have experience demonstrating successful ownership of the exact type of property you are borrowing against. That isn’t always possible, especially for those investors trying to break in to the commercial multifamily world.
Many multifamily investors get their start in the residential markets and graduate to larger commercial properties. Any residential experience you have won’t hurt you, but it may not exactly help you obtain a commercial real estate loan.
It isn’t uncommon for multiple owners to be involved in a multifamily deal. This is usually handled by forming a business entity, typically an LLC. The owners contribute funds for their ownership share in the business, which in turn owns the property.
Before venturing out on your own, a viable strategy is to partner with successful and established multifamily family investors on some of their projects. This gives you a small piece of the pie in a property where you can gain experience learning what works well and what doesn’t. But don’t treat this opportunity too passively. This is a great time to learn and determine the type of strategy you’ll choose for operating a property when you become the lead sponsor.
The important thing to recognize is that it can take some time to develop the know-how to ultimately go out on your own. Joining forces with other investors will help you get into the multifamily game, while you begin gaining valuable experience.
3. The Pitfall of Poor Record Keeping
There’s a reason why the bookkeeping and accounting professions exist—most people don’t love keeping records. And while it may not be fun, organized record keeping is incredibly valuable and useful.
Most investors know they need to keep financial records about their multifamily property, such as rent rolls and operating information. In fact, it’s difficult not to because the IRS requires these records for tax obligations. But, the requirement doesn’t exactly translate into records that are entirely useful or as complete as an underwriter would like them to be when it comes time to kick off the loan process.
Rent rolls are pretty straightforward documents detailing what the current rent should be, and how much rent has been collected on a monthly basis. One detail that is often overlooked is including a column for when the tenant moved in and initiated their lease. Another useful column is one that shows the length of the current lease, or if it is a monthly agreement. The reason this is so helpful to underwriters reviewing a property is because it shows how long a tenant has been living there, which is essentially how long they committed to living there. If you can show low turnover and long leases, the property will look that much stronger to a lender.
As for operating statements, they don’t have to be rocket science. Here’s the most important consideration: make sure you have them updated every month. If you have multiple properties, make sure you keep all the records separate and don’t allocate expenses from one property to another. Stay on top of your insurance expenses and your property taxes. These things will usually change each year, but typically you’ll only have small increases. If there is a big jump, something may be amiss and may require further investigation to make certain you aren’t overpaying. But the only way to spot a potential red flag is if you are keeping track.
The last thing I want to do is to discourage a budding multifamily investor. But as Ben Franklin once suggested, a bit of prevention can make a great deal of difference in avoiding snags and a mountain of work. By recognizing common pitfalls, you’ll be better prepared to propel your multifamily ownership career forward. And, for the experienced investor, it’s not a bad idea to go back to the basics from time to time, to prevent negligence and inertia.