Apartment building loans are a lot like other residential real estate financing. It all starts with a property, borrower and lender, and it all ends, if all goes well, with a closed loan and newly purchased or refinanced property.
Here’s a guide to what borrowers need to know about how to buy and finance apartment buildings:
What constitutes an apartment building?
Detached homes, condominiums, duplexes, triplexes and fourplexes typically are classified as one-to-four-unit properties, or one-to-fours. Properties that have five or more dwellings are categorized as apartment buildings or multifamily housing.
A loan for a duplex, triplex or fourplex doesn’t differ much (if at all) from a loan for a detached house, but loans for larger properties involve “a little different underwriting, a little higher qualification,” says Dan Borland, office manager for commercial real estate at Wells Fargo in Orange County, California.
How to qualify
One difference is that before an apartment loan is approved the lender might consider more qualitative information to try to understand the borrower’s experience as a rental property owner or manager.
“We’ll look at the candidate and say, ‘What has that person owned and what has been their management experience collecting rent, managing properties and handling a project of that size?” Borland says.
The borrower’s credit score, income and personal and business tax returns will be considered along with two years’ operating statements and a current rent roll for the property.
The most important property metrics are:
Net operating income: The annual income, minus expenses that a property generates from its operations
Debt service coverage: Measure of cash flow relative to debt payment obligations
Loan-to-value (LTV) ratio: A measure of the loan amount relative to the value of the property
“The property has to service its debt at a comfortable margin,” Borland says.
Borrowers who need more flexibility might want to turn to a small bank, says Blake Kreutz, commercial loan officer at County Commerce Bank in Ventura, California.
“We typically look for a 30 percent down payment and credit score is important, but it’s not a deal-breaker,” Kreutz says. “If someone is stronger in one area and weaker in another, we can work around that.”
Mixed-use and partially-occupied properties
Mixed-use properties might be classified as commercial or residential, depending in part on the proportions of each use. A typical configuration of many apartments over a few stores is treated as an apartment loan.
“If it’s 50-50 or there’s a lot more commercial, the underwriting changes and it becomes a little more conservative structure,” Borland says.
Apartment buildings that are vacant or only partially occupied can be financed; however, the loan might be short-term and have a variable rate with the expectation that it would be replaced with long-term financing once the property has been stabilized.
If the rents don’t support the debt, the borrower’s cash flow could help; however, “it would take a pretty strong borrower to support a whole building with a mortgage on it,” Kreutz says.
Conforming or portfolio?
Like one-to-four loans, apartment loans come in standardized types that lenders can sell to Fannie Mae or Freddie Mac and customized types, known as portfolio loans, that lenders keep on their own books.
Standardized or conforming loans typically have a slightly lower interest rate, but the guidelines are more rigid.
Loan terms and types
Apartment loans can be long term (25 or 30 years) or short term (five, seven or 10 years).
Interest rates can be fixed, variable or hybrid, which start out fixed and then reset or become variable after a specified time period.
Shorter-term loans can be renewed or refinanced at the end of the initial term, though the interest rate likely will adjust and some fees could be involved.
“When the loan matures, the rate is probably going to change,” Kreutz says. “It could be fixed for three or five years and then adjust at some point. You’re probably going to be dealing with at least one rate change throughout that time period.”
Most lenders offer apartment loans from $1 million or $2 million up to many millions. LTVs top out at 70 or 75 percent, which means the borrower needs a 25 or 30 percent down payment to buy (or that much equity to refinance). A lower LTV usually gets a lower rate.
Borrowers typically pay a loan origination fee and customary closing costs, including appraisal, title and escrow costs, plus expenses for any inspection, environmental or other due diligence reports. Property insurance is a must. Flood insurance will be required if the property is located in a government-designated flood zone.
Most buyers purchase an apartment building through a limited liability corporation, or LLC.
“It is very rare that an individual has the title in their name,” Borland says. “Usually it’s an LLC.”
LLCs do what their name implies: limit liability.
“Most borrowers own their separate properties all in their own special purpose entity, or SPE,” Borland says. “They do that so if one property has an issue, (such as) a slip-and-fall accident, it can’t bleed into (the owner’s) other assets.”
Another level of complexity that might be required for a very large apartment loan is the single-asset bankruptcy-remote entity, which protects the property from the borrower’s personal bankruptcy and bankruptcies of his or her other properties.
“The asset is protected for us,” Borland explains, “so in case it stops paying interest on our loan, we can pursue foreclosure on our building and we don’t care that you and your other entities have filed bankruptcy.”
Some apartment loans have a prepayment penalty known as yield maintenance. If the borrower pays off all or a large portion of the loan, the lender applies a formula to determine how much the borrower must pay to make up the forgone interest.
Other apartment loans have a prepayment scheme known as a step down. The 3-2-1 format is an example.
Borland explains, “If you pay the loan off in year one, you owe 3 percent of the amount you prepaid. Year two, it’s 2 percent. Year three, it’s 1 percent. Starting in year four, at month 37 or after, you get to pay it off with zero prepayment.”
The same scheme could be applied with a 5-4-3-2-1 format.
“It’s definitely a good thing to ask about and try to negotiate,” Kreutz says.
Some apartment loans are assumable, which means a new borrower can take over the original borrower’s loan. An assumption can be used to sell a property and avoid a prepayment penalty.
“The same credit guidelines imposed on the original borrower would be imposed on the incoming borrower,” Borland says. “If so approved, that borrower would enjoy the remainder of the terms and conditions of the loan that’s being assumed.”
Not all loans are assumable, so borrowers should ask whether a loan has this feature.
Recourse, non-recourse loans
If the loan is “full recourse,” the lender can seize the borrower’s (or guarantor’s) personal assets if the loan isn’t repaid. If it’s nonrecourse, the lender’s only option to satisfy the loan in default is to foreclose and take the property.
“A nonrecourse loan would price a little higher because the bank is taking a little more risk, so the rates are higher,” Borland says.
Once the decision to apply for a loan has been made, the borrower needs to give the lender all the information he or she needs to make a decision, says Frank Barefield, Jr., president of Abbey Residential, a Birmingham, Alabama, company that owns 8,500 apartment units in Alabama, Texas and Florida.
Rather than force the lender to extract the information piece by piece, Barefield prepares a 30- or 40-page package that is designed to provide the lender with all the information they need about the property. The package includes:
Pictures of the property
Property description: lot size, year of construction, number of units and existing amenities
Plans for upgrades such as a dog park, children’s playground, new appliances, countertops, plumbing or lighting fixtures, and how much those improvements will cost
Map showing the location of the property and nearby competing properties
Explanation of how competing properties compare with the property to be acquired
Rents and how much they will be raised or lowered
Copies of floor plans
Summary of sources and uses of funds for the transaction
Purchase price and closing costs
Loan amount and cash equity amount
Contingency fund amount
Names of real estate brokers, title companies, attorneys and other professionals involved in the transaction