Buying an Investment Property
Breaking down the difference between
1-4 units versus 5 or more units
Something to keep in mind when considering purchasing and financing investment properties. There are two ways one can invest; either a 1- 4 unit property or a 5 unit plus property, such as apartment buildings.
1-4 unit properties are considered residential, while 5 or more unit buildings will fall under commercial properties.
When it comes to commercial properties, commercial financing is completely different from residential financing. Some aspects are similar, but in general commercial financing focuses primarily on the experience level of the borrower in relation to the type of real estate being financed and in the case of rental units, the financials of the building being financed and the potential income the property can expect to earn. A lender will consider the debt service coverage (DSCR) ratio. This is defined as the Net Operating Income (NOI) divided by Annual Debt service for the desired loan. Debt service is just another word for the loan payments. Taxes, insurance or reserves are not calculated in the debt service coverage. Here’s what it looks like:
Debt Service Coverage Ratio = Net Operating Income/ Annual Debt Service
In general commercial lenders are looking for the net rental income of the income property to be able to carry the mortgage payment. Lenders will also require reserves for the unexpected vacancies or unforeseen expenses that can arise. Secondarily, lenders look at the wherewithal of the borrower, such as credit worthiness, assets, income, past experience, knowledge, etc…It will be difficult to prove experience and obtain financing, if you have never owned and managed a multi-unit property.
Soft costs for a commercial loan versus a residential loan are generally more costly. Compare a residential appraisall of approximately $300-$500 with a $2,000-$5,000 or more commercial appraisal. Commercial appraisals may also require environmental inspections referred to as Phase I and Phase II. The type of environmental inspection will depend on the property and the lender providing the financing. Typically a multi unit property or apartment building may be viewed as a low risk property type and limited environmental due diligence may be considered. These extras involved in commercial lendingcan drive up costs significantly.
Down-payment requirements for commercial loans are higher than regular residential conventional financing. One can expect to put down 25%-30%, opposed to the 20% for residential loans. However, there are lenders that offer the traditional 20% downpayment specifically for apartment financing. Rates for financing a commercial loan are higher and instead of a typical 30 year loan, as with residential you will often find terms that only extend to 5, 7, or 10 years with pre-payment penalty terms. These loans are typically amortized over 25 to 30 years which means that by the time the loan terms in 5, 7 or 10 years, the borrower will have a large balance and balloon payment due. With these shorter length loans, you are exposed to potential rate hikes when the loan terms, unlike locking in a 30 year term on a residential and having the ability to refinance if rates drop low enough to make sense of refinancing.
Costs can add up quickly when you are dealing with multi units including higher insurance costs, maintenance, or the inevitable cost of unforeseen repairs and/or damage to units. Your monthly expenses without any unforeseen issues will be principal, interest, property taxes, insurance, HOA if any, cost of property management, if you are not doing it yourself, and normal maintenance required to upkeep the exterior of the building and grounds.
If you have never owned multi unit investment property and you are not going in with a seasoned partner, my suggestion would be to start with something in the four unit and under range, at least until you get some experience and understanding on what it entails to own a multi unit investment property.
The absolute best scenario would be to purchase a four or less unit property and live in one of the units right away; now you own an investment property that is classified as Owner Occupied (OO). This tag allows the borrower the lowest interest rate, and all around costs possible. If done right, your income can basically pay for your mortgage, so that you are living mortgage free or close to it.
If you can’t live in one of the units immediately, due to the location of the property you plan on purchasing, you may be better off starting smaller with a four or under unit property vs 5 or more units, just for the sake of costs to obtain, as well as making it possible to secure financing, unlike the difficulty trying to qualify for a commercial loan.
If we consider a 4 unit or less investment property, we can assume the best financing will be if you put down at least 25%, As far as location, be aware of rent control, some cities have strict rules regarding rent and it’s wise to be familiar with each city’s rent ordinances as you will be restricted to whatever the ordinances are of that city.
If you can’t qualify for a loan yourself, you may consider a co-signer. Keep in mind a co-signer would be expected to apply and be on the loan along with you. When qualifying with multiple applicants the income as well as debt from each borrower are taken into consideration. Lenders will look at the mid FICO score of the lowest borrower.
In conventional residential lending, when factoring debt to income (DTI) to qualify, lenders are looking for a ratio of approximately 45% or lower. In addition you will be expected to have two to three months reserves remaining in the bank account to cover principal, interest, tax, insurance (PITI) and HOA or special assessments, if applicable.
If you decide to purchase an investment property, do your research and make sure you’ve lined up your lending prior, know what you qualify for and are represented by a knowledgable real estate broker.
Happy Hunting ~Suzette!