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Apartment Loans: Common Multifamily Misconceptions

A property selling for $1,000,000 with $100,000 in annual income has a GRM of 10.  The cap rate measures the return on investment for the capital invested in a property.  The cap rate assumes that the property is purchased all cash and is calculated by dividing the Net Operating Income (NOI) by the purchase price. 

I had the opportunity this past week to answer a number of questions about apartments.  I find a great deal of misinformation out there concerning the financing of this excellent type of income producing investment.  Before going into some common misconceptions, I should explain the state of the apartment market in general.

Apartments are seeing an overall increase in rents after a long period of stability thanks to the increase in single family home and condo prices over the past few years.  Some markets, such as Houston, are overbuilt.  Others, such as Los Angeles, are radically over priced.  Pricing in multifamily is often expressed as a function of the Gross Rent Multiplier (GRM), but more accurately reflected in the capitalization rate (cap rate).

The GRM expresses selling prices and value as a multiple of the annual gross rents.  A property selling for $1,000,000 with $100,000 in annual income has a GRM of 10.  However, it doesn’t tell the whole story.  The cap rate measures the return on investment for the capital invested in a property.  Using our GRM information, we could have two vastly different cap rates on two seemingly similar properties.

The cap rate assumes that the property is purchased all cash and is calculated by dividing the Net Operating Income (NOI) by the purchase price.  If we had two properties selling for $1MM with Gross Rents of $100,000 and GRMs of 10, which would be the “better” investment?  If Property #1 has a NOI of $60,000 and Property #2 has a NOI of $30,000, their respective cap rates are 6% and 3%.  Property 1 has a 100% better return on capital than Property 2.  A lot of factors come into play in this process, but you can see that GRM can be misleading.

So what does all of this have to do with apartment loan misconceptions?  A ton! 

Misconception #1:  80% LTV means 80% LTV!  Wrong.  Most apartment lenders are concerned with something called “debt coverage.”  This means that they look solely to the property to be the source of repayment of their loan.  So while a lender may say they can give you an 80% loan on a purchase, once they look at the property’s NOI and cap rate, they may only be able to offer you 50%.  So look to your cap rates, check your cash flow, and don’t believe everything you read about maximum loan amounts.

Misconception #2.  Seller Financing Can Make Up The Difference.  I hear this one a lot.  The typical statement is something like:  “The seller can carry the difference for no payments for 5 years.”  That’s great, but it won’t get you the property.  Those lenders I mentioned above are subject to certain rules when underwriting seller financing.  First, they have to impute a monthly payment based upon the amount of the note and its rate, usually using interest only.  Then, they take this payment and add it to the payment they’re using for their loan.  Once again, they have to test for debt coverage.  The reality is that the most seller carry that a property can qualify for is around 10% of the sales price.

Misconception #3:  The Rents Are Way Below Market!  That may be the case, but the lender is only going to base its loan on the rents in the property NOW.  There are a few exceptions to this, but they’re not really going to help you much.  An owner-occupied unit and vacant units will be set at market, but you don’t want too many vacant units or the lender won’t want the deal.  It is possible to get estoppels back acknowledging an increase in rent prior to the close of escrow, but good luck getting a seller to agree to that.

As you can see, the financing process is never as easy as some would have you believe.  Work with professionals, do your Due DiligenceHealth Fitness Articles, and work out the financing ahead of time and your projects will go much more smoothly.

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