Mixed use building BRRRR

[Kasie Kay]

Needing advice from someone with more experience. I just won an auction on a mixed use commercial/residential building. What is the downside of using a commercial lender to purchase, my own cash to rehab, and then refinancing?   Everyone always says don’t use your own cash…but why? What am I missing if I purchase, improve and refinance using commercial lending? Just More closing costs?  What is the advantage of using private money or hard money? Some private money lenders want me to put 30% down. If I can get away with putting 25% down on a commercial loan, what am I missing here? 

Thanks is advance! 

[Stuart Udis]

What makes most sense for one person may not necessarily make the most sense for someone else. At the end of the day, total finance charges (interest, origination and pre-payment penalties), leverage and cost of equity should be considered when deciding on the financing option that makes most sense. This will vary depending on the individual investors personal situation, strategy and resources.

Keep in mind mix-use real estate is generally more difficult to finance than multi-family or residential real estate. Many alternative lenders simply do not lend on mix-use real estate or require the commercial to residential exposure to be below certain thresholds. Meanwhile the alternative lenders and even banks who do finance mix-use real estate normally require lower leverage than single family or multi-family real estate. This makes the BRRRR strategy a bit more difficult to pencil because the same leverage cannot always be achieved (with some exceptions of course). Despite this, I generally view mix-use real estate as an overlooked opportunity. I personally buy buildings that either have limited commercial exposure in relation to the total units or building SF or alternatively buildings that possess commercial spaces that are large enough where placemaking can attract amenity tenants that benefits my residential real estate in close proximity. The financing obstacles have to be priced into the pro-forma but I generally find the pricing concessions I can achieve on these acquisitions due to lack of market interest far outweighs the financing obstacles.

Another thing to be mindful of if you use a bank/commercial lender is the pre-payment penalty many include in their loans if you choose to refinance (many have descending penalties in years 1-5 that can start upwards of 4-5%). This is something that should considered  if this is an acquisition where you are seeking a construction loan or expect to refinance in the near future. Presently  traditional banks construction debt will be  WSJ Prime +.5-1% which is only 2-3 points higher than where most Alt lenders are. A few years ago there was a greater spread between bank originated construction debt and alt. lender construction debt but there's currently a contraction. When factoring in many alt. lenders do not include a pre-payment penalty when you refinance the total finance charges including pre-payment penalties differs slightly between bank and alt. lender.  Now the fed is expected to begin cutting rates and we may begin to see greater separation between bank and alt. lender rates but if the fed cuts rates slowly as predicted  there is likely still a window where alt lenders will be competitive, especially in the scenario I described. 

For added context it's something I have weighed on a few recent projects. As a good case study I  acquired an 11 unit mix-use building in May where I vacated 9 apartment units and will complete kitchen/bath renovations and build out one vacant commercial space. My intent is to be ready to refinance the building through a local credit union that does not have a seasoning requirement within 9 months of purchase.  The building is effectively 50% commercial and 50% residential (both in SF as well as projected rent roll). Despite good valuations on the appraisal, traditional banks were only willing to lend construction debt 70% LTC because of the commercial exposure with a 4% year one pre-payment penalty and an interest rate of 9.5% as most bank construction debt is currently priced whereas I had an alt. lender willing to go to 82% LTC at 12.25% interest and no pre-payment penalty (the contract price was $1.73M and appraised for $2.1M which helped with the leverage). 

The total cost of the project including improvements, soft costs and carrying costs from acquisition to stabilization will be close  to $2.65M and the equity requirement using the alt. lender was $480,000 vs. the traditional bank which would have been $800,000. I will ultimately spend $35,000-$40,000 more on finance charges when looking at the total picture (not paying the $50,000+ pre-payment penalty) but was able to complete the transaction with $320,000 less equity. Given equity is always more expensive than debt, in my view the additional finance charges were a good trade off.