Most investors that have tried to purchase an investment property recently have been shocked by how high prices have remained given the higher interest rates and growing negative economic news. What gives?

I am currently in the market for a small apartment building (10 to 18 units). With all the headlines showing large apartment buildings selling at 30% to 40% less than a few years ago I thought the same would hold for the small apartment market. I mistakenly thought that we would see sellers bringing their asking price more in line with todays interest rates to help facilitate a sale of their property.

Unlike DSCR (Debt Service Coverage Ratio) loans for smaller multifamily (i.e. duplexes, fourplexes, etc.) that allow market rents (not actual rents) to help determine if the property covers the mortgage payment, commercial loans look at what is happening today. When you have 5 or more units these loans are classified as commercial loans. Most commercial lenders require a DCR (Debt Coverage Ratio) of 1.25 or more. This means that net rents (after operating expense or what they call Net Operating Income -NOI for short) has to cover the mortgage payment plus 25% or more. So if the mortgage payment is $10,000 a month the property needs to have an NOI of $12,500 (25% more than the mortgage payment). Banks do this because they know that with this difference a borrower probably will not get in trouble and default on the loan.

This brings us back to small apartments. With higher interest rates mortgage payments are obviously higher. That means the NOI has to be higher to have a DCR of 1.25 or better – its just basic math.

I recently bid on a 10-unit apartment building that was getting below market rents ($320 below current market rents on average). The Seller did not want to Seller finance the property. He wanted his cash now. Normally this would not be an issue. We would figure a price that was commensurate with the lower rental rates so that we could get commercial financing given the DCR requirement of 1.25 or higher. That did not happen. The Seller wanted a price that was the same as if he was already getting market rents. There were 3 different parties offering on this off-market property including myself. I offered about 33% less than the asking price as this was the maximum I could pay with 25% down and still get a commercial loan. I was told that a second investor offered a very similar amount. We both lost out to someone that was willing to give the Seller almost the price they were asking because they were doing a 1031 exchange were they had a substantial amount of cash and they liked the property location.

This similar scenario has played out for me several times over the last few years because the market was so hot. Unfortunately, the distress of the larger properties does not seem to be trickling down to the smaller apartments. I have spoken to several local banks and credit unions and none have any properties where they are in default.

I am left wondering do I stick to my guns and stay patient and wait for properties that make sense given todays rents and interest rates OR do I ignore the gap in what I am willing to pay and what the Sellers want knowing I will have to increase my down payment to 35% to 40% to get a solid property? What would you do?