Making the jump from residential to commercial multi family?

Question

New investor here looking for advice on moving to commercial multi family for our next property. We started out with a 4 unit last year in HCOL that has been going extrmerly well.

I was hoping to try and go 8+ units for our next property this year but am finding the terms of commerical loans very prohibitive.

We did our first deal FHA 3.47% down which made it extemely affordable. With much higher minimums, and different loan terms (balloon payments etc), how are people making that jump to commerical? I feel like the ROI on small Residential multi family is so good in our area (for us at least), with such little capital up front, that I don't see how going commerical would be more lucrative besides being a strategy to aquire more units more rapidly in a single deal.

The additional upfront cost seems to outweigh the extra units and lower cost per unit, in my calculations.

Ant advice is greatly appreciated.

4 unit @ 800k @ 3.5% down = $28k

8 unit @ 1.5mm @ 20% down = $300k

Just looking at cost to get your foot in the door, the commerical option is almost 6x the price. I could 3 or 4 residential buildings in the time it would take to save for the commerical building.

I know I'm taking a narrow view on the upfront cost but please enlighten me! I know commerical real estate is the way to go eventually, and all roads lead there, but how do I overcome this intiial cost barrier?

Erik W. · Answer

Since you're already thinking commercial, I'll throw in thought regarding non-residential commercial.  I took the leap in 2020 and doubled my portfolio.  Two shop/warehouse properties with 6 units each and a self-storage facility that has a small commercial building with a business in it.  There are several advantages I've found with these types of properties:

1) The eviction moratoriums that are causing so many headaches for residential land lords do not impact my commercial units.

2) Many investors are now looking for multi-family rentals, which are driving up prices.  I had almost zero competition for the places I bought.  Got one seller to come down $27,000 on an already below market property, just by waiting a week and representing.  He'd had no activity for 3 months, and after seeing a genuine offer he was ready to deal.

3) Almost zero hassle.  You may have heard the old spiel about dealing with "tenants and toilets" from guys like Scott Meyer who specializes in self-storage.  It's true.  Commercials tenants are responsible for their own toilets per our lease.  Also most inside repairs are on their dime.

4) All of my spaces are large metal boxes with concrete floors and steel framing.  Maintenance costs are extremely low, and they are immune to termites, dry rot, and a host of other problems that plague wooden structures.

5) Creativity.  I've managed to find additional ways for these properties to produce income.  For example, one of my warehouse/shop properties has about an acre of commercial land that isn't being used right how.  I'm getting bids for some compacted gravel and chain link fence to put up and will lease parking / storage space for boats, RVs, campers, etc.  It was "dead land" in the owners eyes, so I basically got it for nothing.  We based the purchase price off perceived rents of the warehouse shops themselves, and since the Seller had inherited the units vacant already they used old, out of date lease rents that were below market value.  So not only did I get a discount, I am able to take advantage of the excess land that the Seller wasn't savvy enough to see any value in.

Just a few reasons to consider non-multi family commercial.

Anthony Vicino · Answer

@Arn Cenedella nailed it on the head. You're going to find it difficult to scale with FHA loans. If you're okay with that, and taking the long view, then yeah, you'll have a hard time getting into an equivalent investment vehicle for less money down.

But less money down isn't always a good thing, especially depending on what you're buying.

There are many reasons why moving up to larger multifamily properties makes sense, but one I'll point out here that's worth considering lies in how properties are valued.

Your quad is based on comparables, which means it's worth pretty much exactly what all the other similar quads in the area of your property are worth. This is fine in a rising market, but hard when things to get soft.

Personally, I always hated having the value of my building dictated by how other people were managing their buildings.

That's why I made the move to larger multifamily properties where the valuation technique is based more on Net Operating Income (Revenue - Expenses).

This is an important difference from smaller residential buildings because it allows us to execute the value-add model whereby we go into the property, increase rents, decrease expenses, and ultimately increase the value of our building.

After we've driven up the valuation, we then execute a cash-out refinance (typically within the first 2-3 years), returning at minimum 60% of our initial capital. We then take that capital and roll it into the next deal while still cashflowing on the first.

This is the power of larger multifamily assets.

Arn Cenedella · Answer

@Jason Krasavage

The problem you will run into is you can only get 3.5% down loans on owner occupied property - ie live in one of the four units. So that takes care of the first purchase. I guess you could live in the original 4plex for a year or two and then buy another property and move into that and get a 3.5% down loan on it.

You will find it hard to scale buying one 4plex every two years.

At 5+ units, you will almost always need 20% down.

The other way to scale up is to partner with other investors.

Spencer Gray · Answer

@Arn Cenedella hit the nail on the head with the difficulty to scale using owner occupied FHA Financing. Also to keep in mind that 96.5% LTV is extremely high leverage unless you have ample cash reserves a downswing could wipe you out.

The hard part that many face when going from non-commercial multifamily to commercial multifamily (5+ units) is that the financing gets worse before it gets better. Once you are looking at larger deals that qualify for agency (Fannie and Freddie) or HUD financing, the terms become superior than just about any residential loan product - although none with as high of LTV - typically 85% LTV is the most leverage you can get on a commercial multifamily, but the loan will be non recourse, 30-35 year amortization, some period of interest only and terms 7-35 years.

There is a gap that includes small commercial multifamily properties that only qualify for bank loans which typically (but not always) have the least attractive terms.

Arn Cenedella · Answer

@Spencer Gray

Spot on comment. Once you can get above about a $1M loan amount, agency debt becomes really attractive.

Evan Polaski · Answer

@Erik W., the other part of moving to what I will call "true commercial" versus "lending commercial" is business hours.  I used to work in retail real estate.  The company owned grocery anchored shopping centers.  1 property manager covered between 8 and 12 properties.  Secondly, these were generally 9-5 jobs, maybe more like 10-8 jobs, since retail tenants only know something is wrong when they are in their store, so you don't get calls at 2am.

The downside is not everyone needs a place to run a business, but everyone needs a place to live, so your potential tenant pool is smaller.  But you underwrite longer vacancy at turns, and balance it with longer leases.

You also suffer from less favorable lending world for true commercial versus the ability to get agency loans in MF. For instance, the company I used to work for, it took the principals over 10 years of running and growing the company before they could get non-recourse debt.  And then you are dealing in the CMBS market which isn't quite as favorable as Fannie or Freddie.

John Warren · Answer

@Jason Krasavage you are not wrong. Commercial can be tricky, and it is counterintuitive because it is actually easier the larger you get. I have done seveal deals over 1 million, and the loans were actually easier and had better terms than what you could get on your standard Chicago style six unit from a local bank. Agency debt in particular is very, very attractive.

The other issue you are running into is that the price per unit is going up fast in a lot of submarkets in Chicago. It is harder to find deals that make sense, but they are still out there! I recently sold two eight unit deals in Berwyn and Stickney that were solid deals at under 75k per unit, so these types of deals still exist.

Kenneth Reimer · Answer

@Jason Krasavage Also, depending on the area in which you are investing, 20% isn't reasonable given how the banks are reacting. In California, I haven't seen anything above 70% LTV in quite some time. Even at 70% LTV, you have to have a solid deal at a reasonable price to hit their DSCR requirements. Lenders are a bit gun shy due to Covid and all of the lockdowns, so scaling the accumulation of 5+ unit properties is a bit difficult.

Another point to consider, and I'm curious if @Spencer Gray would agree: Agency debt can be a big pain in the butt, both in working through acquiring it, as well as the maintenance. I've had clients that complained constantly of the reporting necessary when you have Freddie small balance loans. I've not had one, so I can't say, but it can be unnecessary time spent if the price/terms between agency/non-agency debt is comparable. Most of the time, agencies will beat out local lenders on price and terms, but everything comes at a cost. Some people decide that it's just not worth the headache.

Paul Moore · Answer

@Jason Krasavage, you got some great input here. Since you seem serious about building a real business here (as opposed to doing some side deals) you will likely want to get to more of a commercial level/sustainable debt level. Many of the big, experienced guys shot for 50% to 60% debt levels.  As a fund that invests in operators like this, we like that type of LTV when looking at multifamily, mobile home parks, and self-storage. Good Luck!

Andrew Schutsky · Answer

+1 on looking at partnering with an experienced operator to achieve the benefits stated above at scale.  If you're short on cash, it's completely worth considering partnering up to go bigger - there are tons of benefits besides the financing considerations noted above.  I was in the same shoes as you not too long ago looking at figuring out creative ways to buy a smaller 10-12 unit MF, but quickly realized my time was far better spent finding a partner.

Making the jump from residential to commercial multi family?

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