Multi-family commercial loans: All you need to know [2023 guide]

What are multi-family loans in commercial real estate?

Multi-family commercial loans provide real estate investors the funds to purchase, repair, or refinance properties with five or more residential units. Multi-family homes include duplexes, condominiums, apartments, and townhomes.

It’s important to remember that although a building with two to four residential units is a multi-family property, a multi-family commercial loan refers to funds that are advanced for a five (or more)-unit asset. Why? Because banks and other lenders define commercial real estate as residential properties with five or more units.

There’s another key aspect of multi-family commercial loans: repayments are typically made using the income generated from these properties. Consequently, when lenders conduct their credit appraisal process, they evaluate the borrower’s capacity to repay after ascertaining the rental income the property will generate.

Is it safe to invest in multi-family commercial real estate?

Before we go into further details about multi-family loans, let’s take a minute to discuss a crucial aspect of this form of borrowing. Are multi-family properties a sound investment? Is it safe to deploy funds to purchase residential units that will be rented out?

A report titled “U.S. Real Estate Market Outlook 2023“, published by CBRE, a commercial real estate services and investment firm, provides several compelling arguments for investing in multi-family properties. These arguments have been given below.

Home prices and mortgage rates have shot up

Today, renting a house is far cheaper than buying one. According to CBRE data, the average monthly payment for a new home in Q3 2022 was 57% more than the average monthly apartment rent. That’s the biggest gap on record. With new homes becoming more expensive, the demand for rentals will remain strong. The following chart provides a stark illustration of this point, covering the cost of ownership vs. cost of renting:

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Cap rates are increasing

The cap rate of a property is a crucial metric for real estate investors. It’s determined by dividing the net operating income that a property yields in a year by its value. The CBRE report states that cap rates on multi-family properties increased by at least 75 to 100 basis points in 2022. Further, cap rate expansion is expected in 2023.

Demand for multi-family units is growing

CBRE projects that an estimated 3.5 million new multi-family units will be needed by 2035. These three factors (rentals being cheaper than home purchases, increasing cap rates on multi-family properties, and growing demand for multi-family units) make for a perfect scenario for multi-family real estate investors. On top of all this, multi-family occupancy rates are over 95%, and rent growth is expected to be 4% in 2023.

There’s something else that makes multi-family properties a highly attractive investment. Regardless of the state of the economy, people will always need a place to live. As a result, demand for residential units is bound to remain strong.

Different types of multi-family real estate

Multi-family real estate covers a wide range of residential properties. It includes:

1. Duplexes: A duplex is a multi-family building with two residential units. It’s a single property with two separate entrances, one for each unit. The properties could be side-by-side or on separate floors. Similarly, you could have a triplex (three residences) or a fourplex (also referred to as a quadplex, which houses four homes).
2. Townhouses: In a townhouse, two families live in the same house, but an interior wall separates the residential units.
3. Semi-detached houses: This is a single-family house that shares a wall with the next home.
4. Apartments: A multi-story building with several residences. An apartment building could contain hundreds of apartments.

Different types of multi-family commercial loans

There are many borrowing options for investors looking for multi-family commercial loans:

Conventional loans

Financial institutions like banks and life insurance companies offer multi-family loans. To understand how these loans work, look at the multi-family commercial loan provided by JPMorgan Chase, a prominent lender in this category.

JPMorgan’s loans are available for borrowers investing in apartment buildings with five or more units. The loan amount typically ranges from $500,000 to $25 million. In certain instances, the bank lends sums over $25 million.

The loans are available only to purchase or refinance “stabilized multi-family properties”. To qualify as “stabilized”, the property must have a minimum occupancy level of at least 85% in addition to meeting certain other conditions.

CMBS loans

Commercial mortgage-backed securities or CMBS loans can give investors the funds they need to purchase a multi-family property. These loans are securitized and sold to investors.

CMBS loans usually carry high prepayment penalties. The purpose of these penalties is to incentivize borrowers to continue making regular payments against the sum they have borrowed instead of repaying the loan early. JPMorgan Chase, Wells Fargo, and Goldman Sachs are some of the biggest CMBS lenders.

FHA-insured loans

The Federal Housing Administration (FHA) is a United States government agency under the U.S. Department of Housing and Urban Development. One of its programs – Mortgage insurance for purchase or refinancing of existing multi-family rental housing – insures the loans taken by multi-family property buyers. To be clear, the loans are provided by private lenders regulated by the FHA. These loans carry a government guarantee.

FHA loans come with several distinct advantages. They have long terms which can extend up to 35 years. Additionally, borrowers usually get the benefit of higher leverage with these loans. However, the greatest drawback with these loans is that the FHA rules stipulate certain occupancy restrictions. Borrowers are required to live in one of the multi-family units. This can be a dealbreaker for many investors.

Eligibility criteria for multi-family commercial loans

Lenders typically evaluate both the borrower’s capacity to repay as well as the attributes of the multi-family property. Let’s address these two areas separately.

The criteria a property must meet to be eligible for a multi-family commercial loan: Bear in mind that multi-family commercial loans are a form of asset-based lending. Therefore, it’s essential that the property has an acceptable occupancy rate. Most lenders would need a minimum of 90% physical occupancy for at least 90 days before the loan is underwritten. A higher occupancy rate makes the loan application stronger. Here are some of the other criteria that lenders typically look out for:

• Zoning regulations: Does the property comply with land use and zoning regulations?
• Licenses: Are all the applicable licenses and permits for the property available?
• Age of the property: How old is the property? Will it comfortably outlive the amortization period of the loan?
• Neighborhood: Is the property located in a good neighborhood? Are there an adequate number of employment opportunities in the area? Real estate in a prime location will likely have a higher occupancy rate than one in a non-prime area.

The criteria a borrower must meet to be eligible for a multi-family commercial loan – it’s equally important for the borrower to meet the conditions listed below:

• Credit score: Borrowers must have a credit score above the specified threshold. Government-backed multi-family commercial loans usually require a minimum of 650.
• Loan-to-cost ratio: The loan-to-cost ratio or LTC is the number that reveals the ratio of debt to the overall cost of the project. Remember that the LTC is different from the loan-to-value or LTV ratio. Lenders typically stipulate an LTC of between 50% and 75%.

• Loan-to-value ratio: In the LTC ratio, the denominator is the project’s cost. In the loan-to-value ratio, the denominator is the value of the project. The two ratios are very different. The cost refers to the amount spent by the borrower on, among other things, buying the land and on construction. On the other hand, the value is the price the property could get if sold in the market.

A lender usually insists on an LTV of 75% to 80%, or less. Additionally, most lenders would decide on the loan amount based on the lower of the two ratios. For example, if a property’s cost is $20 million and its market value is $30 million, the loan amount would be 75% (if that’s the percentage that the bank agrees upon) of $20 million.

• Debt service coverage ratio: The debt service coverage ratio or DSCR is used by lenders to determine if borrowers can meet their debt obligations. The ratio is calculated by dividing the property’s yearly net operating income (NOI) by the annual debt payments required for the property.

A DSCR in the region of 1.25 is usually acceptable to lenders. However, the devil is in the detail. You would think that the NOI would be calculated by taking the annual revenue generated by the property and subtracting operating expenses. While that’s usually the case, consider a situation where the property is self-managed. When calculating the DSCR, the lender may reduce the NOI by subtracting a notional figure for property management expenses.

How multi-family investors can make the most of a rising rate environment

As recently as the beginning of 2022, the Federal Reserve’s target rate was 0 to 0.25%. Since then, there have been ten rate increases. The target rate currently stands at 5% to 5.25%.

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One of the consequences of these rate increases has been a significant rise in the cost of mortgages and a consequent reduction in single-family housing starts, which dropped 30%-40% in 2022. But the multi-family sector has remained robust.

The slowdown in single-family housing starts could be good news for multi-family property owners. People could remain renters longer as they wait for economic conditions to improve and interest rates to fall.

Of course, interest rates have risen for multi-family commercial loan borrowers over the last year as well. However, you need to remember that when you receive an offer from a lender, there could be scope to negotiate. It may be wise not to accept the first offer and shop around before you finalize the deal. You should also read the fine print. Take the time to understand:

• Origination fees: This covers the loan application processing cost and related charges. Origination fees typically range from 0.5% to 1% of the total loan amount.
• Prepayment penalties: These could be much higher than you would think. CMBS loans typically impose prepayment penalties throughout the term of the loan.

Documentation requirements

Each lender has their own set of documentation requirements. The following table provides an idea of the records that you may need to provide:

*Budget providing details of the income, expenses, and NOI for the property

NOTE: This is only a part of the complete list of documents needed for a multi-family commercial loan.

The bottom line

Multi-family investments are an attractive option for investors. Rentals are up and expected to rise further, and the demand for multi-family units is anticipated to keep increasing well into the next decade. Additionally, this asset class has retained its appeal despite adverse economic conditions.

People will always need a place to stay, and in recent times it has been far more economical to rent a house than buy one. This has provided a further push to the demand for multi-family real estate. Investors will do well to give this asset class serious consideration.