Why Bigger Is Better When It Comes to Commercial Real Estate Deals
Many real estate investors start out like I did with that first duplex before investing in single-family residences (SFRs) and then later trying to move into commercial deals.
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At one point, I was well on my way to owning 100 houses, but that was before I changed my strategy.
What caused the shift was gaining experience working as a property manager while selling rentals almost exclusively to real estate investors in my network. Between eviction court, inspections, turnovers, and routine maintenance, I quickly realized how much time and how many headaches were involved, and I started to question my strategy.
Commercial Real Estate & Financing
It wasn’t long after I purchased a 6-unit building with commercial financing that I realized some of the risks that I was taking on. I thought it would just be a normal transition into small apartment buildings. I figured, like many of my friends, that I could own more units, just under one roof and in one location.
Related: How to Use Commercial Real Estate to Add $1M to Your Net Worth in 5 Years
What could possibly go wrong? If one unit was empty, I had all the other units to help pay the mortgage, right?
Little did I know the impact of commercial financing and the fact that I didn’t have enough scale (or number of units) to justify on-site management and maintenance.
When utilizing commercial financing for apartments between 5 units and 70-100 units, the first thing you need to realize is even if you purchase the property in your LLC, the bank will usually want you to personally sign on the loan.
This one fact alone will open you up to a lot of risk exposure when you factor in the other, stricter terms of commercial loans, especially when compared to the more favorable terms you can get when buying SFRs, even in your own name. Plain and simple: You'll get better loan terms with personally owned real estate, especially when it’s owner-occupied.
But with larger commercial deals that you’re personally signing on, there’s much more risk. Often, banks not only charge a higher rate and require more money down (thus lowering your overall yield) and commercial insurance (much more expensive), but they also recast these loans.
Recasting basically means the bank can adjust the loan at a later point in time, usually after five or seven years (sometimes even 10 years), usually to lower their exposure to interest rate risk.
The bank may take a look at the borrower and the property again to see if they still qualify for the existing loan to be extended. If they do qualify, this typically means the property hasn’t dropped in value (potentially jeopardizing the bank’s equity position) and nothing has materially changed in a negative way to impact the borrower’s financial picture.
Once you exceed 70-100 units, banks usually won’t be sticklers about getting you to personally sign on the loan. These situations are much safer for the real estate investor in many ways. By not having to sign, there’s much less personal risk, especially with exposing any of your other assets.
On-Site vs. Third-Party Maintenance
Also, there’s enough scale with the number of units that you can start to justify on-site management and maintenance. You know how I know? I was a painting contractor who did multiple apartment complexes from 2 units to 600 units and everything in between. If you only had between 4 and 70 units, you pretty much had to bring in your entire maintenance team from outside. This can dramatically impact the bottom line, especially since apartments have much more common area maintenance and a higher turnover rate than SFRs.
The other advantage of these larger apartment complexes is that they’re often purchased with private equity or capital that’s raised through the use of a private placement memorandum (PPM). The PPM not only protects the investors in the deal, but it also protects the fundraiser in the event that things don’t work out. It’s almost like an insurance policy on the deal.
Personally, if I’m going into commercial investing such as apartments, I definitely want deals in excess of 100 units. Otherwise, I’ll just stick to my SFRs.
But, what about you? For those of you on BiggerPockets, what’s your experience with apartments between 5 and 70 units? Do bigger or smaller complexes work better for you, and why?
Weigh in with a comment!