Commercial Real Estate

Why Bigger Is Better When It Comes to Commercial Real Estate Deals

Expertise: Business Management, Mortgages & Creative Financing, Landlording & Rental Properties, Real Estate Investing Basics, Personal Finance, Real Estate Deal Analysis & Advice, Commercial Real Estate, Personal Development, Real Estate News & Commentary
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Modern apartment buildings exteriors or Contemporary Architecture Office In The City.

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.

close up of two men shaking hands one light skinned one dark skinned laptop in background

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

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.

modern complex of office buildings in the evening

Related: Case Study: How to Give Investors a 9% Cash-on-Cash Return in a Syndicated Apartment Deal

Syndications

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!

Since 2007, Dave Van Horn has served as president and CEO of PPR Note Co., a $150MM+ company managing funds that buy, sell, and hold residential mortgages nat...
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    David K. Investor from Attleboro, Massachusetts
    Replied about 3 years ago
    After owning 3-3 family houses and a single family I decided to go the larger route. Currently into a 12 unit building. With management in place I’m thinking this is the best way to move forward at this time. I’ve always put 20-25% down so this is nothing new, I’m hoping having more units under one roof will be more profitable in the long run. Time will tell.
    Chuck Woffe Investor
    Replied about 3 years ago
    I have 3 residential properties, and I have been itching to take that multi family leap. Nice to read this to give me some more thought. Curious to hear others’s takes on it for sure….
    John Moon from Palpark, NJ
    Replied about 3 years ago
    Thank you for the informative article. I’m want to get into commercial 5 – 25 units within the next year. @mark mentioned that he likes to refinance every couple years b/c banks give him a 5 year loan. Could you talk more about different exit strategies you utilize for commercial buildings?
    Dave Van Horn Fund Manager from Berwyn, PA
    Replied about 3 years ago
    Hi John, Many loans are recast around year 5 (though sometimes they recast later). Plus the person or team who put the deal together is usually looking to take out their private investors, so that tends to be why investors like to exit by that time. The exit strategies are really just either refinancing or selling. You could also sell and hold paper. Best, Dave
    Arun Iyengar Investor from San Jose, California
    Replied about 3 years ago
    I agree with the article and do subscribe to the bigger is better philosophy. The concept of economies of scale do help out when you go with larger number of units. Of course the only thing holding me back from getting into a 100+ unit single complex is the cost!! When I started multi family investing in 2014, I was contemplating the same questions on the size of the property and location. After choosing to stay in San Jose, I figured that the amount of time I would spend managing the property would be the same whether it was 10 units or 100 units, since I was going to use an outside property management company. In California, state law requires that there is a resident manager in any complex that has 16+units. Again a good reason to have many more units in the same complex, since free rent can eat up a larger % in a 16 unit complex. I’ve had no issues in getting loans. All my loans including my first property (30 units) have been non recourse loans, all on my LLC. I refinanced the properties that I bought in 2014 and purchased a larger complex in 2016. Commercial loans have a prepayment clause that can be pricey if your loan amount is large. I started with 5 year loans and for the 2016 purchase, got a 3 year loan. I am now refinancing the 2016 purchase and will likely get into a 7 year loan, since I got all my capital out of it.
    Kevin Keithley Developer from Menlo Park, CA
    Replied about 3 years ago
    I agree with you. This is a really good post. Thanks for sharing.
    Ant Turner
    Replied about 3 years ago
    Insightful article. I’m looking to invest into commercial 5 – 32 units within the next year and this information will help along my journey. As for financing, how much to factor in for closing costs and for the replacement reserve?
    Rick Grubbs Rental Property Investor from Salisbury, NC
    Replied almost 3 years ago
    Always enjoy reading your articles! I have been in RE for 28 years but I still learn something from them every time. I have a $650k loan on a $1.1M property that will need renewal in another 3 years. By then I will have gained quite a bit of equity thru pay down and appreciation over the first 5 years of a 20 year amortization. In a scenario like that would most banks allow me to take cash out and start the 20 years over again?
    Joseph T. Rental Property Investor from Los Angeles, CA
    Replied over 2 years ago
    Great article, Dave! Currently I have for SFR properties, but I’ve been looking to get into the 5-35 unit space. I’m not familiar with the commercial lending aspects and pitfalls and I found your article very enlightening. Also, @Mark thank you for sharing your experience and perspective. I’ve learned a lot from your comment.