Key differences in 1-4 units vs. 5-12 units

16 Replies

Been looking at OOS small multifamily properties and I'm curious what the not so obvious differences are.

What does one need to know when looking at a 6 unit building as opposed to a 4 unit? What changes when a building is zoned commercial instead of residential?

•Lending issues/ requirements

•Tax responsibilities

•Code requirements

•Insurance rates and coverage.

•value or appraisal process

This would be non occupied properties either way and most likely funded w investment loan or private money.

Any advice or insight would be appreciated. I've read quite a few books but always looking for more if there is one pertaining to the above.

Main difference will be the financing. With a 5-12 unit you will need to get a local bank to finance it, which is tough for out of state investors. The loan will be a commercial loan, with 20-25 year am and 5-10 year balloon. You will possibly get into the $1mm+ loan amount, where you can tap in to agency debt and get a 30 year am, fixed for 10-12 years. 

Other differences - 

Possibly licensing and inspections with the city

Appraisal for a 5-12 unit will be much more expensive and is based more on the financials of the asset vs the comparable sales. 

Originally posted by @Todd Dexheimer :

Main difference will be the financing. With a 5-12 unit you will need to get a local bank to finance it, which is tough for out of state investors. The loan will be a commercial loan, with 20-25 year am and 5-10 year balloon. You will possibly get into the $1mm+ loan amount, where you can tap in to agency debt and get a 30 year am, fixed for 10-12 years. 

Other differences - 

Possibly licensing and inspections with the city

Appraisal for a 5-12 unit will be much more expensive and is based more on the financials of the asset vs the comparable sales. 

Todd,

How much more expensive would the appraisal be? I recently bought seven condos at a complex and the lender wanted an appraisal for each unit. So that was about $600 per unit. The Appraiser did one for each unit as if it was an individual deal for every condo. If I was buying the entire 30 unit complex it would have been more?

 

@Erik B. great questions. Hopefully I can provide some insight or answers to your questions.

-Lending issues/requirements

You're probably already familiar with the lending but 1-4 units is residential, 5+ commercial. When dealing with smaller multifamily though you may more frequently find mom and pop owners that would be open to seller financing. 

-Tax Responsibility

As far as tax responsibilities I'd advise talking to a CPA to get more detailed info. Obviously the more doors you own the more you can depreciate the asset and save more on taxes. If you qualify as a real estate professional that will allow you to take the most advantage of your losses. As far as property taxes, that vary's state by state. In a lot of states the sale of a property triggers a reassessment which can greatly increase your annual tax expense. Especially if it's a property that's been under the same ownership for 15+ years. I live in Arizona and in 2015 a proposition was passed that the Limited property value can not increase more than 5% a year. This includes the sale of a property. From my understanding the only thing that would trigger a reassessment is major additions or development to the existing structure or a zoning change. This has kept property taxes increasing around 3% per year.

-Code Requirements

This will vary from state to state and municipality. Wherever you're looking to buy, go to the City and/or county page and contact the planning and zoning supervisor. 

-Insurance Rates and Coverage

There are a lot of variables that go into rates and coverage on these types of assets. The best way to gather this info is to get in contact with an insurance broker that focus specifically on commercial and multifamily. 

-Value or Appraisal Process

Any building 4 units and less will be heavily appraised based on comps. 5+ structures weigh more heavily on the income approach (Value=NOI/Cap Rate) but also incorporate comps in the area


The beautiful thing about all the questions you posed is that there are professionals in each one of those areas that can assist you further without having to expend all your time and energy trying to figure it all out on your own. Sounds like it's time to start putting your team together!

Originally posted by @Abraham Kaplan :
Originally posted by @Todd Dexheimer:

Main difference will be the financing. With a 5-12 unit you will need to get a local bank to finance it, which is tough for out of state investors. The loan will be a commercial loan, with 20-25 year am and 5-10 year balloon. You will possibly get into the $1mm+ loan amount, where you can tap in to agency debt and get a 30 year am, fixed for 10-12 years. 

Other differences - 

Possibly licensing and inspections with the city

Appraisal for a 5-12 unit will be much more expensive and is based more on the financials of the asset vs the comparable sales. 

Todd,

How much more expensive would the appraisal be? I recently bought seven condos at a complex and the lender wanted an appraisal for each unit. So that was about $600 per unit. The Appraiser did one for each unit as if it was an individual deal for every condo. If I was buying the entire 30 unit complex it would have been more?

 

No, your cost for 1 building that is 7 units would cost less than $600/unit. Probably closer to $1500-$2000. $600 for a condo is robbery BTW.

 

Thanks Todd. I'm glad I got those condos but the purchase process was a real pain. I felt the seller had ties to the title company and appraiser.



Originally posted by @Todd Dexheimer :
Originally posted by @Abraham Kaplan:
Originally posted by @Todd Dexheimer:

Main difference will be the financing. With a 5-12 unit you will need to get a local bank to finance it, which is tough for out of state investors. The loan will be a commercial loan, with 20-25 year am and 5-10 year balloon. You will possibly get into the $1mm+ loan amount, where you can tap in to agency debt and get a 30 year am, fixed for 10-12 years. 

Other differences - 

Possibly licensing and inspections with the city

Appraisal for a 5-12 unit will be much more expensive and is based more on the financials of the asset vs the comparable sales. 

Todd,

How much more expensive would the appraisal be? I recently bought seven condos at a complex and the lender wanted an appraisal for each unit. So that was about $600 per unit. The Appraiser did one for each unit as if it was an individual deal for every condo. If I was buying the entire 30 unit complex it would have been more?

 

No, your cost for 1 building that is 7 units would cost less than $600/unit. Probably closer to $1500-$2000. $600 for a condo is robbery BTW.

Thanks Todd. I'm glad I got those condos but the purchase process was a real pain. I felt the seller had ties to the title company and appraiser.

 

•Insurance rates and coverage - 1-4 can possibly be written by many companies that will write SFH.

5+ you're getting into Multifamily - not a problem if you have a broker who knows the space. 

Originally posted by @Todd Dexheimer :

Main difference will be the financing. With a 5-12 unit you will need to get a local bank to finance it, which is tough for out of state investors. The loan will be a commercial loan, with 20-25 year am and 5-10 year balloon. You will possibly get into the $1mm+ loan amount, where you can tap in to agency debt and get a 30 year am, fixed for 10-12 years. 

Other differences - 

Possibly licensing and inspections with the city

Appraisal for a 5-12 unit will be much more expensive and is based more on the financials of the asset vs the comparable sales. 

Thanks for your reply. I know what a balloon payment is but why do they write the loan thay way for commercial loan?

 

Originally posted by @Dallon Schultz :

@Erik B. great questions. Hopefully I can provide some insight or answers to your questions.

Thanks Dallon, I will definitely lean on the professionals when a deal passes preliminary analysis. Right now I'm just looking for some insight to get a more accurate picture when looking at multiple properties and to hopefully avoid any major obstacles. 

Someone mentioned fire sprinklers to me the other day in commercial multifamily and it got me thinking what else am I missing.  

Originally posted by @Ben Guttman :

•Insurance rates and coverage - 1-4 can possibly be written by many companies that will write SFH.

5+ you're getting into Multifamily - not a problem if you have a broker who knows the space. 

Thanks @Ben Guttman im sure the commercial coverage is significantly more? 

 

@Erik B. well it sounds like you're taking the right approach! I wish I had a simple answer for you but even in the world of commercial multifamily everything will vary from building type to building type. For examples, the fire sprinkler requirement you mentioned I believe is only for buildings that are 4 stories or higher. I'd imagine that is part of the reason why I keep seeing large Class A developments that are going in that are 3 stories max. You mentioned a 6 unit in your initial post, is that what you're looking at? The best suggestion I could make is to narrow down your criteria and do the research required for that particular building style, size and market. 

Originally posted by @Erik B. :
Originally posted by @Ben Guttman:

•Insurance rates and coverage - 1-4 can possibly be written by many companies that will write SFH.

5+ you're getting into Multifamily - not a problem if you have a broker who knows the space. 

Thanks @Ben Guttman im sure the commercial coverage is significantly more? 

 It depends - it may actually be less per unit since they all share certain coverages. Every building is kinda unique and each carrier has their own appetite so it's hard to make a blanket statement.

 

Originally posted by @Dallon Schultz :

@Erik B. well it sounds like you're taking the right approach! I wish I had a simple answer for you but even in the world of commercial multifamily everything will vary from building type to building type. For examples, the fire sprinkler requirement you mentioned I believe is only for buildings that are 4 stories or higher. I'd imagine that is part of the reason why I keep seeing large Class A developments that are going in that are 3 stories max. You mentioned a 6 unit in your initial post, is that what you're looking at? The best suggestion I could make is to narrow down your criteria and do the research required for that particular building style, size and market. 

I've shifted my mindset from flipping to buy and hold about a year ago. After realizing NY is not the place for me to invest I am now looking OOS for any deal 12 units and under that offers a great return hopefully with value add. Ive selected a few different areas and am doing some research currently

@Erik B. The other big difference is how they are valued. The residential properties are based primarily on comps. The commercial units are valued based on the NOI and the Cap rate. You will really need to know how to evaluate a pro-forma in multifamily and how you can affect the NOI and value of the property. Even though 6 units is small, each property is treated like it's own little business.

@Erik B. wow, you are getting a lot of incorrect info here thanks to some rather bizarre assumptions others seem to be making...

Financing is where you're going to see the biggest difference between these two types of properties. +5 units means you're forced to be use a commercial lender. They do not have to be local. There is no requirement that you need to have a local bank finance a +5 unit property. That's absolutely absurd. But you're going to need to adjust your numbers. Whatever interest rate you're assuming on a residential loan, you're going to have to add at least 2% if not 2.5 to 3% interest for commercial loan. Plus, whatever the closing costs are of a residential loan, double them or even triple them for a commercial loan. Instead of paying a $395 application fee, expect to pay $1500.

Commercial lenders also have prepayment penalties and are not bound by the regulations of Frank Dodd which means you can expect to see a dramatic increase in the total fees either right at closing or just before closing. Residential lenders are forbidden from doing this egregious practice.

the following is neither a benefit nor cost, but when you use a commercial lender the payment history is not something that goes on your personal credit report. Frankly, I see this as a bit of a negative if you're intending on hanging on to these properties for a few years at least.

Also, and again because commercial lenders are not regulated by Frank Todd, you can expect the commercial lenders will sell your loan and its servicing to the lowest bidder. This means that the quality of the servicing company is going to be rather poor and the probability of running into all sorts of errors with accounting and especially with insurance, are incredibly high.

Also, commercial lenders will require the property be titled in an LLC. This means you're going to have to pay to have an LLC formed, maintained annually and of course you're going to have to file taxes on your LLC which frankly, is usually between 4 and 5 times more expensive than getting your personal taxes done.

Insurance rates might be comparable but you may also see some small economies of scale with larger units depending on the insurance agency. Definitely shop around for this.

The appraisal process is the only true benefit that commercial properties (+5 units) have over residential (1-4 units). instead of the highly subjective and highly variable sales comparison method, appraisers must use the income approach which means the predictability of value is exceedingly high. After all, it's a pretty simple calculation that even an appraiser will have a hard time screwing up.  Admittedly, the cost of a commercial appraisal will be higher and dependent on the number of units, but I would argue that compared to the grossly excessive fees charged by commercial lenders, the difference in appraisal cost is relatively insignificant.  

In short, it is only the appraisal process that is superior with a commercial loan over a residential one. Sometimes this advantage can be rather significant and sometimes it can be rather subtle. I think you will find that if you run your numbers you will see very quickly that there are a lot of problems with commercial lenders and you will be better off in the long run sticking with four units and fewer.




@patrick britton

Wow, some really good points here. I did not know any of that about commercial lending and it would definitely cause me to be more cautious if deciding to go w a property w 5+units.  

I already have a LLC set up and I was under the impression that fees to file would be more on the minimal side. Im going to consult w my accountant and find out for sure.

Really appreciate your insight. Im trying to minimize any surprises that may pop up if I venture over into the commercial space.

Originally posted by @Erik B. :
Originally posted by @Todd Dexheimer:

Main difference will be the financing. With a 5-12 unit you will need to get a local bank to finance it, which is tough for out of state investors. The loan will be a commercial loan, with 20-25 year am and 5-10 year balloon. You will possibly get into the $1mm+ loan amount, where you can tap in to agency debt and get a 30 year am, fixed for 10-12 years. 

Other differences - 

Possibly licensing and inspections with the city

Appraisal for a 5-12 unit will be much more expensive and is based more on the financials of the asset vs the comparable sales. 

Thanks for your reply. I know what a balloon payment is but why do they write the loan thay way for commercial loan?

 

I shouldn't have really written balloon, as it is fixed for a specific length and then resets to current rates. For example, you get a loan today for 3.5% locked in for 5 years. After 5 years, they ask for full financials on you and the property and they typically do a property valuation (usually not a full appraisal, unless the asset is potentially underwater). Then assuming all is good, the lender will extend another 5 years at current market interest rates. 

This loan could be called due after the fixed 5 years, but only if the loan isn't performing or the bank is no longer wanting the loan.