Why Bigger is Better When it Comes to Commercial Real Estate Deals

by | BiggerPockets.com

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.

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

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.



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!

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for over 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

5 Comments

  1. Mark Hentemann

    Thanks, Dave. Good points on the sometimes overlooked risks of commercial loans. My real estate experience has been buying and holding 15 apartment buildings, ranging from 4-30 units over the past 15 years. Each year I am financing or refinancing multiple buildings, and get a good comparison between the residential financing available for my 4-units and commercial financing for my 5 units and above. I usually find that the commercial financing offers a better interest rate than residential financing, especially when your loan amount exceeds $1m (banks prefer underwriting fewer, larger loans than underwriting many smaller ones, so they incentivize larger ones with a better rate).

    I find that the leverage allowed is the same between the 1-4 units and 5-and-above, since they are all non-owner-occupied and must underwrite to a standard debt coverage ratio.

    As you mentioned, commercial loans often want a personal guarantee, called a recourse loan. But they also offer non-recourse versions of the loan, where the owner is not liable, but at a slightly higher rate. I don’t like taking on the risk of recourse loans but I always have opted for recourse over non-recourse because I find the lower interest rate too tantalizing. Perhaps it will bite me in the ass some day and I will be ashamed & embarrassed for having written this, but I owned 10 buildings through the 2007-2009 crash and recession, and survived. One bank did, however, require me to add funds ($60,000) to my $1.1m loan because my debt coverage ratio had gotten too low. So I didn’t get off scott free. You’re right, there is risk.

    I usually prefer 5-year fixed loans, because investment return depends on leverage, and as your building appreciates, your leverage weakens. So every 5 years, I look forward to refinancing and thereby re-leveraging my investment. I also like pulling the cash out, which I use to buy another building or two.

    But the thing I like best about the commercial apartment building space between 5-70 units, is the operating costs are more efficient compared to 1-4 units, especially management. I give all my buildings to a management company. In my area, I tend to see companies charge 10% for 1-4 units. I pay 4% for 5 and above.

    I agree with you that 100-unit plus buildings offer wonderful economies and scale and management efficiencies. I dream of getting into that space (although I’ve heard it’s a more competitive market segment because you’re competing with bigger players, & it’s harder to find great deals). But the 5-100 unit segment of the market is a step that most growing investors will have to take along the way. And from my experience, it’s given me financial independence and done far better than the stock market. It’s not a bad place to be.

    Thanks for your perspective!

    • Dave Van Horn

      Thanks for commenting Mark.

      This is the reason I ask at the end of the article because I learn from people who invest in other regions and in other ways.

      Since I was focusing more on 100+ units (which usually has onsite management), I don’t think I even considered the lower property management fee, especially since you’re dealing in properties at $1 million+. And considering the better rates you would get is also a really good point. So thank you for mentioning those two things.

      I see from you’re LA, and your strategy definitely fits that market considering the (accelerated) appreciation play. So It sounds like you found a strategy that works for you and your area. Perhaps the 100+ units is something to also consider in other markets.

      Best,
      Dave

  2. David K.

    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.

  3. john moon

    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?

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