Apartment loans can be tricky, especially if the property is located in the Bay Area’s hot real estate market. Even if you purchased your current apartment building only a few of years ago, you can see tremendous pricing appreciation. Finding affordable buildings are difficult enough—but finding a lender with the right combination of pricing, service, and speed is even tougher.
Lenders look at apartment lending very differently from mortgage lending by evaluating income and expenses expected from the property cash flow that will support the new debt. Typically lenders look for a debt servicing ratio (DSR) of 1.20, which is the annual loan debt divided by net operating income. Basically, a debt servicing ratio of 1.20 means that for every $1.00 of debt, the property generates $1.20 of income that allows for a cushion in the event of unexpected repairs or tenant vacancies. Likewise, a debt servicing ratio of 0.80 means that for every $1.00 of debt, the property generates 80 cents of income. Obviously, this is not an ideal situation as the owner could end up supplementing the gap from his/her own personal resources, defeating the reasons to own investment property in the first place.
Additionally, lenders are risk-averse creatures by nature and view apartment loans as having a higher probability of loss—if adversity strikes, borrowers are much more likely to make payments on their home mortgage than on their investment property loan. Thus, in starting the search for an investment property, you should request to see a proforma for any property you may be considering as well as two years of historical income and expenses (if obtainable) to determine the debt servicing ratio.
Before you get too involved in the property search, however, you should take a quick, three-step assessment of your financial situation and goals.
Step #1: Check your credit and debt situation
To get an apartment loan, you’ll have to prove not only your credit worthiness, but also the solvency of the property itself. First off, what’s your debt servicing ratio (DSR)? Lenders typically look at historical income/expense statements, current rent rolls on the property, in addition to personal debt-to-income ratio (particularly if you’re keeping your other property). Not only will prospective lenders review this information to see if the property pays for itself, but they will also verify your current level of debt to determine available personal cash flow. If you’re just breaking even, you’re probably not going to qualify for the best interest rate or loan program. And if your FICO is low, you should expect to pay a fee from most prime lenders in order to qualify for a better rate.
Step #2: Set your goals
What is the purpose of this purchase? Are you simply adding to your real estate portfolio with this purchase, or are you looking to sell and buy? If you’re looking to sell an existing apartment building to buy a different one, you might want to choose a lender who has experience with 1031 exchanges to help you avoid hefty capital gains penalties.
Do you plan on keeping the property, or are you looking to fix it up and sell it at the earliest opportunity? Knowing the duration of your investment is important when it comes to choosing the terms of your loan. Rates have risen this year, but they’re still at historically low levels. If you’re looking for the best rate, you’ll probably want to go with an adjustable loan. If security is more up your alley, you’ll probably still want to explore a fixed rate. And if you’re looking for a little bit of both, your might be interested in hybrid adjustable-rate loans that have a longer fixed-rate period.
Step #3: Identify your challenges and find solutions
Is your DSR a little higher than you expected? One popular option is to choose an interest-only loan. Because your DSR is based on your monthly expenses (much like your debt-to-income ratio in a home loan), your reduced monthly payments during the interest-only period can also reduce your DSR—helping you to qualify for larger loan amounts or more flexible features.
Have you already identified a property and want to move quickly? Make sure you choose a responsive lender with a good rate-lock policy. A good turnaround time on an apartment loan is 40 days, but getting an extended rate lock is always a good idea. Shoot for a 60-day rate lock, even if you need to pay a fee—some lenders only charge $250 for this assurance, and it may be tax deductible (consult your tax advisor). In addition, make sure that you can lock in your rate once the property inspection is completed. (Some lenders make you wait until after they sent a letter of interest—so be sure to clarify how quickly you can lock the rate.) Choosing a lender with local underwriting can also speed up the process.
Going through these first three steps will help you get a better apartment loan faster and easier. Apartment lending is generally more complex than mortgage lending, so once you’ve completed the three steps listed above, it’s a good idea to get in touch with a trusted lender who can help you through the next and best step: closing the deal on your hassle-free apartment loan!