Insider guide to financing 5+ units

In this edition I interview a commercial lender at a well known bank in the New England area. He requested to stay anonymous so he could speak openly. And he did.

You can listen to the audio here, or read the transcript below.

A few nuggets from our conversation (full transcript below this summary):

• Commercial lending is for multifamily buildings with five units or more, or anything with a commercial business unit.
• Once landlords are considered professional investors - typically more than two investment properties at one bank - financing additional properties may fall under commercial lending.
• Investors can skirt commercial lending if they have buildings with fewer than four units at multiple banks. But that comes with complexity in managing multiple banks.
• What banks look for when making a commercial multi-family loan: cashflow, business plan, you (your background, experience etc.), and a long-term relationship.
• Banks use debt service coverage ratio (DSCR) or debt yield to measure cash flow coverage.
• Find the right bank and recognize it's a relationship, not a transaction.
• "Right bank" means: capability to handle you future loan sizes in the geography you want, and one with the risk profile that matches your own.
• Everything is up for negotiation with a commercial loan: rate, origination fee, term, amortization, guarantee.
• Investors looking for alternatives should consider HUD financing.

Laziest Landlord: Hello, everyone. This is Manu as the Laziest Landlord and I'm here with Nate this day and we are going to be talking about commercial real estate investing amongst other things. And you'll notice that I've intentionally not given Nate's surname or a place of work and the reason why I'm doing that is so that Nate maintains confidentiality and hopefully that will allow him to get a little bit deeper. So welcome Nate.

Nate: Thanks Manu it's a pleasure to be here.

LL: Great stuff. So Nate maybe before we dive in, without giving away the organization you work for, maybe you can tell us a little bit about your role and what you do and then we'll get into some questions.

Nate: Sure, so I'm a commercial lender at a regional bank and my role is to help landlords and also business owners to finance properties, businesses, but I'm also am a generalist meaning I also can do things like equipment and working lines of capital. I've been in the banking industry for about 15 years and generally work in New England.

LL: Give us an idea of how many of these loans you're doing yourself and your organization a year just so we have some scale of who we're talking to.

Nate: I work for a larger bank, not one of the big three or four. In a given year I might finance 8 to 15 different projects. And those project range from a million to 5 to 10 million dollars each.

LL: And then tell us what happens to the really big ones.

Nate: At my institution, and a lot of other institutions, when you cross the 10 million dollars or 15 million dollar level if it's a bigger bank or a bigger financial institution, they generally have a specialized free lending group who only does commercial real estate and they tend to go after bigger, larger apartment buildings, things that require much more sophisticated financing. Those lenders, those institutions don't want to do the smaller deals. So if you get on the phone and you can talk to somebody and they're asking if its a $50 million dollar loan you talking to the wrong guy. They're absolutely not interested in financing a two million dollar loan. They can't do it. We have different lending guidelines and rules and regulations internally about what those two different loans might look like.

LL: Terrific Let's start with the basics. It would just be helpful maybe to start with some basics. There are a wide variety of people who read laziestlandlord.com. Just explain the difference residential and commercial investing or lending is.

Nate: That's one of the most common things that happens to me is I get a phone call from somebody who says I want to buy this piece of property and the very first question I ask them is "how many units are in the building apartment building?". And that's the very first question I ask because if it is four units or less then they can qualify for, in most cases, for a residential loan residential loan. In this case means conforming and four units or less will fit into that bucket. And all things being equal in most cases you want to try to get a residential loan because that will allow you to get a 30-year fixed mortgage. Where for a commercial loan require a larger down payment and may only offer you a 20 or 25 year amortization in rare cases they can do a 30. But most of the cases is 20 or 25 year amortization. You know the closing costs are higher its usually only a five or seven or a 10-year loan. If you do a commercial loan, whereas a residential loan in theory, you could buy a property and never have to refinance it again for 30 years. No one ever asks you for documentation after its closed. It's much easier. Then usually the following question I get is "But why, why is it so different between a 4 unit in a 5 unit?". The answer to that is that when a bank originates a four-unit or smaller property mortgage they are able to sell that mortgage in the secondary market. They don't have to do that. They don't have to do that, but they're able to. So that means the bank conforms with a bunch of normal rules. And as long as the underwriting is all done within those guidelines the bank's able to sell that loan and then they can remove that risk from their books. On a commercial loan when a bank underwrites it the underwrite to their own rules and regulations and with the large majority of time, they keep that on their books and they have to follow up with every single year, do a new annual review of that loan, collect financials from it. It is a much higher touch and higher cost product for the bank and that's why the pricing is higher the fees are generally higher and it requires a lot more sophisticated borrower.

LL: When you talk about requiring more paperwork, how much of that is down to the specific bank vs more broadly commercial lending rules?

Nate: Yeah, that's a great question. When you're going to a commercial lender, the first thing you want to do is just be able to speak to your other properties and your plan. So you should really kind of present to a lender "here's what I own and here's what I'd like to buy and here's how that new property cash flows (here's the income that it produces and here are the expenses) and here's how it fits into my overall plan and here is my overall plan.". Because when you get into a commercial financing situation you really starting a longer-term relationship with a bank because that loan is not going to be sold. So the lender that you're speaking is the same person your going to be speaking to on a yearly basis. Where with a residential loan you might get one loan officer one day and then call the 1-800 number the next day and get another one. And frankly they may never call you again because they are just only interested in an originating that loan and moving on. Commercial financers don't want to originate bad loans because they have to be responsible for them. They have to be responsible that payments are being made and covenants are being met and all those things. So that was a long way of saying you just need to have all your financials prepared. You need to be prepared to speak to your plan and you really need to know a little bit more about that property than "Its a four-unit, here's the rents". You should be able to speak to the market while you like it, the upside to it and then you should be able to speak to the expenses. What expenses are there that shouldn't be there, what upgrades do you want to make, those types of things.

LL: So it sounds very much like you want a business plan as opposed to an application which you would typically have for a residential that sounds like the broad distinction. Obviously different people have different experiences with creating that business plan. One of the things you mentioned in there was around projections. How long do you like to see in there: 3 years, 5 years...tell me a little bit more what were talking about here.

Nate: We don't really need many many years. What we need is a comparison between what the what the rents are now and what the market rents are and then we'd like to see maybe a couple years out if you're making any improvements, say you're changing the heating system or something like that. You know what we expect with the expense load to change. You're going 3, 4, 5 years out is not something that we require because we have internal underwriting guidelines that underpin plans for how we anticipate Inflation happening in and what how its expenses will inflate over time.

LL: Great. Now you mentioned about going to five units is that kind of what triggers a commercial loan. Under what other circumstances, and example a storefront and things like that, what other things trigger having a commercial loan versus a residential loan?

Nate: Another key one is the ownership of it. In some rare cases banks will allow you to own a 2 or 3 unit in an LLC. That's rare. More often if you have something owned in a corporation or LLC, you're going to have to deal with a commercial bank. You mentioned a storefront. Even if building is two or three units, if one of the units is commercial in nature, say you have a bodega on the ground floor, that will trigger it as a residential property. The next thing is many banks including the financial institution I work for have a limitation for how many residential mortgages you can have. So at ours the general rule is you can have a primary residence, a second home and then two investment properties. Anything after that we consider you to be a professional investor or a landlord and we often require you to then take that next step and start getting commercial financing.

LL: And what's the reason for that last one? What drives that idea that hey, you're not really kind of a regular landlord, you're this other landlord and therefore you need a commercial loan. Why not just give someone a residential loan?

Nate: Yeah it's not my area of expertise per se but I think there is something in the Fannie and Freddie guidelines - those same rules that determined conforming - that say, you know, if there's more than two investment properties here, then this is not a residential loan. We have to consider this person a professional investor. That doesn't mean you can't go to another bank and start that that four all over again. You could have other loans at another bank. Often times I've seen portfolios of landlords that have had 20 or 30 properties that have two mortgages, two residential mortgages at every bank around. I have seen that and it takes a lot of dedication to do that. At some point those guys get big enough and they come to a commercial lender and say "hey, I want to finance 15 properties all together and make one clean nice note" and that's where and I would step in as a commercial lender and say there's some logic to doing it at that point.

LL:  And what would be the logic? You mentioned at the beginning you get better rates doing residential vs commercial. Is it purely about a simplification thing or there something else that's the advantage for the landlord themselves?

Nate: Yeah it in in some right environments I can offer a better rate on a 5-year note than a 30-year mortgage. Now, you wouldn't ever want to compare those two things. But if you're a landlord and you have 40 or 50 properties and you want to finance 20 of them together and they're all at a really low loan-to-value, if I can offer a rate in the twos or low threes and a 30-year mortgage for the same properties with you being the high threes. There's a logic to doing it. Simplification is another. But generally you get that big and you start doing that many properties you really looking for simplification you looking for just ease of dealing with one person. It's a lot of work to pay 30 mortgages to 15 different backs and keep that all straight.

LL: One thing you mentioned to me just now is this idea of a relationship with the bank which I certainly hadn't thought about. Talk to me a little bit more about what that means from the bank's perspective. This idea of if you're getting a commercial loan there's a relationship aspect. How do you look at that?

Nate: Yeah, I mean my job title is relationship manager. In all purposes I'm a commercial lender but I also handle the deposit accounts for my clients but I also will help them get referrals to other parts of the bank. So relationship don't matter as much when things are going really well. Relationship matters a lot more when things go a little sideways. You got a 10 unit building and you had a problem say there's a flood or something. Working with a bank where you don't know your lender is not going to be a pleasant experience for you.  You're going to get charged default interest rates. Lots of things go wrong. So that's on the downside. When things are going well and you have an established relationship with a bank and you go back to them at least give them an opportunity to finance any new properties you are looking at or any new projects you're looking at...they already know your business. They have your financials. The credit and risk officer who are going to be making those decisions: well, they know your business and have some respect for the way that you manage your business. And it just gets makes things a little easier to do. It can help with pricing. It can help with ease of getting approvals, you know, it's important to the bank that you don't just look at them as a single transaction entity that you establish a relationship with them and you come back to them and give them an opportunity to win your future business too.

LL:  When you're looking at potential customers or existing customers, can you talk about the top three or four characteristic of the either the individual or their portfolio business that you give the high benefit of the doubt to?

Nate: Yeah, I kind of generally comes down to fit. Right so a there are lots of banks and have lots of credit profiles. Some of them will do riskier things and will charge a higher rate and some of them will do less risky things and charge a lower rate. And those things should kind of go in line. I work for a bank that's considered to be more conservative. I'm looking for investors who are a little more conservative and they need to understand the trade-off. The trade-off is I will provide you with better rates but my terms and my structures can be a little tighter and that won't work for some really aggressive investors. And that's okay. I like to find that out early. But if you're a conservative investor investing for a long period of time and have a strategy behind it, then that's a good fit for me. I'm just looking for a fit. I don't try to be a lender for every customer. Sometimes the best thing for me to do is to look at a property and look at what somebodies asking for it and just say no really quickly because it takes a lot more time for me to originate a loan as a commercial lender than it does for a residential lender. A residential lender might do 100, 150, 200 loans a year. I do 10 or 15. So you can imagine that the 10 or 15 I have to do are more difficult to do. They take a lot more cultivation. So if I can weed the customers or the opportunities out quickly, that's a very important skill for a commercial lender.

LL:  You've been in the business 15 years. Someone starts thinking about "Okay, I'm thinking about  a 6-unit building". Let's go back to that example. I'm going to look for potential commercial lenders to do this. What should be on their list of criteria? I think everyone straight away jumps to "where do I go get the best rate?". How else should that person be thinking? What else should be on their list of criteria?

Nate: Yeah, that's a really important question. I think this all goes back to match. Right? So you need to make sure that your short-term, medium plans and long-term plans, although more short and medium kind of match with what the bank is. So if you have a plan to buy, you know to buy many properties over the next couple years you should make sure that that bank is big enough to be able to handle that amount of lending. Some of the smaller banks were you know around in the greater New England area can't handle more than 5 million dollars in lending. So they may be able to do a little more flexible things. But you then built a relationship with somebody who can't help you get to the next stage. So first thing is size. The next thing is geography. Banks are often limited in where they can lend. So if you have a strategy in the you want to be able to borrow in Florida because you think there's a great opportunity there and you also think that South Carolina's good. Well, there's only so many banks that will do a deal in South Carolina and Florida if you want to use the same bank, which is preferable because you can have a relationship, you need to think about geography. The risk element I kind of mentioned before, but you want to make sure that you're in line with their risk profile. So if you want the most aggressive amortizations and terms, then you're going to not necessarily get the best rates and so you want to have those things correspond with your risk profile. Again, and there's nothing wrong with being an aggressive investor and trying to put as little as down as possible and get the longest amortization and longest terms, but you're going to pay a higher rate for that. So there's trade offs. And the last thing you ideally you really want to look for a bank that has lenders who have been around at that institution for a little while. It's absolutely no fun trying to get hold of a commercial lender and having them change banks every six months. Because then you don't know who to call and if something goes wrong with your loan, you're looking to refinance and the phone doesn't ring and no ones answering...it can be really frustrating. Generally the banks that have lenders that stick around for a little longer are going to be a higher-quality institution. And that's something to look for as well.

LL: One of the things that you mentioned was if your basement floods as an example of something else happens that is unexpected and you know, you need to call the bank up. How do you evaluate a bank before you have a relationship, knowing that they will be a little bit more flexible or a little bit more understanding or they will try and partner with you? How do you find that out before signing the contract and finding that out for yourself?

Nate: I mean you want to be talk to your attorney. If you have an attorney already lined up, they will have dealt with banks in the past and have some experience with that. Your CPA will have that. A real estate broker or agent will have some of those contacts. But then as you get bigger and bigger and bigger, you can even use a commercial loan broker. They will be able to give you some insights. They will put together a package of your financials and things and shop it off to several banks and be able to give you some feedback about the criteria or the characteristics of that bank. That's something we haven't talked about in the past. But it's something that you get to the 5, 10, 20 million dollars in debt range that becomes more common.

LL: One thing we haven't talked about yet, which is negotiating the terms. From what I understand residential [vs] commercial, you have more the levers at your disposal. Can you talk through all the different things that can be negotiated on? And then if you were a landlord, where should you push when should you hold back? Talk a little bit about that.

Nate: Yeah, so in general the basic things you're looking at are: the rate, an origination fee, the term of the loan (meaning how long is that rate locked for), the amortization (meaning how many years are the payments stretched over), the guarantee. So in most cases commercial loans have some type of personal guarantee, as loan-to-value get very low in a normal environment outside of COVID those guarantees are the ones you can negotiate. Those are the big ones they know and then you kind of get into some of the nitty-gritty in the default language and some of the things that you'll find in the actual legal documents. That's something that should be mentioned. As you know, when you do a residential mortgage, it's a its a set of form documents that are generated that for every single residential mortgage they just change the address, the amounts of money of the interest rate, and the dates. On a commercial mortgage in theory every single term on that note could be negotiated. Well, that's good for the landlord it comes with a price because the bank has to hire an attorney and they're going to charge you for that. So everything is negotiable in a commercial loan: it's an art. I like to think of commercial lending as an art and residential lending as a science. In science there are rules, rules you can't break and you can't change. In commercial lending for the most part everything's up for the conversation. It really depends on the institution you're working with and how much you want to push them to be outside of their their bounds.

LL: That's a great analogy about the art and science. Where would kind of push harder and realize that banks have a little bit less flexibility over on these kind of terms?

Nate: That's a tough one. I mean smaller banks will have a harder time negotiating on rate. They have a higher cost of capital, it costs them more to borrow from where they get the money. Therefore, they have lesser places to move on the rate. They are more flexible on term and amortization. Bigger banks will have more regulations, so they will have less ability to move on term and amortization but have a much lower cost of capital so they can be pushed on rate and fee.

LL: Great. Let's maybe dive into alternative financing. So we've talked about residential, we've talked a little bit about commercial. What other avenues are available to landlords that maybe they don't think about straight away?

Nate: Interesting about thing about landlords is landlords are often not only landlords. They often have other businesses. Often you find a landlord who's also a contractor or plumber or has some kind of other trade and so I think there's always an opportunity to find synergies between their businesses and rental spaces. So there's really attractive programs right now with the SBA and the USDA for financing that allow much lower down payments (as low as 10%) and will allow, say, someone who is a contractor or plumber to move their business into a ground floor and maybe have apartments above. There's lots of rules and regulations about when and you won't qualify. But if someone is entrepreneurial and is going into landlording, but also has an opportunity to kind of find some synergies with their business that's a really great opportunity. Another thing I'd encourage your listeners to read about is is HUD financing which allows properties that are 5 units or more to take advantage of some special direct programs from the Housing & Urban Development. It's not something that I offer. But it is something your listeners should Google it and learn a little more about. Particularly as they get more sophisticated and end up with 5- or 10-million dollar loans.

LL: A lot of people who listen and read about Laziest Landlord tend to be professionals who have a full-time career on the side and then, you know, this is kind of where they invest their excess or should I say hard earned money if you like. What about for them? Would there be any avenues for them that would be unique for them given that most people have full-time jobs and a full-time career and they're trying to do this on the side of that desk?

Nate: There's nothing that really kind of strikes me as for those folks in particular. It's important for those folks to recognize that the loans are underwritten completely differently for a commercial loan and a residential loan. When you do a residential loan it includes that income to that person is making into the calculation. When you doing a commercial loan it's really about that property and your greater portfolio. So I would encourage them to, you know, be strategic about using those four loans that they have in the conforming world: the primary, the secondary and the two investment properties that are 4 units or smaller and making sure you create a good track record with those in a good cash flow because that will help you quite a bit when you make that leap. I can't say that having a good professional job and having that W2 salary doesn't help you. It certainly does help your profile with a commercial lender. But you know, even the folks making you know, 7-digit salaries can't get a loan on a bad property. Because at the end of the day the bank figures that their first source of repayment is the building itself and we don't want to foreclose on anybody. That's the last thing I want to do is finance a bad loan. So you just I think its important for professionals to keep that in mind that sometimes when I'm turning down a building or a deal I'm doing you a favor because I'm telling you that we, the bank, don't think that's a great transaction so I think you can find a better deal. So I think that's an important thing for professionals to keep in mind - that your interests and my interests are aligned. We want good stabilized cash flow buildings. We shouldn't be looking at each other as competition. It's really, you know, when the deal is right, it's going to be easy to do and when the deal is not, when you're struggling to find a bank to do a deal that you maybe need to relook at your deal and see if that's the right deal.

LL: You talked about cash flow. That's one of the things I know you look at and a lot of other banks look at is obviously debt service coverage ratio. But I've also heard a couple of other newer terms come in around cash flow on the particular building itself as you described. Can you maybe just talk about debt service coverage ratio, what that is? And what you typically would look for and other banks might look for and some of these other ways that banks evaluate the cash flow of a property?

Nate: Yeah, so debt service coverage means how many times the NOI for a property - so the net income property plus the add-back for depreciation - can cover the payment on the loan. So very simply, if the annual payment for a loan was $100,000 and the net income for depreciation and add-backs comes to $120,000, then you say you have a debt service coverage ratio of 1.2 times. 1.2 times to 1.5 times is generally the range of what you'll see out there from banks. And you know for us at my institution, you know, essentially, it's different for every single deal. Sometimes its 1.2 if you have a CVS as a landlord and they have a 25-year lease guarantee by the corporation. And then it might be one point for it 1.4 if it's a four-storey walk up in a neighborhood that's riskier. So that is a part of negotiation process that debt service coverage covenant, that's something I should have mentioned earlier. It's not something that the lender often is able to negotiate because he negotiates with the risk officer in the back and he's got to get this loan guarantee approved. So as you negotiate on some of the covenants, whether that's loan-to-value and how much you have to put down whether it's the debt service coverage ratio that has to be maintained going forward, you know you make the loan more and more difficult for the lender to get approved and his risk by his risk officer. The other way that banks have been looking at loans is through debt yield. And so debt yield is a ratio of the NOI (the net operating income from a property) as compared to loan size. Right, so if you had again in the same scenario the debt you owe me the net income from a property was $100,000 and your loan was $1,000,000, you'd say you have a 10% debt yield. So the debt of a million dollars provides 10% debt yield outcome or income. 10% is what the current target kind of for my institution. It's been as low as say 8% in better times outside of COVID. But the deals that are getting done quickly and easily are 12% debt yield. It really depends on the type of property, the location and then the sponsor or guarantor or what they're providing to mitigate any risk perceived by the risk officer.

LL: And to be clear that's net operating income divided by the debt, that's the ratio that you're talking about that's the debt yield.

Nate: Yes, that's correct.

LL: Terrific. Nate, I'm conscious we're bumping up against 30 minutes. Tell me what's the question that I haven't asked that I should have asked you about this that you think Laziest Landlord readers might want to know.

Nate: I think you asked a really good question, as you know, how do you find a commercial bank and I suggest in the past that you know, you might talk to your CPA, you might talk to your attorney, you might talk to the real estate agent. I think it's a really good place to start with where you have your deposit accounts. I think that's another important thing is you already have a relationship with a bank, you know, even if you only have a residential mortgage there. That residential loan officer might know a good commercial loan officer and an even within a bank you're going to have many commercial loan officers and not all of them have the same quality, you know, not all of them are always interested in doing commercial real estate. And it's really interesting to hear peoples' bad experiences a different institutions, not because the institution was wrong because the lender who didn't do that type of loan. And sometimes that lender doesn't have enough concern to hand you off to his colleague who might be better at that type of loan. So I just think that's an important thing to mention.

LL: It's interesting because that does sound like, you know, going back to the relationship piece that you really do need to find that person even within a bank and so the referral aspect becomes much more important than you know when I've gone and got my residential for our primary it's pretty straight forward. You don't really care who is on the other end as much as do you have enough experience you can fill out the forms on your side type of thing.

Nate: Right, right. I mean residential lending should be governed by and is governed by fair lending laws. Fair lending laws in United States say that regardless of your color, creed or condition, you know, you should get the same rate regardless of who you are, given you qualify. In the commercial world that's entirely not the case. You know of course the banks try and treat everyone equally. We try to be good shepherds of capital and good people. But there's really very little requirement that we treat everyone exactly the same. Because no-one is exactly the same. I could interpret some person's portfolio profile one way and then the next lender could do it differently and the risk officer, you know depending on how the presentation goes and what they had for lunch that day might say no to one person and and yes to the next. It's like I said before, it's really an art and so you'll get a sense when you're interviewing a loan officer or you're asking questions about the loan about whether you think that they're confident in what they're doing? You know you don't need to be afraid as a landlord to ask questions and come off as dumb. If someone is treating you like a jerk and not responding to you quickly or treating you like in responding to you in a civil way, the chances are they're not that great at getting your loan done and through the risk officer. You know, people skills are the same on both sides. I kind of referenced this before. What's interesting from a job perspective in my position is I have to sell something twice. I have to sell you the landlord on working with me as a banker and then I have to sell you, my new prospect (my landlord) to my risk officer as someone who we wanted to bring it to the bank. And I think that you should be why you should want to work with this lender going forward and you think that they are going to go represent you properly in front of the risk officer.

LL: Are there any personal characteristics in that representation, you know, beyond the property, beyond the income and things like that...are there any things about the person themselves that you represent to the risk officer?

Nate: Yeah, absolutely. What their profession is. Where they might have gone to school. Because these are all looked at as fallbacks, right, so if your building is not going well, you know, but you're a doctor and you're working at a prestigious hospital then we think were going to get our money back, right. Your community involvement, how engaged you are in the community. And then interesting things like if I know I'm going to get financials from you on an annual basis and it is easy to get financials from you when you're applying, it's a pretty good sign for me. It means that I'm going to get, I don't need to bug you every year and say "Hey, can I have your personal financial statement? Hey, can I have your tax returns?". You just send it to me. That's something that is not only important to the relationship manager or the commercial lender but also to the credit management and risk team because getting your financials on time and being able to evaluate your loan on an annual basis and having it go quickly and easily is important because you have to do it for 5 years or 7 years or 10 years. People have long views on their careers in banking. They know they're going to look at this loan forever. Like I said before, no one wants to deal with a bad loan.

LL: Nate, I think that's a great place to leave the conversation actually. So thank you again for making the time to talk today about all things commercial real estate and beyond. I think listeners and readers of Laziest Landlord will have got a lot out of it. Thank you.

Nate: Thank you, thanks for having me. I wish all the best to the landlords out there and I hope that they find the right match.

LL: Thank you.