Commercial real estate has historically been considered an alternative asset class. Yet commercial real estate, as an asset class, has performed exceptionally well over the past decade. As a result, investors are increasingly investing in the sector.

For those who are just entering the commercial real estate foray, many will begin by investing in multifamily real estate. Multifamily, as a subset of the broader industry, is relatively easy for the average investor to understand – particularly for those who have owned their own home. Multifamily real estate also has lower barriers to entry than other property types, such as retail or office. First time investors can dip their toes into the waters gradually, starting with a property as small as a two-unit duplex.

That said, even those who are interested in buying multifamily real estate often get hung up on how they’ll finance the transaction. They’re often up against more seasoned investors who can pay with cash on hand. Although all-cash deals have become more common, an investor need not have deep pockets to get started. In this article, we look at the many options for financing multifamily real estate.

What Is Multifamily Commercial Real Estate?

Multifamily Housing
Multifamily housing is really a catch-all term to refer to any type of rental property with two or more units. On the smaller end, multifamily housing can refer to duplexes or triplexes. Multifamily housing also includes mid-sized properties (such as garden-style apartments) and larger apartment communities. Multifamily housing can be further segmented by its audience, such as student housing or senior housing.

Apartment Buildings
Apartment buildings are a specific type of multifamily housing. Typically, most people refer to buildings with 5+ units as “apartment buildings”. (The smaller buildings would be referred to by more exact unit size, such as duplex, triplex or fourplex.)

Buildings with five or more apartments begin to fall into the “commercial” financing category (vs. “residential multifamily”). In other words, the attractive financing options you might be able to get on a duplex or triplex (e.g., FHA loans with as little as 3.5% down, 30-year fixed rates, etc.) are typically not available when financing apartment buildings. Apartment buildings, even if owner-occupied, will usually require at least 20- or 25% down, with the balance being financed over a 10- to 20-year period.

Multifamily Construction
There are generally three categories of multifamily property that investors will consider:

(1) stabilized multifamily apartments
(2) value-add multifamily properties
(3) ground-up multifamily construction

The latter refers to a development opportunity in which a sponsor either buys land or otherwise permits a property for multifamily construction. Multifamily construction is one of the more challenging types of multifamily investing, and carries certain risks associated with permitting the project. Multifamily construction also utilizes distinct financing tools, such as short-term debt that is released in tranches as construction milestones are achieved.

Are You Ready for Multifamily Real Estate?
Anyone who is considering buying multifamily real estate should make this decision within the context of their broader investment goals. One’s investment goals, which includes their personal risk tolerance, will influence not only whether to invest in multifamily real estate, but also the type and location of multifamily real estate.

Those with a higher risk tolerance may be more open to investing in opportunistic deals, including ground-up multifamily construction in secondary or tertiary markets. Those with a lower risk tolerance would be better served by investing in stabilized multifamily properties, including Class A multifamily buildings in core markets. The latter have the lowest risk profile, but also tend to generate the lowest returns.

There is also an important distinction to be made as it pertains to operating multifamily real estate. Investors must determine whether they’ll self-manage the building or hire a third-party operator. This decision is usually made based upon an investor’s capacity (namely, time) and knowledge of rental property. It is usually easier to self-manage smaller, stabilized properties than it is to manage a larger multifamily apartment complex. Similarly, those with less experience will certainly want to partner with an adept sponsor if considering a ground-up or value-add multifamily project, as these are more complicated and can easily veer off track without astute project management.

The Multifamily Real Estate Market
Multifamily real estate is often used to describe any type of residential rental property, but there are important distinctions to be made between multifamily and other forms of residential investments. Moreover, multifamily is an entirely different property type than other forms of commercial real estate, such as office. We look at the differences below.

Multifamily vs. Single Family Real Estate
The multifamily real estate market includes both “residential” rental property (1-4 units) and “commercial” rental property (buildings with 5+ units). Residential multifamily is the easiest to finance and has the lowest barriers to entry. This is how most multifamily investors typically get started. Some will even owner-occupy one of the units in their first rental property as a way of securing the most attractive financing.

Residential real estate also includes single-family rental properties, though single-family rentals are not considered “multifamily” property. There are some investors, however, who have achieved great success by investing in one single-family rental property at a time. This investment strategy appeals to some, particularly in lower cost markets where property values are low but rents are strong.

That said, managing a portfolio of single-family rental properties is no easy task. There are more systems to manage, more landscaping to maintain, more travel time to factor in when traveling between properties. Investors realize more operational efficiency when investing in multifamily properties. A single, 20-unit property, for example will have one roof, one heating system, one driveway to plow, etc. A portfolio of 20 single-family rentals will require maintenance of 20 roofs, 20 heating systems, 20 driveways, etc.

A final factor to consider when comparing multifamily to single-family rental investing: if a tenant vacates a single-family home, the owner is no longer collecting rents. It is much easier for an owner to find themselves underwater on their mortgage compared to losing a tenant in a multifamily property. With the latter, there will be rents coming in from the other units to help the owner remain solvent during periods of vacancy.

Multifamily vs. Commercial Real Estate
People often confuse the terms “multifamily” and “commercial real estate,” as though these were two separate things. In fact, multifamily is just a type of commercial real estate. Commercial real estate refers to an entire asset class that includes multifamily, office, retail, industrial, hospitality and land development.

The exception to this rule, however, is when referring to 2- to 4-unit rental properties, which are considered “residential multifamily”. As soon as a building has 5+ units, it falls into the “commercial” real estate category and will require a different set of financing tools compared to 2- to 4-unit residential multifamily properties.

Financing Terms to Know

Interest Rates
Any commercial real estate loan will charge the borrower an interest rate depending on the merits of the deal, the quality of the sponsor, and the source of the loan. For example, if an industry veteran is looking to finance a Class A apartment building, they’ll probably seek a traditional bank loan, life insurance company loan, or agency (Fannie Mae / Freddie Mac) – the three sources of multifamily debt that typically have the lowest interest rates. If a borrower has less experience, less equity in the deal, or if the project carries higher risk, the borrower will likely pay a higher interest rate. Interest rates are highly variable and deal-specific.

The terms of any commercial real estate loan are also deal-specific. For example, term length will often depend on whether the deal is new construction/value-add, typically short to mid term, or a fully stabilized property, in which case, long-term debt might be the best option. Conventional multifamily mortgages will usually amortize over a 15- or 30-year term, whereas short-term loans can be as short as 6 months to three years with extensions.

Loan Amount Limits
There are no specific loan amount limits in commercial real estate. Individual banks may have loan limits. For example, a community bank may max out at a $7 million loan. In situations like these, individual banks may partner with other banks to offer loans of greater amounts. It is not uncommon, though, for a single bank – particularly a large national bank, life insurance company, or debt fund – to do individual loans of $50-$100 million or more.

Loan to Value Requirements
Residential (2-4 unit) multifamily lenders will have more flexibility than commercial multifamily lenders. The former will often allow borrowers to put down less than 20%. Some even allow for no money down (a 100% loan-to-value ratio). These situations are rare, and often require the borrower to utilize a loan through the Veterans’ Administration, but they are possible.

Commercial lenders, on the other hand, will usually want to have at least 20% equity in the deal, or an 80/20 loan-to-value ratio. Higher-risk deals require even more equity, sometimes maxing out at 65% loan-to-value. Once again, it depends on the merits of the deal, the quality of the borrower, and the specific lending institution.

Conventional Financing Options
When people talk about “conventional” financing options, this usually refers to a few different types of multifamily lenders: banks, life insurance companies, agency, and CMBS lenders. Traditional banks include large, national institutions such as Bank of America and JPMorgan Chase. They also include smaller banks, such as regional or community banks.

Life insurance companies are also common multifamily lenders. “LifeCo” loans, as they’re often called, will typically have some of the lowest rates for those who qualify. LifeCo debt is most often utilized on low risk and low leverage large ($20+ million) deals.

“Agency” loans refer to those backed by government-sponsored enterprises (GSEs), most often, Fannie Mae and Freddie Mac. These loans are packaged and sold off as bonds to investors. Agency loans come with what’s known as an “implied guarantee.” In other words, if the borrower defaults, the government will step in and repay the debt on the bonds. Multifamily is the only property type eligible for agency loans.

Commercial mortgage-backed security (CMBS) loans are another type of traditional loan product. Like agency loans, CMBS loans are structured through a conduit, packaged and sold as bonds. Unlike agency loans, which are only available through GSEs, CMBS loans are usually offered banks and life companies.

People will often ask, “what are the top commercial real estate lenders”? Of course, like most subjects related to commercial real estate financing, the answer is – “it depends”. In terms of the top, or the best commercial real estate lenders, it really depends on the borrower and the specifics of their deal. Almost any large national bank will have some sort of commercial lending arm. As mentioned earlier, this includes Bank of America and JPMorgan Chase, Santander, Wells Fargo, Goldman Sachs and the like. However, depending on the specifics of a deal, a borrower might actually get better loan terms through a local or regional bank that has a better understanding of the hyper-local marketplace.

Alternative Financing Options
In addition to traditional loan products, there are many alternative financing options available for those interested in financing multifamily real estate. These include debt funds, online marketplaces and hard money lenders.

Debt funds are pools of private-equity backed capital often used to fund commercial real estate transactions. Debt funds are often used by borrowers taking on complicated commercial construction projects, for bridge loans or lease-up financing, and for certain property rehabilitation projects.

Online marketplaces have emerged as an alternative financing option in recent years. These online marketplaces pool capital from various investors and then provide both debt and equity financing to borrowers. Most of these platforms are structured to be match-making services, and therefore, investors are cautioned to do their own due diligence before proceeding with this financing strategy.

A third source of alternative financing is hard money lenders. Hard money lenders are private lenders that tend to extend loans on a short-term basis, usually as a means of last resort, and therefore, typically carry the highest interest rates. Borrowers should only consider using a hard money lender if they have a solid execution strategy that will allow them to repay the loan in short order.

Related: Should You Buy an Investment Property with an IRA or 401k?

Short Term vs. Long Term Loans
Multifamily commercial real estate financing tools provide both short-term and long-term loan options. Whether a borrower uses a short- or long-term loan really depends on the nature of the deal, and therefore, the purpose of the loan.

The most common uses of short-term commercial loans are for property acquisition, new construction or property repositioning. For example, an investor might use a short-term loan to purchase two side-by-side single family homes with the intention of clearing the lots and building a new 20-unit multifamily apartment building. Short-term loans will typically range 6-12 months, with one year being the most common short-term duration. Traditional banks, debt funds and hard money lenders are all common sources of short-term debt.

Long-term loans are used by most borrowers financing a commercial real estate transaction. In fact, even those who use short-term loans will often put long-term debt on the property once the property has been stabilized. Conventional, long-term multifamily mortgages will usually have a 5- to 20-year loan term, though the loans may actually amortize over a 30-year period.

Long-term loans are available through almost any source of capital mentioned above, including traditional banks, life companies, agency and CMBS lenders, debt funds and online marketplaces. Hard money lenders are the exception, as these lenders rarely provide long-term capital given their higher interest rates.

Related: Short-Term Rental and the Effects on Housing Affordability

Other Considerations to Make

Pro Forma vs. Underwriting
There is no difference between the term “pro forma” and “underwriting;” in fact, these terms can be used interchangeably. If one had to make a distinction between the two, you could think of underwriting as the process by which to create a pro forma. The pro forma is essentially a financial statement indicating how a deal is expected to perform. It will include a summary of expected revenue and expenses, which allows a prospective investor to determine their expected rates of return using various calculations. Lenders will typically conduct their own detailed underwriting of a deal before extending credit to any borrower.

Market Rate vs. Affordable rent
There’s an important distinction to be made between “market rate” rents and “affordable” rents. Market rate rents are based upon, well, what the market will bear. Units that are priced below market rate will typically lease faster than those priced at or above market rate.

Affordable apartments have rents below the market average. Housing experts will usually refer to affordable housing as either “capital A Affordable” or “lower case a affordable.” Capital A Affordable units are those that are subject to government regulation and therefore, must meet certain conditions. For example, some municipalities require that 15% of new multifamily apartments be designated as “Affordable” to people earning at or below a certain median income. Rent-controlled apartments are another example of “Affordable” housing.

“Lower case a affordable” is a different type of affordable housing. In this case, the units are not mandated to be affordable by any government agency. Instead, these are apartments in which the owner, willingly or unknowingly, has priced rents below market rate, therefore making the units more “affordable” to the masses. Another kind of affordable housing are units that are affordable ‘by design.’ This might be because they are particularly small in square footage and so the monthly rent is also lower from a tenants point of view, making them more affordable.

What Are Typical Loan Terms?
As indicated above, there are no “typical” loan terms. In multifamily commercial real estate financing, loan terms vary depending on the nature of the deal, the quality of the borrower, and the reason for borrowing capital (e.g., construction loans vs. long-term loans). Short-term loans will usually be anywhere from 6 months to 3 years in duration, but will often come at a higher interest rate. Long-term loans will usually span from five to 20 years, though most of these loans will amortize over a 30-year period. With long-term loans, borrowers may be able to get an “interest only” period of six months to a year by negotiating with the lender.

There are many nuances to financing multifamily commercial real estate projects. The good news, though, is that the market for short- and long-term multifamily debt is robust, giving borrowers several options.

Anyone who is interested in learning more about multifamily financing may want to schedule a meeting with a multifamily debt broker. Multifamily debt brokers usually have a thorough understanding of the tools available to borrowers, including the pros and cons of each source of capital. They’ll be able to guide you to a loan product that best suits your needs.

However, be forewarned that debt brokers will charge anywhere from 50- to 100- basis points if actually engaged to arrange that financing. On a $100 million deal, this equates to a fee of up to $1 million. That may seem like a lot, but in the long-run, using a debt broker to find the best loan terms can save the borrower that much or more in interest over the duration of the loan.

Check out our portfolio of multifamily homes at Trion Properties.

Related: The Ultimate Guide to Multifamily Real Estate Investing