As you make the switch from residential rental properties (i.e. less than 5 suites) to multi-family there are some things to watch out for. In fact if you are not prepared you could be in for a rude awakening. The process is just far more intense – taking much more time and much more money than what you may be used to.
When you buy a multi-family property you are buying a little business, complete with multiple sources of revenue and multiple cost centres. Because of that your lender will require a lot more information. Here are some things you need to be aware of:
Cost of Reports: At a minimum you will be required to supply:
- a) an Appraisal – You are used to getting an appraisal but a commercial appraisal is much more detailed and much more advanced. It will also cost you a couple of thousand dollars. While the bank probably paid for the appraisal when you bought your last residential property, you will be responsible for obtaining and paying for a multi-family appraisal.
- b) a Building Condition Report – to create this report an engineer will go through the building and inspect the roof, wall system, boiler / furnace, plumbing, electrical, windows, foundation (basically the entire building) to find issues that need repair or replacement and to determine the remaining useful life of the building. Typically a lender will amortize a mortgage to a maximum of the remaining useful life plus five years. The engineer will also want to see two or three individual suites to get a feel for the quality of finishing. This report will also cost you two or three thousand dollars.
- c) a Phase 1 Environmental report – this is a report where an engineer or consultant will go back in the past to see what existed on your property and on neighboring properties and if there was ever anything that may have been environmentally hazardous around your site. For example, did there used to be a gas station with underground tanks that may have leaked? Was there ever a plastics factory or an auto junk yard? Are you close to railroad tracks where there may have been an accident that leaked chemicals into the soil? The bank wants to be aware of what might be in the soil that could come back to create a future environmental incident. If nothing is found then no problem. If something does come up you will have to do a Phase 2 and probably re-mediate the issue. All reports are at your cost and will run you two or three thousand each.
You may also be required to test for asbestos or mold.
All of the above reports will be at your cost and must be from a list of vendors that the bank approves of. This is to lower the chance of mortgage fraud.
Cost of Money: The bank probably didn’t charge you a fee to get a residential mortgage but you will have to pay them to give you a loan on a multi-family property. “What? I have to pay them to give me money?” Yep. This will probably be around 1% of borrowed funds plus maybe an application or processing fee. In their defense there is a lot more paperwork / effort for them to process a file of this size. However, there is a bit of ‘they will charge you just because they can’. The people / corporations that buy multi-family have more money and the lenders know that. You will also be responsible for not only paying for your own legal fees but that of the lenders (and those fees will be higher than in the residential world too).
Personal Guarantees: You and your partners will probably be required to sign personal guarantees on the loan. That means that if you run into trouble and can’t pay the mortgage for this property that they can come after you personally to get the money. Having the property owned by a corporation won’t help you here.
Time: It takes significantly more time to buy a multi-family than it does a residential property. While it typically takes four to six weeks to arrange financing on a residential property (i.e. two or three weeks to get inspections and arrange financing plus a couple of weeks to close), it will take you three or four months to get the keys on your new apartment building. All of the reports listed above will take three to four weeks to create. The bank will need the same to process the application once they get the reports back before they can issue you an actual commitment letter. Add on three to four weeks for legal and it starts to add up. Make sure, that when you make your offer to purchase with the vendor, that you put a closing date of 90 to 120 days. Do not let them talk you into anything less.
Due Diligence: While the engineer will go through the major building systems (roof, wall, plumbing, heating, electrical, foundation etc.) they will only visit a couple of representative suites. Make sure you go through the entire building with the engineer AND make sure you go through every suite. This is so you know what repairs are required in every suite and in the building as a whole. If there are major issues that you were unaware of (with the roof or foundation for instance) you may want to renegotiate the deal or even get out while you can.
Tenants: You also want to get a feel for who your tenants are and how they live. These detailed visits will let you know who the hoarders are vs. who keeps things neat. You may see some bugs / pests which will allow you to eliminate those issues ASAP after purchase. If anybody is doing anything illegal you need to know that before you buy the property too.
Other Sources of Income: One of the good things about multi-family properties is that they can provide more sources of income. For example, laundry – are the machines under contract with a service or will you own them and be responsible for their repair. Do you have a chance to have extra parking revenue? Can you clean up a storage room and rent it out? Can you rent out your roof to a phone company to put up their antenna? Can you put some advertising outside?
How They Are Valued: As a business, multi-family properties are valued based on their ability to produce money. The income / revenue of the building is more important here than the financial strength of the borrower. I go into great detail on multi-family valuations in my book Comparing Real Estate Strategies.
What Banks Won’t Lend On: Sometimes the quality of the building will be so bad that the traditional, level 1 banks won’t lend on them at all and you will have to go to a private lender and pay more interest. For example, banks won’t lend on motels that have been converted to apartment buildings (because the rooms are too small). They won’t lend on boarding houses (where multiple bedrooms share a common bathroom or kitchen). If there is significant mold or asbestos you will get a ‘No’ from the bank too. I bought a building once that had sat empty for two years with a leaky roof resulting in grass and mushrooms growing on the carpet of the top floor – definitely a deal for a private lender. If you own an entire building that has been condominiumized so that each suite can be bought and sold separately, the bank will still treat it as an apartment building and lend on that lower value vs. the higher individual condo value.
Insurance: You may have trouble finding insurance at all for empty buildings that require some significant renovations to get back to normal. Insurance companies get scared by empty buildings and major redos. If the electrical in your building is older and has the older fuse style panels (as opposed to the newer breaker style) or if your building has aluminum as opposed to copper, you will also be looking at fewer companies who will even entertain giving you a quote. Those that do quote will quote very high until you can bring the building back into balance. The lender may have their ‘insurance consultant’ review the insurance that you do get to ensure they are protected. This will be at your cost too. Make sure you factor extra time into purchasing the building if you think it will be harder to find insurance.
As you can see there is money going out the door for fees and reports every time you turn around during the purchase / diligence phase. Now that you are aware of that and can budget for it you won’t be surprised. Also, make sure you give yourself enough time to get everything done properly. It will cost you money if you have to go back to the vendor and negotiate an extension.
Read more about this in Comparing Real Estate Strategies.