100% Financing on Acquiring Apartment Buildings: Reality or Myth?

Every so often I hear of investors seeking a way to finance 100% of the acquisition cost for an income property such as an apartment complex. I suppose it is fueled by the ads on social media touting no money down deals and using pictures of Class A apartment buildings. The way it comes across, one would believe that all you have to do to become a millionaire in real estate is to buy a particular real estate guru’s course, then acquire the properties with “OPM”, meaning Other People’s Money, and then just sit back and collect the big fat checks they like to flash on the screen.

I scratch my head whenever I hear of someone looking for 100% financing because it is a very dangerous game.  People often chase that dream without properly assessing the real cost.  That’s the peculiar state of mind that surfaces when the target of our desires looks so good that we’ll do anything to get it, with no regard for the consequences.

The Desire to Acquire

In real estate, the “desire to acquire” is present when the investor is willing to do anything to get a deal they really like. Convinced that once you own real estate you’re on your way to the good life, they tap their home equity, or find a seller that will owner finance, and get a bank loan on aggressive terms. Now they’re in a deal, but have they thought it through? Let’s take a look at what happens when you “catch” the 100% leveraged deal.

The ads gurus teach that if you find the right seller, then you can structure the deal so that there is no money out of your pocket, and leave the impression that there will be plenty of money in your pocket after you do the deal. More often than not, that’s not the result.

Let’s say that you do find a lender that will loan 80%, and a seller that will carry 20%. In all but the rarest of cases, the combined debt payments are going to eat up all but the tiniest portion of the cash flow. It has to be this way, and I can show you why. Instead of projecting how much you’re going to make from the deal, think about it in terms of the occupancy level it takes to break even. Then consider the difference between physical occupancy and economic occupancy.

Economic Occupancy vs. Physical Occupancy

Let’s face it, the deals that we look at with decent prices, motivated sellers, and opportunities for turnaround or upside are usually not the crème de la crème. If it were an “A” property, with well-screened tenants it probably wouldn’t be on the market at a price that would interest us anyway.  You are getting a property that’s marketed as “mismanaged” and a “perfect value-add opportunity”.  So it’s pretty likely you’re going to inherit a less than stellar group of tenants. The first advice here is to factor delinquency into your projections to avoid a rude awakening later. Comparing the economic occupancy to the physical occupancy can be an eye-opening exercise.

Economic occupancy differs from physical occupancy, sometimes widely so. Economic occupancy is calculated as the actual cash collected divided by the total potential rents. The answer will be a percentage, and it is important, as we will see in a moment.

Whether you are looking at class A or class C property, delinquency in apartment rent rolls is a fact of life. You are not going to collect 100% of the money due, on time, 100% of the time. It is not uncommon for even well-run apartment buildings to run a 5% delinquency rate, and poorly operated projects may run a 30% or higher rate. For calculation purposes, if the rent is collected past the due date it is not included in rent received for that earlier period.

In the same way, vacant apartments are also a fact of life in the apartment business. Vacancies are actually phantom expenses that only show up in an economic occupancy analysis. Together, vacancy and collection losses are typically projected to run at least 5% of gross income for well-run buildings.

In my experience that is a low number, but we’ll use the 5% figure for this discussion, just to save the argument, and to prove the point that even using optimistic numbers a 100% leveraged deal is tough to structure.

Always Run the Numbers

Let’s use twenty-unit apartment building with potential gross income of $100,000. That works out to average rents of $416 per month (i.e. 20 units x $416/month x 12 months is $100,000). If it is a normal building that is not new construction, there will be about 40% expenses, ($40,000), including management, but not including vacancy and collection (delinquency) loss. Included in the expense estimate is a “reserve for replacement” deduction. This is an annual estimate of funds needed to perform capital improvements. An average figure is between $250 and $300 per unit per year. While many owners do not actually reserve the funds, some lenders will deduct the amount from the cash flow before calculating the debt coverage ratio. Other won’t, but that doesn’t mean the improvements won’t be required.

Lastly, if you use the optimistic projection of about 5% ($5,000) for vacancy and collection loss, then the building must have an economic occupancy of 45% just to operate (40% operating expense + 5% vacancy and collection expense).

That leaves a Net Operating Income (NOI) of 55%, or $55,000. We call it NOI, but the lenders call it, “funds available for debt service.” Ever wonder why? Read on.

Most lenders require a minimum 1.25:1 debt service coverage ratio (DSCR) to fund a deal. Some are higher, very few are lower. There’s a good reason for that.

At a 1.25:1 DSCR, 80% of the NOI is used for debt service. (1/1.25=.80). In our example, the maximum debt service would be $44,000, (NOI of $55,000 x 80%), or 44% of the gross POTENTIAL rent. Add the 45% of expenses to the 44% of the debt service, and you need 89% economic occupancy to break even. That leaves 11%, or $11,000 for profit, pre-tax.

That’s with normal deal structure, and 20%-25% cash equity. At $416 average rent, the profit margin is equal to just over the annual rent on two of the twenty apartments. Or, looked at another way, if there are on average two vacant apartments for twelve months, and the rest of the complex operates normally, the project is going to lose money for the owner. The lender will get paid (in theory!), but the owner won’t. And that doesn’t take into account any increases in utility costs, insurance costs, property taxes, fix-up cost for a trashed apartment (which will happen!), or any other of a hundred things that can go wrong and cost you money. Now can you see why the lenders are so tough on debt coverage ratios?

Pushing the Limits

So now let’s move to a deal that has 100% financing. Say you find the above building and the owner just has to get out. He’s willing to let it go for $500,000. That’s an 11% cap rate on the $100,000 NOI, and sounds like a great deal. You’ve got a bank that will work with you on high leverage deals, and they offer to finance the deal with terms of 80% of cost, 6% rate, and twenty-year amortization. Further, we’re assuming you’ve got great credit, high net worth and are an experienced real estate operator and can get the best loan terms available. The seller wants out of town so bad he’ll finance the rest at 7%, with twenty-year amortization, but a balloon in three years. He wants out, but he does want his money.

The annual debt service on the first mortgage ($400,000) with the bank will be $34,389 with a DSCR of 1.60 (NOI of $55,000 over $34,389). So far, so good. The annual debt service on the second, seller held mortgage ($100,000) would be $9,304. That’s total debt service of $43,993, or 44% of gross potential income, and a cumulative DSCR of 1.25:1. Add 45% “expense and an optimistic vacancy/collection loss allowance”, and the break-even economic occupancy level is increased to 89%. Or, stated another way, the best-case profit is 11%, or $11,000 per year. The most you can make is $917 per month, if everybody pays on time and nothing happens. That’s a cushion of just over two apartments per year over break even, before any unanticipated costs or expense increases. That is a very small margin.

Now go back to the more realistic 10% “vacancy and delinquency loss” (anecdotally speaking, none of our apartment buildings are less than 10%) and the break-even economic occupancy becomes 94%. If anything outside the perfect world of the paper projection happens, anything, then you’re running negative cash flow. You’re upside down from the get-go, and few if any options to cure it.

So now tell me, you’ve caught this deal, now what are you going to do with it?  Your seller financing will mature fairly soon, and without a massive improvement to the performance of the property, your NOI is unlikely to change to a point where you can refinance the seller financing.  The truth is you will have to dip in your pockets for any unexpected expenses, which are nearly certain to happen.  When you run out of cash, or when the seller financing maturity date will be around the corner, you will scramble to sell the building and at best walk away with a small loss.

No Room for Error

If all of this doesn’t give you pause to think twice about high leverage, then consider this. If the building in our example is full, there are twenty tenants with payments due each month. That’s 240 payments due each year. That’s also twenty potential stories each month as to why you can’t get your money, 240 potential stories each year. What is the probability that of the 240 potential payment events per year, somebody won’t pay on time? That should make you wonder how well the tenants you inherit from the seller were screened. Or did he just get warm bodies to fill the place to sell? We recently took over a building where out of 14 existing tenants, 6 were squatters. It will easily take us 3 to 4 months to legally evict the squatters, which is just one example of an expense that’s easy to miss during your underwrite.

Don’t get me wrong; there are situations where 100% leverage is possible and profitable. One clear exception is when you are getting a steal on the asset, and the property is worth much more than what you paid for it.  But these cases are few and far between, as it is rare to find a seller who is completely out of touch with reality regarding the market value of their asset.

I hope you can see from this discussion why high leverage is a strategy that requires the experience, capital, and resources to use it properly. Be careful when you contemplate highly leveraged deals. Figure the break-even economic occupancy rate. Know what the costs are going in. Know the market. Know your own capabilities and be able to move quickly to capitalize upside. Above all, do not tweak the numbers to support your own “desire to acquire.”

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Should you find a great deal and have a need for financing, please consider PSG Lending (www.psglending.com) for helping you financing the transaction.  We close in as little as 1 week and finance anything from flips to commercial real estate ground-up development.

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