6 Things You Must Know When Scaling from Residential to Commercial Investments
Few investors are content with their current portfolio – most want to scale and add more units. This is especially true for residential investors looking to make the leap to commercial apartments. However, there are pitfalls that could derail your goals if you are unaware of the landscape. Many investors begin with residential multifamily (two to four units) with plans to move up to commercial multifamily (five or more units). It’s kind of like trading in those green houses in Monopoly for the red hotel. But unlike the popular board game, it’s not as simple as collecting more rent. There are key differences that investors should be aware of when making the leap from residential to commercial multifamily apartments.
Scaling from residential to multifamily entails managing a different caliber of challenges. Recognizing the key differences allows you to prepare and position yourself accordingly when pursuing larger opportunities. It also allows you to avoid key mistakes when scaling into commercial apartments. Here is a list of differences to note and mistakes to avoid.
One of the main differences between residential and commercial apartments is the scale. Residential properties are two to four units, while commercial is five units and above. However, the number of units only tells part of the story. The more units you have, the easier it is to anticipate and forecast monthly income and expenses. If you have a two-unit property, you are either 100% occupied, 50% occupied, or 0% occupied. And one major expense can wipe out all the cash flow for a year.
Conversely, if you have a 100-unit property, one resident moving out does not drastically change your occupancy, operations, or projections. In fact, you are anticipating a certain amount of turnover each month for a net occupancy in the 90-95% range. This predictability allows you to make better financial projections, thus reducing the risk of the unknown. With that noted, you want to make sure you accurately forecast expenses because an extra $50 per unit, per month in expenses quickly adds up.
In residential real estate, it is common to come across an owner who is motivated to sell due to a lifestyle change, inheritance, or financial distress. You may also come across an inexperienced real estate agent that underpriced or overpriced a deal. And while this is possible in commercial multifamily, don’t get your hopes up.
For starters, factor in that commercial property owners have been successful enough to actually own a commercial property. These properties require more experience and capital than residential properties. Also note that these properties have less volatility than residential, and multifamily has appreciated drastically over the last 10 years, with the price per door shooting up 156% according to a study by Commercial Search.
Consequently, you are less likely to encounter a desperate, motivated seller in the commercial multifamily space. In a seller’s market, owners are actually interviewing you to see if you are worthy of their time. A colleague of mine learned this the hard way when an owner sent her a list of questions to answer before they would even let her tour a building. You’ll need to establish credibility with brokers, owners, and other industry professionals if you want to gain traction with commercial apartments.
Residential properties are valued based on neighborhood comps, so if your neighbor does not maximize their value or sells at a discount, it will impact your valuation. Most investors of two to four-unit properties are not professional investors, so they may not actively raise rents or employ the strategies and techniques to maximize returns.
Commercial properties are sold based on the profits they generate. In this case, you are not as impacted by your neighbor selling at a discount. You will have more control over the value with the ability to increase revenue and manage expenses. Income is not limited to rent, as you can charge other fees and offer revenue-generating services such as coin-operated laundry, storage, covered parking, and more. All of this additional income boosts cash flow and the overall value of the property.
Residential properties are easier to self-manage or find a qualified property manager (PM). Typically, these property managers operate multiple properties at a time. Most charge a fee based on rent collected, with additional fees for services like coming onsite to the property.
Smaller commercial properties (five to 10 units) will operate similarly but require a PM that can dedicate time to maintain the personal touches of a small commercial property. The next size up is 10 to 75 units and many investors struggle to find quality PMs in this range. These properties tend to overwhelm residential PMs and offer little financial upside for seasoned commercial PMs.
This caught me completely off-guard when I bought a 28-unit building and found a sizeable gap between my expectations and realities. Half of the companies we interviewed were not qualified to manage the building and the other half declined because they felt it was too small for their business. We eventually found a good fit, but this was a major eye-opener. If you are looking for deals in the 10-to-75-unit range, spend an ample amount of time finding a quality PM.
Larger apartments (75 units or more) can handle a dedicated onsite staff. This provides a professional solution for residents with business hours to address their needs. It also allows for better attention to details, such as picking up litter, which would be difficult to manage without onsite staff. In addition, you still have the resources of a larger PM firm to help you drive efficiencies and optimize income.
Standard residential debt is a 30-year term, amortized over 30 years so the only factor investors consider is the interest rate. For commercial apartments, the terms range widely from bridge loan products to agency debt. Bridge loans are shorter in nature, usually two or three years, with higher interest rates. Agency loans are usually set for five, seven, 10, 12, or 15 years. The amortization schedule is usually set at 20, 25, or 30 years. And then there is the pre-payment penalty to consider.
Outside of the terms, the loan qualification process differs among the different types of loans. Residential loans examine the borrower closely and want to see a strong work history with W2 income. Lenders rely heavily on your credit history and investigate your source of capital to ensure you have the funds to cover the down payment for the investment.
Commercial lenders look at the borrower, but they are usually more concerned with the property’s current performance and your business plan. They will underwrite the deal and use their own numbers to determine their comfort level. To qualify for a commercial loan, borrowers will need to show the net worth and liquidity equal to the loan amount, along with evidence of some operational experience. If there are gaps with your personal balance sheet or experience, commercial lenders will allow you to bring in partners to help meet these requirements.
6. Equity Structure
When acquiring residential properties, you are typically going to own them yourself or partner with one or two other entities. Typically, all parties will apply and sign on the loan and share the equity according to each member’s contributions. This scenario is called a joint venture or JV. Commercial apartments present an array of options for stacking the capital. If each investor will be active, a JV is still common. However, if some of the investors will be passive, this is considered a syndication, and typically you will have a class of shares for the active partners and a separate class of shares for all of the passive or limited partners. This can get fairly complex and requires the assistance of a securities attorney to ensure you are in compliance with current regulations.
These six areas certainly are not the only differences worth noting, but they are some of the areas that surprise many investors. Whether you plan on moving into commercial apartments to invest in syndications or just to get more doors under one roof, you will want to understand the key differences between residential and commercial multifamily to make a smooth transition.
John Casmon has helped families invest passively in over $90 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Target Market Insights: Multifamily + Marketing. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.