If an investor buys a single-family residence to live in, the property will generate no income. Therefore, the lender qualifies the borrower with regard to the ability to make the payments.
Likewise, if an investor buys a residential property as a rental and the tenant moves out, the borrower will be required to make the mortgage payments until the property is re-rented. Therefore it should be no surprise that the lender is going to qualify the borrower with regard to the ability to make the payments. A single-family rental house is either 100% rented or 100% vacant. The lender will look at the worst-case scenario (100 % vacant) and determine whether the borrower can make the payments from his/her own income.
In apartment building financing, it is the property that primarily qualifies for the loan and not the individual borrower. While apartment buildings are purchased for potential appreciation, the actual cash flow called “Net Operating Income” (NOI) is what gives the building its value. NOI is what lenders are considering when making a loan on a property with the individual borrower’s financial situation as a secondary consideration.
In apartment building financing, the mortgage payments are referred to as the Annual Debt Service (ADS), and are made from the NOI of the property. Paying the mortgage in apartment building is called “servicing the debt” or “debt service.” Rents are collected. Expenses to operate the property are paid. The remaining cash flows called NOI are available to service the debt.
Apartment buildings are rarely 100% vacant or 100% rented. In the apartment building project the property can have significant vacancy and there may still be enough cash flow necessary to service the debt.
The lender considers numerous factors when qualifying the property. What is the typical vacancy and rental rates in the area? How does this building compare to those rates? What is its current vacancy rate? How long does it typically take to get units rented? Even with vacancies, does the property cash flow and if so, at what vacancy rate will it no longer cash flow?
The lender has many considerations and not one of these was your (or your money partners) FICO (credit score). What the lender may look at is your (or your investor’s) character. In other words, if the NOI is sufficient to service the debt, will the investor use that cash to service the debt or will the investor buy a fancy new car instead? Does the investor understand how to operate this type of apartment building and if not, has competent management been retained? They want assurances that their NOI will be protected.
The lender will also likely require the investor to retain a portion of the remaining NOI as “reserves.” Most lenders will require those reserves to be deposited with the lender so they can be easily used to cover any unexpected shortage in cash flow, allowing the investor to continue to service the debt.
Additionally, the lender is going to apply a margin of safety in their loan underwriting to assure that the amount of debt service the investor is obligated to make is less than the cash flow the property produces. To do this, they will apply what is called a “Debt Service Coverage Ratio” also called “Debt Coverage Ratio” (DCR) to determine the amount they will loan on the property.
In conclusion, apartment lenders base their lending decisions primarily on cash flow from the property and not of the financial strength or creditworthiness of the borrower. Additionally, they apply safety measures including the establishment of reserve accounts and a DCR to assure that the cash flow from the property will be sufficient to service the debt.
There is a lot to learn before you jump into apartment foreclosure investing. Make sure you join me and National Foreclosure and Apartment Industry Expert, Investor and Foreclosures.com Coach Michal Ballard, Wednesday, July 28th, 6pm Pacific (9pm Eastern) in our Brand New Professional Investors Webinar “Make Huge Profits Investing in Apartment Foreclosures.â€
