By Mike Heayn
Every now and then, I get a phone call from a potential borrower who wants to buy a 100 percent financed apartment building. I try to explain that the property must support the loan by itself, without any help from the owner. I usually get one of two answers: the “Oh, OK, thanks,” with a hang-up, or the “Why? I don’t get it.” When they ask why, I usually run through a scenario with a hypothetical property.

If you were to find a property and it were to cash flow, and by chance you found a lender that would allow owner financing for the difference between the loan and purchase price, you would still have to make sure that the property could carry the loan based on a reasonable debt service coverage. Remember, debt service is a measurement of a property’s ability to support a specific loan payment. Debt service is expressed as a decimal.

Let’s run through a hypothetical scenario:
Purchase Price $1,000,000
Units 10
Square Feet 10,000 (1,000 sq. ft per unit)
Gross Income $120,000 ($1,000/month/unit)
Effective Gross Income $114,000 (subtract 5 percent vacancy/loss of rents)
Taxes $12,500 (.0125 x purchase price)
Insurance $4,000 (.40 x 10,000 sq/ft)
Utilities $7,000 ($700 per unit per year x 10 units)
Maintenance $6,000 ($600 per unit per year x 10 units)
Management $5,700 (5 percent of the Effective Gross Income)
Cash Reserves $2,000 ($200 per unit per year x 10 units)

Total Expenses $37,200

Effective Gross $114,000
Less Total Expenses $37,200
Net Operating Income $76,800
Debt Service Coverage Ratio 1.15 (Debt Service Divided by Net Operating Income)
Equals Annual DSCR $66,782
Interest Rate 7 percent
Amortized Over 30 years
Loan Amount $750,000
Purchase Price $1,000,000
Deficit $250,000

Now if you were to add a second trust deed, or other owner financing to the deal, you have to add it as an expense as well, which would lower your first loan amount.
See the example below:

Purchase Price $1,000,000
Units 10
Square Feet 10,000 (1,000 sq. ft per unit)
Gross Income $120,000 ($1,000/month/unit)
Effective Gross Income $114,000 (subtract 5 percent vacancy/loss of rents)
Taxes $12,500 (.0125 x purchase price)
Insurance $4,000 (.40 x 10,000 sq/ft)
Utilities $7,000 ($700 per unit per year x 10 units)
Maintenance $6,000 ($600 per unit per year x 10 units)
Management $5,700 (5 percent of the Effective Gross Income)
Cash Reserves $2,000 ($200 per unit per year x 10 units)
Second Trust Deed Payments $20,000 ($250,000 TD at 8 percent interest only for 5 years)

Total Expenses $57,200

Effective Gross $114,000
Less Total Expenses $57,200
Net Operating Income $56,800
Debt Service Coverage Ratio 1.15 (Debt Service Divided Net Operating Income)
Equals Annual DSCR $49,391
Interest Rate 7 percent
Amortized Over 30 years
New Loan Amount $615,000
Plus 2nd TD $250,000
Total Loan Amounts $865,000
Purchase Price $1,000,000
Deficit $135,000

As you can see, the second T.D. lowers the first loan’s proceeds. This is due to the second T.D. payment, which is treated as an extra expense. Remember, you should always use real numbers to evaluate a potential property. Even if you remove the management, because you are not going to pay yourself a management fee, take out the cash reserves, which is not a good idea as things will go wrong with a property and need repair, lower the utilities and maintenance to $600 and $500 per unit per year; you would still not have enough available cash flow for 100 percent financing.

Even though you are close to full leverage, you will have placed yourself in a tough spot as any major repair or vacancy would give you negative cash flow, per the example below:

Purchase Price $1,000,000
Units 10
Square Feet 10,000 (1,000 sq. ft per unit)
Gross Income $120,000 ($1,000/month/unit)
Effective Gross Income $114,000 (subtract 5 percent vacancy/loss of rents)
Taxes $12,500 (.0125 x purchase price)
Insurance $4,000 (.40 x 10,000 sq/ft)
Utilities $6,000 ($600 per unit per year x 10 units)
Maintenance $5,000 ($500 per unit per year x 10 units)
Management $0
Cash Reserves $0
Second Trust Deed Payments $20,000 ($250,000 TD at 8 percent interest only for 5 years)

Total Expenses $47,500

Effective Gross $114,000
Less Total Expenses $47,500
Net Operating Income $66,500
Debt Service Coverage Ratio 1.15 (Debt Service Divided Net Operating Income)
Equals Annual DSCR $57,826
Interest Rate 7 percent
Amortized Over 30 years
Loan Amount $720,000
Plus 2nd TD $250,000
Total Loan Amounts $970,000
Purchase Price $1,000,000
Deficit (Down Payment) $30,000

My readers should note that the above examples are also very generous in terms of price. You would be hard pressed to find a deal that works this well in Los Angeles currently. Unlike other areas of the country, Los Angeles County apartment property values are astronomically high. This is due to shrinking supply and ever increasing demand. An apartment loan is always going to be driven by the property’s actual income. One way to counteract this reality and enter the apartment market is to do so with other investors. Keep in mind that no matter how good or bad the current real estate market, a good deal will always sell quickly.

Mike Heayn is a Washington Mutual multi-family loan consultant. He can be reached at (310) 428-1342 or michael.heayn@wamu.net.