Buying Multifamily Realestate Risk

Loan to Value, Capital Expenditure and Buying on Actuals

Rules of Thumb, Part 5.

In our previous article, we discussed performing due diligence and provided a checklist for carrying out due diligence.  In this article, we want to examine

  • Loan to Value (LTV)
  • Capital Expenditure Accounts
  • Purchasing properties on actual numbers.

Here we go!

Loan-to-value is simply the relationship between the amount of the loan and the market value of the property. For example, if a property is worth $1 million and the loan is $700,000, then the LTV is 70% (700,000/1,000,000).

Commercial lenders are willing to lend 80% of a property’s appraised value, so you may be able to negotiate a lower down payment if you can show the bank that you have a solid business plan along with a proven track record. If you’re purchasing a home, first time home buyers can obtain excellent financing, sometimes putting down as little as 3% of the purchase price with the LTV on this mortgage being 97%.

In regards to investment property, the rule of thumb is that lenders usually require between 15 –25% as a down payment, but we’ve been able to negotiate 15% as a down payment due to our track record and relationship with the bank.

This allows us to reserve more capital for the next deal and achieve a higher cash-on-cash return. Novice investors can expect to put down 20% –25% of the purchase price because the bank views them as a higher risk. The reason for the higher equity on the property is a mode of protection just in case the bank has to foreclose on the property.

Let’s move on to Capital Expenditures. At first, some investors confuse capital expenditures with repairs. Replacing a few shingles on a roof is a repair while replacing the entire roof is a capital expenditure. A capital expenditure is a purchase to buy or upgrade physical assets with a useful life that lasts beyond the taxable year. 

Other examples of capital expenditures are replacing hot water heaters, purchasing appliances, paving driveways, and replacing siding.

Our rule of thumb is to allocate $250 per unit per year to a special cap ex fund that is responsible for these major repairs.  For example, on a 20 unit property, deposit $5000 per year ($250×12), or $420 per month.  One of our first mistakes was not funding a cap ex account. 

When we purchased our first property, the septic fields had to be replaced the following year.  We were fortunate to receive a great price for the job, and were allowed to pay over an extended period.  Life would have been much easier if we had built up our cap ex account.

The last rule of thumb, buying a property on actual numbers, is one of our most important rules.  When an investor purchases a property, he’s purchasing the income stream of the asset. The investor shouldn’t be concerned with future appreciation, but instead, should strive to generate a return on his investment.

Consider the future appreciation the icing on the cake.

Novice investors may concern themselves with what material the countertops are or what type of flooring the apartments have, but their main concern should be what’s going to be the return on the investment. Investors have to temper their emotions and focus on the actual numbers that the property is producing. A pro-forma statement is an estimate of what the property would be generating if it were achieving optimal performance. It’s our job to achieve pro-forma numbers, but buy on actual numbers.

When applying for financing, banks will not lend on pro-forma numbers and will require you to submit actual numbers on the property.  ALWAYS buy on actual numbers.  Any wise investor will tell you that money is made when you buy right.

In our next article, we are going to tackle another 3 rules of thumb. We hope this has been helpful.  We always refer back to the rules of thumb to keep us on the right path.