Four units is the ceiling of ordinary home lending. Freddie Mac’s table of maximum loan-to-value ratios runs to one-unit and two-to-four-unit properties and stops there: 75% on a two-to-four-unit investment purchase, 85% on a single-family one. Above four units the table has nothing to say, because those loans are not the product.
That one line in a rate sheet is the whole difference between buying a fourplex and buying a six-unit building.
What changes at five units?
Three things, and the first is the one that catches buyers out.
- The loan is sized on the building, not on you. A home lender checks your income and your credit, then lends against the price. A commercial lender starts from what the building earns and asks whether that covers the payment with room to spare.
- The note comes due before it is paid off. The payment is usually worked out over 25 or 30 years, but the loan itself matures in five, seven or ten. On the maturity date the balance is due in full, so you refinance or sell at whatever rates exist that year. The CFPB describes a balloon payment as a large, one-time payment at the end of the loan term, and warns that you can lose the property if you cannot make it.
- Nothing is standardised. There is no agency rulebook for these loans the way there is for the loans Freddie Mac buys. Coverage floors, terms and reserve requirements are set lender by lender, so two quotes on the same building can lend very different amounts.
How does a lender size the loan?
By coverage. The lender divides the building’s net operating income, which is its income after running costs and before any loan payment, by the yearly loan payments. A floor of 1.25 means the income has to be 1.25 times the payments.
Work that backwards and it gives a maximum loan. Whatever the loan-to-value would have allowed above that figure is not a loan you can argue for. It is cash you have to bring.
What the six-unit building earns
A six-unit building at $900,000, which is $150,000 a unit, all six let at $1,700. Property taxes are $11,000 a year, insurance $6,500, and the building pays $700 a month for water, trash and common-area power. Repairs and big-ticket savings take 5% of the rent roll each, management 8%, and vacancy is set at 6%. The loan is 75% of the price at 7.5%, paid down over 30 years.
| Monthly | |
|---|---|
| Rent roll (six units at $1,700) | $10,200 |
| Empty and unpaid (6%) | −$612 |
| Property taxes | −$916 |
| Insurance | −$542 |
| Water, trash and common-area power | −$700 |
| Repairs (5% of the rent roll) | −$510 |
| Big-ticket savings (5%) | −$510 |
| Property management (8%) | −$816 |
| Loan payment ($675,000 at 7.5%) | −$4,720 |
| Cash flow each month | +$874 |
These are example figures, not a forecast for any market.
Running costs here are 41.7% of the income. Well under 40% on a seller’s sheet normally means a line is missing rather than that the building is cheap to run: water and sewer, trash, hallway power, lawn care, snow, or a resident manager. Net operating income comes to $67,124 a year, a 7.5% cap rate on the asking price.
What does the income test cost you?
At $67,124 of income the payments on a $675,000 loan give a coverage ratio of 1.19. A lender holding a 1.25 floor will not write that loan. The most that income supports at 7.5% over 30 years is $639,994.
The price did not change, so the $35,006 the lender withheld comes from you.
| The 75% loan | The income-sized loan | |
|---|---|---|
| Down payment | $225,000 | $260,006 |
| Closing costs (3%) | $27,000 | $27,000 |
| Cash to close | $252,000 | $287,006 |
The smaller loan is not all bad news. The payment falls to $4,475 a month, so cash flow rises from $874 to $1,119 and coverage lands exactly on 1.25. You bought that cushion with $35,006 of your own money.
This is the gap to model before you make an offer, because it is the one number a seller’s marketing package will never show you. Type the lender’s minimum coverage into the multifamily calculator and it reports what the income supports next to the loan you asked for.
What happens when the note comes due?
On the $675,000 loan at 7.5%, five years of payments leave $638,668 still owed on the maturity date. On the income-sized loan it is $605,546.
Neither number is a payment you make out of rent. It is a refinance you are committed to five years from now, and its terms depend on three things you cannot see yet: the rate that year, what the building appraises for, and what it earns by then. If rents have grown, the refinance is comfortable. If the rate is two points higher, the same income supports a smaller loan than the one coming due, and the difference is cash again.
That is the argument for underwriting a building at today’s rents rather than the rents a broker says are achievable. Reading a fourplex line by line shows what one empty unit does to the same arithmetic, and what counts as net operating income covers the figure the whole loan hangs on.
What should you check before you offer?
- Ask the lender for the coverage floor and the maturity, in writing, before you price the deal. Both change the cash you need, and neither is negotiable after you are under contract.
- Run the building at today’s rent roll, with the empty units marked empty. A building sold on market rents is being sold on a forecast.
- Work out the balance at maturity and ask what rent it would take to refinance it at two points higher.
- Compare on price per unit and rent per unit, which is how two buildings at different prices get set beside each other.
If the deal only works at the loan-to-value limit, it does not work. The lender’s floor is the constraint that decides it.