Buy Fourplexes: Refinance One of Your Bigger Buildings
Several of my clients – particularly, those who often seem to be ahead of the curve – started doing this last year and so far it seems to have worked out pretty well.
Abstract: As you know, there are constraints on new mortgages that weren’t in place a year ago and they’re not going away. We have to learn to work within the new restrictions. This usually means managing the underlying financing so the borrower benefits as much as he can. As rates go up some of the items that need to be managed are the (a) interest paid over the life of the loan, (b) effect on cash flow and (c) impact upon resale. There are also some situations where it probably wouldn’t be appropriate to actively manage costs of debt.
The New Mortgage Restrictions
It’s become increasingly difficult to borrow money on both one to four unit residential properties and residential investment properties (i.e., 5+ units) due to three major hurdles.
- Minimum Loans: Primary lenders (those with favorable rates / fees / terms) are reluctant to fund apartment loans (five units and up) under $500,000. Some require a $1,000,000 loan application before they’ll even return calls. It doesn’t make any difference whether it’s a purchase loan or a refinance.
- Limits on Mortgages: Second, the banks have placed a limit on the number of residential properties (1-4 units) they will allow to be mortgaged. Used to be that nobody cared: as long as your credit and income were satisfactory you could borrow against a new property any time you wished. That’s no longer the case. Now an investor can have a maximum of 10 residential property mortgages (1-4 units), including the personal residence, and still qualify for a rate and term (no cash out) refinance. To refinance and receive cash out the investor is limited to a maximum of four (1-4 unit) mortgages.
- Changes in Rates: Lastly, rates are going up. The Fiscal Times recently stated “The likelihood of rates going up in the near future is almost beyond dispute” and “That rising interest rates are practically inevitable means the price of servicing the federal debt is about to jump” because “. . . the cost of servicing both new debt and debt that is rolled over in the form of newly-issued Treasury securities (increases)”.
Working Within the Restrictions
As long as your (residential) mortgages do not exceed 10, you’re eligible for financing at terms significantly better than commercial loans simply because 30 year fixed rate mortgages are available. That’s particularly important if you agree with the Fiscal Times about interest rates increasing. A fixed rate doesn’t go up.
If we think of apartment buildings as individual streams of income, then as underlying variable interest rates rise there will be less cash flow for the investor. One way to deal with this issue is to refinance into a longer fixed rate period. What this does is to kick the can down the road five or 7 years or so before the loan inevitably shifts to a variable rate, per its terms.
Another way to deal with increasing interest rates is to transfer a portion of your portfolio to assets with fixed rate mortgages. Refinance a larger property, usually one whose loan has already – or soon will – reach the end of its fixed rate period and use the proceeds to begin a portfolio of three or 4 unit buildings. This effectively transfers a portion of the investor’s wealth, whatever portion you wish, to properties with a fixed rate mortgage. It also benefits the larger property because it makes the mortgage on the larger property “fixed” for several years.
Here’s something that often isn’t immediately considered: a 32 unit building has very little liquidity. You can refinance it, but you have to refinance all thirty-two units. You can’t say, “I know its 32 units, but I just want to refi these eight units.”
You can sell it, but you have to sell all 32 units, and then where would you be? But instead of having one 32 unit building, if you had 8 fourplexes – same number of units – and needed some money you could refinance (or even sell) just one of them. Your options are improved.
Should I Buy Now or Wait?
The question is, would it be better to buy now (lower rates / higher price) before the expected rate increases make their big moves, or wait (higher rates / lower prices) until maybe values drop? This question is coming up with increasing frequency as rates leave the dinner table and lace up their running shoes. There are probably many ways to look at the problem, but one simplified way is to compare total interest payments against price change.
We understand that a change in interest rates will affect value, certainly with larger properties, but also with three and 4 unit buildings. At any given net operating income, as rates go down the property value goes up. Alternatively, as rates go up, property value goes down. It’s capitalization at the most basic level. Don’t think fourplexes are immune from capitalization. FreddieMac rates were 16.63% in 1981, dropping to 3.98% in 2013. No wonder values went up!
Rates dropped an average of 40 basis points (0.4%) annually over 32 years. That’s less than half a percent per year. Most people wouldn’t even notice. But it continued for three decades and the cumulative decline helped the value of rental units to skyrocket.
Caveat: Notwithstanding the general wisdom that higher interest / cap rates are bad for investment values, under particular conditions increased interest / cap rates may not result in significant loss for some folks.
The following example is a thought experiment regarding the possible offsets of lowered purchase price vs. increased interest rates. Only certain variables will be tested while others will be strictly controlled. It is stipulated that (a) the same property is offered at two different times; (b) the property experienced no changes in NOI; (c) the mortgage remained at the same interest rate for 30 years, and (d) capitalization and interest rates were the same number.
Total Interest Paid
Now: Assume cap / interest rates are both at 5%. Asking price is $1,000,000. With about 1/3rd down we could borrow $650,000 for 30 years. The monthly payment would be $3,489 ($41,868 annually). Over a 30 year loan term the total principal and interest paid comes to $1,256,000 (rounded). Subtract the original principal ($650,000) and we determine that the total interest paid over 30 years is $606,000 (rounded).
Future: Assume we wait and cap / interest rates rise to 7%. The property hasn’t sold and last Friday the price was reduced to $714,000 (reflecting the 7% cap rate). You seize the moment. After putting 1/3rd down ($238,000) we would need to borrow $476,000 and the payments would be $3,167 ($38,000 annually), or $1,140,000 over 30 years. Subtract the original loan amount and we find the interest has totaled $664,000.
Result: At the higher interest rate the borrower paid $58,000 more interest over 30 years ($161 monthly over 360 months): ($664,000 minus $606,000).
Now: At the original $1,000,000 price the 5% cap rate yields a Net Operating Income of $50,000. Subtract yearly debt service of $42,000 (rounded) and we find the annual cash flow is about $8,000. That’s 2.3% on the down payment.
Future: The price has been adjusted to $714,000 while the NOI remained unchanged at $50,000. New annual debt service is $38,000. Cash flow is $12,000 (5%).
Result: The reduced purchase price increases cash flow by $4,000 a year (30 year total: $120,000).
Generally speaking, for an investor the worth of a property is the capitalized value of the stream of net income. You’ll see immediately the problem. How could we credibly forecast the net income of a property three decades hence? Or even guess at the market capitalization rate in 2044? Use this section (“Resale”) as a continuation of our thought experiment.
Net Income: The U.S. Department of Labor has a clever little inflation calculator on their website that shows cumulative inflation has been 134% during the 30 years from 1983 to 2013 (most recent year available). If that rate continues this property’s present NOI of $50,000, adjusted for inflation, forecasts to be $117,000 in 2043.
Cap Rate: Cap rates almost never exactly mirror interest rates, but interest rates do give us a reference to work from. FreddieMac.com reports that the average mortgage rate thirty years ago in 1983 was 13.24%. In 2013 the average was 3.98%. Can we agree that the 1983 rate was unusually high and the 2013 rate unusually low? An average of the two extremes comes to 8.61%. Call it 8.5% (rounded). For this example we’re going to pluck that 8.5% from the plucking place and call it a capitalization rate. That may not be too far off the mark. If you noodle around you’ll find those cap rates in the non-coastal states even today.
When you sell the property nobody cares what you paid for it. They only care about the benefits they’re getting. Remember the four rules of purchase: (1) What am I going to get? (2) When am I going to get it? (3) What will it cost me? and (4) When do I have to pay it? To the new buyer, what the seller paid for the property isn’t even on the table.
Here’s the math: $117,000 divided by the projected cap rate (0.085) is $1,376,000 (rounded). If you’d bought it for $1,000,000 your capital gains would be $376,000; if at $714,000 your capital gains would be $662,000. The sales value is independent of your purchase price.
Result: If we project NOI at the rate of inflation and cap rates at the mean of the annual average high and low interest rates over the past 30 years, the property will appreciate (inflate) slightly faster than rising cap rates dilute its value.
That may not seem like such a good deal, but the $1,376,000 (includes your down payment) is all yours. The tenants have paid off the mortgage. You have turned $350,000 (assuming a $1,000,000 purchase price) into almost 400% gain on your down payment over 30 years. Appreciation and equity build up have provided a 4.67% compounded year after year return over three decades. In addition, you’ve been collecting the net cash flows which we expect to have maintained parity with inflation.
Had you bought at $714,000 you would have turned $238,000 into $1,376,000 in thirty years. In this case, you would have made a touch over 6% per year, compounded. You would have multiplied your down payment about 575%.
There could be an awful lot of benefits in what we discussed above – pulling money out of a (variable rate) larger building and buying properties financed 30 year fixed rate loans – but that doesn’t mean everybody should do it. As one example, if the underlying loan document states that your interest rate “cap” (as in the highest rate that particular loan can ever go) is in the single digits . . . personally, I think I’d be reluctant to refinance. A new loan will almost certainly have a higher cap and that reduces the long-term desirability of the refi.
I’d also be hesitant to refinance the bigger property if I was living off its income. In that case, all a refi would do is to exchange (future) monthly cash flows for a lump sum payment right now. That may not be a trade I’d seek unless there were no alternatives.
We saw that during the portion of the interest rate cycle where rates are trending downwards a person could become financially comfortable just by refinancing their home and buying a small apartment building. Then, as rates go down and prices go up, refinancing to buy ever more units. Qualification standards were reduced and mortgages are easily acquired. But eventually rates bounced off the bottom and begin to climb back up.
There is a huge issue with rising rates, especially when they flip out of their 5 or 7 or 10 year fixed rate period: we don’t know how high they’ll go. The borrower has to be comfortable with the prospect of 20 to 30 years of ever increasing loan payments. Even at 40 basis points a year, that adds up.
The question is can you raise your NOI enough over a three decade period to offset rising interest rates? There are three ways to handle this question.
1. First, get a loan with a long initial fixed rate period. Hypothetically, if rates rise for 30 years (well, they went down for 30 years, didn’t they?) and you serially refinance every time the existing loan turns adjustable then you’d be looking at the initial refi to get the first 7 years fixed, then three successive refinances (each with a 7 year fixed rate period). That would probably pretty much cover most of the upswing.
If we’re in a rate upswing, the interest rate would rise at each refi, but the total interest paid over the 30 year period should be materially less than if the loan were “adjustable” during that time.
2. Second alternative, refi into a loan with a low interest rate ceiling and just keep it. Sure, it’ll go adjustable but if your ceiling is, say, 9.5% it will never rise above that level regardless of what the market does. The trick here is to not wait. Ceilings are generally figured at a certain percent above the loan’s index plus a margin. So if the loan docs state that the ceiling is 4 or 5 points over the initial rate you know that will be your worst case situation. If this is your choice it might be best to do something pretty soon, because if rates are going up that means they’re about as low right now as they will be. If you wait to refi, both your initial rate will be higher and you’ll lock in a higher ceiling.
3. Thirdly, buy properties that can be financed with long term fixed rate mortgages. Mostly right now, that’s 3 and 4 unit buildings. You can refinance an existing larger apartment building (and benefit from the extended fixed rate period as indicated above), pull cash out, and buy one or more triplexes or fourplexes. In this way you are protecting some, most, or all of your equity from the expected rise in interest rates.
Disclaimer: This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].
If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.