A New High-Impact Loan Option For Real Estate Investors?

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In the past few months, we have published a couple of robust overviews of DSCR loans, a popular loan product that has entered the scene over the past few years. DSCR loans enable investors to qualify for a mortgage loan on an investment property without consideration for personal income or “DTI” ratios—making these loans a top option for investors scaling portfolios, especially for single-family rental properties.

Qualifying for the best rates and terms for DSCR loans is primarily driven by three factors: leverage, property cash flow, and credit. After that, investors can use advanced strategies such as optimally structuring loan terms such as prepayment penalties, adjustable rate options, and borrowing entities to tailor DSCR loans to their specific investing needs.

DSCR loans are typically the best option for investors ready to scale, and first-time investors are usually better suited for conventional financing, which typically have slightly lower rates. Investors generally “graduate” to DSCR loans after having a few investment properties under their belt since there are limits on the number of conventional loans that can be used for investment properties, DTI qualification becomes much tougher with a growing portfolio and the hassle and paperwork can become too much when trying to scale aggressively. While DSCR loans can be a great option for a first or second-time investor, especially for ones who don’t have steady W-2 income (a growing proportion of the population!), the loan product is really best suited for investors looking to scale their way to financial freedom.

More Doors—Ready to Scale

The path of many investors on the journey from real estate rookie to a professional portfolio is to start small—house hacking a duplex, utilizing ultra-low down payment government-sponsored loan products, or experimenting with renting out a vacation property part-time. After gaining well-worn experience owning and operating properties, many investors will take the proverbial next step. They need to shift focus towards seizing opportunities for new deals and more units—and don’t have the time deal to deal with all of the headaches of self-management, conventional loan packages, and the constant personal upheaval of moving every couple of years while “hacking” the process.

When investors face this phase of their investing journey—the time to scale—it often comes hand-in-hand with an interest in investing in multifamily. The reasons are obvious. When it comes to cash flow, generally, the more units, the better. Why settle for one tenant in a single-family residence paying you rent every month when you could get eight checks every month with an octuplex?  

There are also economies of scale—hiring a property manager to deal with maintenance, tenant issues, leasing, and more in a single-family property can really cut into cash flows (or doing it yourself can cost a lot of time and energy). But with multiple units, the cost of a property manager is much more reasonable, considering it will likely be a far smaller portion of the property’s rental income.

In general, the economics, when it comes to cash flow, are far more friendly when you have multiple units rented out. In addition, while as or more important, if harder to quantify, the time and energy considerations are often much better too. It’s far less demanding to find, own, and operate one eight-unit property than eight separate single-family rental properties all across town!

The Definition of “Multifamily”

Surprisingly, when it comes to real estate financing, the definition of what exactly qualifies as a “multifamily” property is not as simple as it sounds. Most simply, multifamily should mean any property that has more than one unit, so everything from a duplex (two units) to a 300+ unit high-rise should count. However, when it comes to the mortgage industry, generally, properties that have 2-4 units (typically referred to as “duplexes,” “triplexes,” and “quadruplexes”) actually do not fall under the multifamily bucket.  

Quasi-government agencies such as Fannie Mae and Freddie Mac dominate real estate finance in the United States, and they pool mortgages into securitizations consisting of 1-4 unit-backed properties. These “conventionally” financed mortgages have a limit of four units, and all fall under the “residential” bucket. The mortgage-backed securities are referred to as RMBS or “Residential Mortgage Backed Securities.” Any loan secured by a property with five units or more is considered multifamily and not eligible for these RMBS securitizations and is typically lumped in with only larger multifamily properties or other commercial real estate loans in CMBS deals or “Commercial Mortgage Backed Securities.”

DSCR loans typically fall under the non-QM bucket for RMBS securitizations and have traditionally been limited to properties of no more than four units. But this definition is arbitrary (as described above—calling a four-unit property “residential” but a five-unit “multifamily” is based less on logic than on Freddie and Fannie rules). And a great thing about non-QM loan programs is that they do not have set and strict rules that loans that qualify for conventional products (QM) must follow—DSCR lenders and securitization platforms can be much more creative and flexible. DSCR loans for properties with more than four units are a great example of this!

Multifamily DSCR Loans

While DSCR loans have traditionally been limited to properties with between one and four units, in the last couple of years, some of the more forward-thinking DSCR mortgage lenders have expanded the product to properties with up to eight or even ten units. Some lenders have even branched out further and expanded the product to mixed-use properties that contain a commercial unit or two as well.

The multifamily DSCR loan is thus an exciting new option for real estate investors looking to scale and enter the world of multifamily real estate investing. And just like its often best for real estate rookies to start small with house hacking or lower-cost fixer-upper SFRs, its typically a smart path for investors new to multifamily investing to also start small—with door counts in the single-digit range—rather than jumping too quickly with large complexes and complicated syndication structures.  

Traditional Multifamily Loans vs. Multifamily DSCR Loans and Their Key Differences

Multifamily DSCR loans, typically eligible for properties with a range of 5-10 units, are structured very similar to normal DSCR loans, which can be quite a contrast in multiple ways with more traditional multifamily financing options, which are closer in terms and structure to loans secured by commercial real estate (such as offices, retail and industrial properties). Also, it is important to note that DSCR loans and the traditional small-balance commercial real estate loans described here are applicable to stabilized or turnkey properties only (properties that are fully leased or leasable and require no immediate repairs or rehabilitation). “Value-add” properties intended to undergo a substantial renovation or turnover are covered by different loan products.

Loan structure and term

Multifamily DSCR loans are 30-year loans and are fully amortizing (fixed payment throughout), either from the start or after interest-only payments for the first 10 years.

Traditional multifamily commercial loans will typically be 5-10 year terms, amortize on a 20-30 year schedule and require a balloon payment at maturity, which creates immense refinance or selling pressure towards the end of the term.

DSCR calculation

Multifamily DSCR loans are underwritten more like single-family rental investment property loans—with the DSCR calculation determined as rent divided by PITIA (principal + interest + tax + insurance + HOA) expenses.  

Traditional multifamily lenders will calculate DSCR through the traditional commercial method, which is net operating income (NOI) divided by debt service. Here, the property tax and insurance numbers are included in the numerator, but most importantly, many more expenses are also included—typically including repairs and maintenance, utilities, management fees, allocations for vacancies, credit loss, and replacement reserves. This method of underwriting thus includes a much larger expense number and results in a lesser DSCR (even if looking at the same property)

DSCR and LTV requirements

Multifamily DSCR loans are much easier to qualify for. Not only is the DSCR calculation more forgiving and includes fewer expenses, but the minimum is usually a 1.15x or even 1.00x DSCR ratio! Leverage (LTV ratio) is generally up to 75% as well, allowing these properties to be purchased with as little as 25% down.

Traditional multifamily lenders will have a much more conservative DSCR calculation method and higher DSCR minimums—typically 1.25x. Leverage can sometimes be higher. However, with current interest rates, shorter amortization terms, and high DSCR hurdles mean the maximum leverage can now fall closer to the 55%-65% range.

Interest rates

Multifamily DSCR loans will tend to have interest rates that are a bit higher than traditional small-balance commercial lenders. However, most real estate investors, especially those focused on cash flow, care more about the monthly payment rather than the interest rate. In fact, the math can be very surprising for a lot of borrowers when you crunch the numbers. Let’s look at this example, a $500,000 loan under representative structures:

• Multifamily DSCR Loan
  • $500,000 Loan Amount
  • 8.500% Interest Rate
  • 30-Year Fixed Rate Term, 10-Year Interest-Only Option

= Monthly Payment of $3,541.67

• Traditional Small Balance Commercial Multifamily Loan
  • $500,000 Loan Amount
  • 7.000% Interest Rate
  • 10-Year Fixed Rate Term, 25-Year Amortization

= Monthly Payment of $3,533.90

Despite the interest rate being a whopping 150 basis points (1.50%, 8.5% vs. 7%) lower for the traditional loan option, the monthly payment is essentially the same! (A difference of $7.77 per month, or 0.22%!) Once you run these numbers, it’s clear why even with higher rates, investors love the multifamily DSCR loan option, essentially the same monthly payments coupled with a much easier qualification, longer, more stress-free terms (no balloons!), and likely higher leverage!

Conclusion

So are multifamily DSCR loans the best-kept secret in financing for real estate investment properties? Arguably, yes!  

While still a niche product (to our knowledge, this product is strictly capped at properties with the specific unit range of 5-10), it’s often surprising how many of these sized properties dot the map nationwide. And with current trends pushing communities towards building more multi-unit housing, it stands to reason this niche will only grow in terms of opportunity and volume over time!  

Multifamily DSCR loans should be in the toolkit of any real estate investor looking to scale a portfolio towards financial freedom (which, if you are reading BiggerPockets, chances are this describes you now or in the near future!)

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.