Multiple-Unit Rentals
Require Tricky Financing

When Kelly Wong, a 44-year-old real-estate agent for Coldwell Banker in the Chicago area, sold a three-unit investment property in the city's Edgewater neighborhood in 2000, he walked off with $45,000 in after-tax profit.

So he set his sights on an even bigger building -- he had in mind a six-unit property (called a six-flat in Chicago) to generate rental income. But he soon discovered, as do many beginning investors, that a property with more than four units would require a commercial mortgage rather than a residential loan.

Mr. Wong had bought his first investment property by making a down payment with a $10,000 home-equity loan against his primary residence and a regular residential mortgage. But the new loan meant tying up his assets with a larger down payment, more scrutiny from the bank lender, and a more complex appraisal process that added to purchase costs.

Although he's pleased with the purchase, he warns investors to fully investigate the restrictions and complications involved in commercial loans before they set their hearts on larger properties. Mr. Wong arranged his commercial loan directly with a bank, but the structure was complicated compared to his first investment-related mortgage, which resembled a conventional home loan. The bank made last-minute requests: He found three days before closing that the bank wanted him to put $15,000 into escrow for repairs and upgrades. If possible, he concludes, "you want to avoid a commercial loan. Every commercial loan is unique, and the bank is more directly involved."

Brigid Mullen, a mortgage broker at Chicagoland Home Mortgage who handles commercial and residential loans, says about 10% of her clients find themselves in Mr. Wong's shoes. As fledgling investors begin making money from their first real-estate holdings, they decide to buy bigger properties that can show more return, but they may not know how to qualify for a commercial mortgage or if one is really in their best interests. For instance, should a buyer who wants to manage six units buy one six-plex using a commercial mortgage or two triplexes using residential loans?

Generally speaking, Ms. Mullen and other mortgage professionals recommend that new investors stick to residential loans when making their first property investment. After that, they might consider diving into a larger building requiring a commercial loan. However, a group of small investors might successfully pool together to buy property via the commercial route. Individuals who have a lot of cash but poor credit scores also may be more likely to secure a commercial loan, since commercial lenders place more emphasis on a building's potential to make money than on the individual buyer's credit history. Ms. Mullen says she's seen buyers with credit scores as low as 560 (on a scale of 300 to 800) secure commercial loans. (Basic mortgage lenders like a 620 minimum score for first-timers and "excellent" credit starts at 680.)

Here are some guidelines to keep in mind:

For a residential loan, a buyer's credit history, the ratio of loan-to-value and cash reserves are major criteria. Buyers of up to four units can tap a wide array of loan packages just as they can for a primary residence. Thus, they don't have to tie up a large sum of cash for the purchase. Interest rates track the residential mortgage market, which as of August 23, hovered around an average 5.43% for a 30-year fixed loan, according to Bankrate.com.

But national standards require a commercial loan for any property with more than four units. (The Mortgage Bankers Association notes that lending for multifamily buildings totaled $49.9 billion in 2003, up 22% or $8.9 billion over 2002.)

With a commercial loan, the property and its history of making money top a lender's list of criteria. Buyers will need to show lenders at least two years' worth of tax records and/or profit-and-loss statements from the building to demonstrate its success as a "business enterprise." They will also have to make a higher down payment -- a minimum of 20% to satisfy commercial-lending requirements, and borrow at a higher rate. For small investors, interest rates may be about one percentage point higher than residential mortgage rates.

Both Ms. Mullen and Richard Juergens, president of Frank S. Phillips Mortgage Corp. in Bethesda, Md., say commercial loans, unlike many residential loans, are rarely arranged at fixed rates or for 30 years. Ms. Mullen says most commercial loans she's arranged on residential property have been adjustable-rate mortgages with 20-year life spans. Mr. Juergens says most commercial loans he originates have an adjustable component and may also have balloon clauses, which require you to pay off the outstanding balance or refinance at the end of a term.

Buyers using residential loans may pay from $200 to $400 for a property appraisal, but buyers using a commercial loan pay anywhere from $1,000 to $2,000. That's because a commercial appraisal evaluates both the building's structure and its "financials" -- vacancy rates, whether it's self-supporting, and how it competes with similar properties in the area.

The two loan formats will appeal to different types of investment buyers, depending on their goals. While both subject buyers to capital-gains taxes if a property is sold less than two years after closing, there may be tax and accounting differences. Those seeking a commercial loan, for instance, might form a limited-liability corporation for tax purposes, which allows different types of write-offs than a residential buyer would be eligible for.

Residential mortgages may be good for buyers planning to hold on to a property as a long-term investment. A residential mortgage with a 30-year term could be easier to manage than a commercial loan requiring a higher down payment and fluctuating rates.

Are you considering buying a place and renting it at a loss for a few years, perhaps until the local economy or rental market picks up and profits can kick in? A residential loan might be easier to secure since commercial lenders want to see proof of profitability. A buyer investing in a not-yet-gentrified neighborhood or buying amid a lousy rental market might find the commercial lender asking, "Why would you want to buy a building that isn't already making money?'' Ms. Mullen says.

There are advantages to commercial loans for some buyers, though, particularly if they're planning to "flip" a property within a short timeframe. A commercial loan might provide an attractive near-term rate, ideal for such buyers.

Planning to pair up with other investors? A commercial loan on a multiunit building may be a useful strategy. Though the average commercial-mortgage loan at Mr. Juergens's company was $10 million last year, his firm -- and others like it -- will arrange equity deals in which individual buyers pool their assets to share a commercial loan on residential property. The minimum loan his firm will handle for such deals is $500,000 -- but buyers don't have to be rich if they partner to share the costs of the purchase.

Mr. Juergens says the difference between residential- and commercial-mortgage loans boils down to this: "With a residential loan, you're not deemed to be a knowledgeable buyer. With a commercial loan, you're considered a knowledgeable buyer."

-- Ms. Hodges is a free-lance writer in Seattle.

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