How Apartment Financing Works
Two loans, a handful of ratios, and one number that turns borrowed money into a monthly rent requirement.
In Lesson 2 we saw that most of the money in a new apartment building is borrowed. This lesson explains how that borrowing actually works: the two loans a project usually passes through, the ratios lenders use to decide how much to lend, and the arithmetic that turns a loan balance into a monthly payment.
By the end you should be able to look at a loan amount and an interest rate and estimate, within a few dollars, how much rent the building must collect just to pay the bank. That single link, from debt to rent, is the one most people are missing when they ask why new apartments cost what they do.
Two loans, not one
A new building is a poor thing to lend against while it is half built. It has no tenants, no income, and a long list of things that could still go wrong. So the lending is split into two stages, each with its own lender, terms, and risks.
The first is the construction loan. It is not handed over as a lump sum. The developer draws on it in pieces as work is completed, typically each month after an inspector confirms that the concrete, framing, or drywall being billed for is actually in place. Interest is charged only on what has been drawn so far, and during construction the borrower pays interest only, no principal. Because the building produces no income yet, that interest is usually funded from an interest reserve, a portion of the loan set aside at the start to pay the loan's own interest. The reserve is part of the "financing costs" line in the budget from earlier lessons.
Construction lenders also want someone on the hook if the project fails. Most construction loans are recourse, meaning the lender can pursue the developer or its principals personally, usually through a guaranty that promises the building will be completed and the loan repaid. That personal exposure is one reason developers are careful about which projects they start.
The second stage is the permanent loan. Once the building is finished and leased to a steady occupancy, a point lenders call stabilization, a long-term lender pays off the construction loan and replaces it with a mortgage that is repaid over decades. Permanent loans are usually non-recourse: the building itself is the collateral. The rest of this lesson is about the permanent loan, because it is the one that shapes rent for the life of the building.
How lenders decide how much to lend
A lender never funds the whole cost. It sizes the loan with three tests and lends the smallest amount that passes all of them.
- Loan-to-cost (LTC) compares the loan to what the project costs to build. Our illustration uses 65%: on a $24,000,000 building, the loan is $15,600,000 and the remaining $8,400,000 is equity, money the owners put in themselves.
- Loan-to-value (LTV) compares the loan to what the finished building is worth, as estimated by an appraiser. If the building is worth less than it cost to build, LTV becomes the binding limit and the loan shrinks.
- Debt service coverage ratio (DSCR) compares the building's expected net operating income to the annual loan payment. A ratio of 1.25 means income is 25% larger than the payment. Lenders set a minimum, and if projected income is too thin, the loan is cut until the ratio is met.
The practical effect is that whatever the lender will not fund, the owners must. Less debt means more equity, and as the next lesson explains, equity is the more expensive money.
Amortization and the mortgage constant
A permanent loan is repaid through amortization: a fixed monthly payment that covers the interest owed that month and a slice of the principal. Early on, nearly all of the payment is interest; over the years the mix shifts toward principal. The total paid to the lender each year is called debt service.
The cleanest way to think about debt service is the mortgage constant: the annual payment expressed as a percentage of the loan amount. It bundles the interest rate and the repayment period into one number.
monthly payment = loan × (r ÷ 12) ÷ (1 − (1 + r ÷ 12)^−(years × 12))
mortgage constant = monthly payment × 12 ÷ loan
annual debt service = loan × mortgage constantr is the annual interest rate. The constant depends only on the rate and the amortization period, not on the size of the loan.
At 6.5% over 30 years: $15,600,000 × 7.585% = $1,183,231 per yearThe first payment is $84,500 of interest and $14,103 of principal. Interest is $15,600,000 × 6.5% ÷ 12.
Notice how little of that first payment reduces the loan. Interest on $15,600,000 at 6.5% is $84,500 in the first month, so only $14,103 of the $98,603 goes to principal. The building's tenants are, in effect, paying the lender's interest first and buying the owners a small piece of the building second.
Why the rate matters so much
Because debt service is the largest single claim on a building's income, the interest rate has more leverage over rent than almost any other input. Holding everything else in our illustration fixed and changing only the rate on the permanent loan gives the following.
| Interest rate | Mortgage constant | Annual debt service | Required rent per unit per month |
|---|---|---|---|
| 4.5% | 6.08% | $948,515 | $1,948 |
| 5.5% | 6.81% | $1,062,901 | $2,048 |
| 6.5% | 7.585% | $1,183,231 | $2,154 |
| 7.5% | 8.39% | $1,308,930 | $2,264 |
Each percentage point of interest moves the required rent by roughly $100 to $110 per unit per month on this building. Nothing about the building changed: same land, same concrete, same staffing. Only the price of the borrowed money moved. The launch article What a 1% Rate Increase Does to Rent works through this in more detail.
The amortization period matters too, though less. Stretching the same 6.5% loan from 30 years to 40 lowers the constant from 7.585% to about 7.03%; shortening it to 25 years raises the constant to about 8.10%. Longer amortization lowers the payment, but most permanent lenders will not go past 30 years, and government-backed programs are usually where longer terms are found.
Illustrative 100-unit building with a total development cost of $24,000,000 ($240,000 per unit).
Permanent loan at 65% loan-to-cost: $15,600,000. Equity: $8,400,000.
Interest rate 6.5%, 30-year amortization, monthly payments. Mortgage constant 7.585%.
Required return on equity 8% per year ($672,000); operating expenses $600,000 per year; vacancy and credit loss 5%. These feed the "required rent" column and are explained in Lessons 4 and 6.
The rate table changes only the interest rate on the permanent loan. Construction-loan interest is treated as part of the fixed $1,200,000 financing-and-contingency line and not varied.
All figures are illustrative and rounded to the nearest dollar. They come from applying standard mortgage arithmetic to the assumptions above; no lender quote or rate survey lies behind them, and the terms of a real loan should be taken from the lender offering it.
A lower loan-to-cost ratio, say 55%, would cut debt service but raise the equity share, and equity requires a higher return, so the required rent would not fall as much as the smaller loan suggests.
A government-backed permanent loan with a 35- or 40-year amortization would lower the mortgage constant and, all else equal, the required rent.
A rate lock, interest-rate cap, or hedge would shift some of the risk in the table above from the building's tenants to a financial counterparty, at a cost that appears in the financing line.
If the appraised value came in below cost, the loan-to-value test would shrink the loan, increase the equity, and raise the required rent.
The lender has been paid. The question that remains is why the owners, who put in the other $8,400,000, insist on being paid too, and what happens when they are not. Next lesson: Lesson 6: Why Investors Require Returns.
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