Financing Investment Property for Aspiring Landlords
Dreams of buying an investment property or two and becoming a landlord with a steady income stream can be enticing until you get to the nitty-gritty of qualifying for a mortgage loan.
Discounted properties that can be turned into rental homes always seem to be on the market. U.S. home prices are rising in many areas, including hard-hit Michigan, according to real estate data provier CoreLogic, though home sales have dropped.
For aspiring landlords who are new to buying investment properties, there's more to it than applying for a loan, adding some paint and then waiting for tenants to start handing you monthly rent checks.
Lenders make it more difficult to qualify for a loan for an investment property because it's more of a risk and easier for the owner to stop making payments on such a property than on their personal home, says Joe Parsons, a senior loan officer at PFS Funding in Dublin, Calif.
"An investment property is believed to have higher risk than an owner-occupied property," he says.
Here are a few things to keep in mind before buying investment properties:
Renting out a single-family house and getting a mortgage is one thing, but renting out a multi-unit property is another that can lead to more complex loan rules.
If you're buying a multi-unit complex, keep things simple by having one to four units, Parsons says. Those properties can qualify for conforming-type financing through Fannie Mae or Freddie Mac, and will normally require a 30 percent down payment to get the best terms, says Brian Koss, executive vice president of Mortgage Network in Danvers, MA.
"If you are buying a property with more than five units, there are a number of different financing options, including commercial and business loans," Koss says.
Low ratios, more down
Before hitting the market, Koss recommends determining your ability to obtain credit by having your income, credit and assets reviewed.
Many lenders will want a loan-to-value ratio, or LTV, of 75 percent, Parsons says. This is established by the lender getting an appraised value or purchase price of the home, and represents the ratio of the mortgage lien as a percentage of the total appraised value.
For example, borrowing $130,000 to buy a house worth $150,000 equates to a LTV ratio of $130,000 to $150,000, or 87 percent. The remaining 13 percent is covered by the borrower's equity.
To get the best rates, a 20 percent down payment is needed, and you'll need to pay points, Parsons says. Paying 1.25 points (with each point costing 1 percent of the mortgage amount) could drop an interest rate by 0.25 percentage points, he says. Putting more money down, such as 25 percent, could drop the loan's interest rate more without having to pay points because you're also dropping the loan amount.
To protect yourself from liability, consider forming a legal entity such as an LLC, says Teresa R. Martin, a real estate investor and coach. Having an established business for two years, along with financial statements for it, could help get a bank loan for an investment property.
Getting your credit in order can also help, Martin says. Typical parameters are 680 credit scores or better, 25 percent down, closing costs and six months of reserves.
Consider total cost of house
As with buying your own house to live in, a rental property includes costs beyond the house payment.
There could be homeowners' association dues, property taxes, insurance, repairs and maintenance. As a landlord, you may also have an empty property a few times a year if tenants move out, when you'll still be required to make monthly mortgage payments if no one lives there. Other rental costs could include advertising, property manager and paying for utilities.
If the lender calculates that you'll have a negative cash flow from the rental property, it will be treated as a debt and will affect your debt to income ratio, which should be 45 percent or less, Parsons says. That ratio is no different that it is if you live in the house, he says.
For new investment property owners, a lender may require that an experienced property manager be hired, Parsons says. For that service, expect to pay a 10 percent management fee that should be counted as another expense.
Research the market
Educate yourself on the local market, and dig deeper than the information a real estate broker give you, says David Hansel, president of Alpha Funding Solutions in Lakehurst, N.J.
"If you're buying rental property, you want to make sure you know what the local rents are," Hansel says.
Look for a property that can provide a modest return of 7 percent, he says. You should be able to afford it without having a tenant for four to six months, though two months may be more likely to be without a tenant, he says.
"Focus on an area and don't look to hit a home run," Hansel says.
Once you've identified a market of interest, have your mortgage banker pre-approve you for some of the listings in your area so you can see if you qualify, and if they match your standard expectation of return, Koss says.
Buy Fannie Mae foreclosures
Instead of a traditional conventional investment property loan that requires up to 25 percent down and up to 10 financed properties, an alternative is the Homepath program that allows investors to buy Fannie Mae foreclosures.
The program allows 10 percent down, no mortgage insurance, no appraisal and up to 20 properties can be financed, says Anthony VanDyke, president of ALV Mortgage in Salt Lake City, Utah. Renovation financing can sometimes be included, VanDyke says.
There are a few downsides: There's a small selection of homes because Fannie Mae doesn't foreclose on many homes, and the program may go away as foreclosures slow down.
'Hard money' loan
If you can't get a traditional loan from a bank, another route is to get what's called a "hard money" loan from private investors, also called "private money."
These have high interest rates - 12 percent, for example - and are usually kept for a year until the borrower can establish a credit history and return to a regular bank for a cheaper loan after seeing that the property has been rented for a year.
Credit doesn't matter with a hard money loan because the loan is secured by the property, says Kevin Tacher, founder of Independence Title in Fort Lauderdale, Fla. Up to 65 percent of the home's value after repairs can be loaned, Tacher says.
For example, a home worth $100,000 after repairs that's being sold for $65,000 to the investor can have a loan of up to $65,000, he says. If the borrower defaults on the loan, the lender takes the property.
Tacher cautions that his company doesn't lend to first-time investors, and would want the borrower to have some money in the deal to cover renovations, along with two to three months of reserves.
"It's more used for the novice investor than the savvy investor," he says.
For an investor who can afford a 12 percent loan for a year, hard money loans can help turn a dilapidated property into a much better one, says JJ Pawlowski, a managing member at Kansas City Investor Funding that provides hard money rehab loans.
After six months of ownership and an appraised value that's likely to be higher, investors can refinance with most banks, Pawlowski says. Besides, he says, most banks prefer not to do rehab loans.
"Most banks want to loan on something that's already fixed and already rented," he says.
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