How to Finance a Rental Property | Minneapolis Property Management Advice
Tom Sedlack - Wednesday, December 7, 2016
I’m sure you’ve been inundated with lots of offers and interest from third parties that want to help you finance an investment property, but there are a limited number of good choices. Residential brokerage companies, Realtors, mortgage loan officers, and other realty service providers can provide some guidance and help when it comes to rental property financing, but ultimately, it’s up to the individual investor to pick and choose from the best alternatives out there to maximize the benefits of financing, minimize the cost, and of course it all drives down to the bottom line for your return on investment.
Gone are the days of no money down investments or low document/no document purchases or stated income loans. All of that has gone after the housing crash and with the implementation of Dodd/Frank, which drastically limited the amount of creativity that banks were taking to qualify investments and investment properties.
Qualifying for Conventional Financing
Today, it does take about 25 percent down to finance an investment property. Usually, the rates are a little higher. The points might be higher with rate parity, and loan reserves are also important for rental properties. Typically, there’s a six month or more loan reserve requirement based on the rental amounts for any properties you have already. You need to have that on reserve before you can qualify for financing for an additional rental purchase. They will season the existing leases and if they aren’t in excess for a year or you haven’t had the property for more than a year, it won’t qualify for seasoning. So, those rental incomes won’t qualify.
If you’re just starting out, you can get a conventional loan for the purchase of your first through fourth property. You can find that most banks and credit unions will provide conventional financing for an investment property. They’ll ask for that 25 percent down and the interest rate must be negotiated to determine whether it’s competitive.
Fannie Mae 5 – 9 Loan
Once you get above four properties, it becomes more difficult to get a mortgage. There is a program called the Fannie Mae 5 – 9 Loan. This requires a lot of documentation. You’ll need loan reserves for each rental property, you still have to put 25 percent down, and the interest rate typically can be a little bit higher. Talk to your lending institution about whether they support these loans.
If you’re buying a duplex or a fourplex, you can consider living there. If you’re living in a duplex and you’re renting out the other side, you can qualify for a residential loan. It’s the same thing with a fourplex; as long as you don’t have more than four units, you can qualify for a residential loan at residential rates. The amount of the building will be subject to the minimum down payment and your interest rate will be a little less because they are residential. This is an option for you if you want to live in the property you buy.
Converting a residence is another very popular way to get yourself into rentals. You might even be living in the home that will become your next rental property. By living in that home, you qualify for a residential loan to buy your next property. You must live in your property for at least a year, and you can go back to your old property and fix it up and use it as a rental. That’s one of the best ways to convert a home into a rental or to get additional rental properties. Simply convert your existing residence into a rental and move on. You can do that once every year. The stipulation for getting a new residential loan is that you live in that property for at least one year. That’s usually mentioned in the acceleration clause of the note in that loan. If you deviate from those requirements, the note or the loan can be recalled.
Another reason converting your residence is a great path is that the reason you bought that home in the first place is because you liked it. The house had the right number of bedrooms and a convenient layout, and the kitchen was open. All those factors you considered when buying are the same factors tenants will use when they decide to rent from you. We have found that typically when owners have lived in a property that they convert to a rental, the property will rent faster. They make better rentals versus the investment property that looks good at the bottom of a spreadsheet but doesn’t have all those qualifying attributes that make it a great rental. I’d even say that if you overpay for a home that has those high quality, functional features that are attractive to tenants, you’ll get that money back with rental income. You’ll also have less vacancy between tenants, fewer turnovers, and longer tenancies. Your cash flow will be higher. So, if you pay $10,000 more, you’ll get that money back over the course of a few years.
Contract for Deed
Another option for financing is a contract for deed. This is when the owner of an existing property has the deed in full without a note and contracts with you to purchase the home. You stipulate the interest rate, the payment period, how long the loan is amortized or, the penalties for default, and all those things. The nice thing about a contract for deed is there’s no qualification. There’s no income qualification, no limits on how many other properties you can own; it’s simply an agreement between you and the seller on what the structure of the deal is and how the payment schedule works. These typically have to be recorded with the county, and once the contract has been satisfied, the deed is completely turned over to the purchaser. Make sure the owner does have the title free and clear because if the owner has a loan on the property that includes an acceleration clause or a payment due when the title is changed, it can cause issues for you.
Cash and Hard Money
Cash is obviously an option. You can do a construction loan for new construction. Sometimes those are organized by the builder through one of their preferred banks, and typically those can be well-negotiated. Their profit is from the sale of the property, so they don’t want to over-extend on the loan itself. Construction loans are also pretty flexible.
Hard money lenders are also available. There are groups out there like Blackstone Group that were buying properties during the housing crash and now they are financing properties. Some of them are recourse loans, which means they can take recourse against you personally versus the against the equity in the property. They could go after you in both directions; foreclose and go after you personally for a default. Sometimes they will also bundle. So, instead of just the one property you’re purchasing, they’ll want to finance or have a lien against all the properties you own, so you’re ponying up all your equity and assets to get one additional property.
Bank Portfolio Loans
Bank portfolio loans are an option. You are extricated from the requirements of Fannie Mae and FHA programs for investment properties. This really boils down to having a good relationship with your bank and your local lender. Sometimes, they will create loans out of their own portfolio. They’ll need to have all the cash on hand from their assets to write the loan; they aren’t underwriting it and selling it off to Fannie Mae or FHA.
Finally, a renovation mortgage is something you can get through Fannie Mae or FHA. The Fannie Mae program is called the Homestyle Renovation Mortgage. Typically, you’re required to put five percent down and you can purchase a property, have a preplanned amount of additional rehab, and you’ll structure the mortgage and the rehab portion so the home can be completed altogether under one loan. The construction portion is metered out based on the contractor and completion of work after the home is purchased. Once it’s done, the value of the property will exceed the cost of the loan plus the construction. FHA has a similar thing – the FHA 203(k) loan, which requires three and a half percent down. It has essentially the same program elements.
Putting it all together – you need help from a full-service mortgage broker or bank. Seeking out the service of a property management company can also be valuable. We do this day in and day out. Some Realtors focus on residential sales only, and don’t deal with the investment side. Find someone you can trust who has the experience you need to make these decisions.
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