Getting a mortgage for a rental property can be very different from getting a mortgage for a personal residence. The first time I got a rental property under contract, everybody told me: “we don’t do mortgages for non-owner occupied residential houses.”
The very first thing you need to do when evaluating financing for your rental property is decide if you are going to buy the property in your personal name or in an LLC or Corporate name.
If you are buying the property in an LLC or Corporate name, you will need to get a commercial mortgage. If you plan on buying the property in your personal name, you can get a traditional mortgage. (Note: you can also get a commercial mortgage in your personal name.)
What’s the difference between a personal mortgage and a commercial mortgage for a rental property?
Residential Mortgages for Investors
Generally, residential mortgages for investment properties require 20% cash down. These mortgages are generally sold off in the secondary market, meaning mortgage brokers package these off and sell them to investors.
Commercial Mortgages for Investors
Commercial mortgages (or loans) are generally only fixed for 3 to 5 years and amortize over 20 years. Commercial mortgages are not as regulated as conforming residential mortgages and are not sold off. Therefore, there are several more variations.
For instance, some investors might want a longer term fixed portion and are willing to pay a higher rate so they don’t have interest rate risks. The bank might offer a 7-year fixed rate option to this investor.
On the other hand, a real estate investor might want to have a lower rate to increase cash flow and take interest rate risks. In this case, the bank might offer a completely variable note on a 20-year amortization or a one-year fixed rate followed by a floating rate.
The majority of investors want a fixed portion for the longest term. However, it’s worth asking about the rate options for a variable rate note or for a fixed one-year option.
A lot of investors choose a variable rate note at purchase, then refinance into a longer term fixed-rate option once the cash-flow has increased and the property has stabilized.
Commercial loans generally require 25% cash down, though these loans offer more flexibility.
Investment Property Loan Requirements
Because these loans are non-owner occupied investment properties, lending institutions want a higher-than-normal cash payment at closing. This reduces the bank’s risks.
Lending institutions will also want to see what the plan is for the investment property so they can properly fix the terms of the loan. For instance, if you are going to flip a property, you don’t want a loan with monthly principal and interest requirements that’s on a 20-year amortization schedule.
It would make more sense to have interest-only payments and have the loan mature in one year. Conversely, if you have a rental property, having monthly principal and interest on longer term amortization makes more sense.
The bank will also want to know your level of experience with certain projects. If you are going to manage a duplex by yourself, do you have the time to do this while you work a full-time job? You probably do.
However, if you plan on buying a 100-unit apartment complex, you probably won’t have the time to manage it yourself. The bank will want to know the history and reputation of the management company.
How does the bank calculate debt service coverage?
These calculations vary greatly by lending institution. I’m going to show you how I calculated debt service coverage when I was an underwriter for rental properties.
– Vacancy (estimate 10% to 15% depending on desirability of location)
– Maintenance Spending (estimate 10% to 15% for older properties)
= Net Operating Income or NOI
NOI / Debt Service = Debt Service Coverate Ratio
Here’s a practical example of this formula:
Let’s say a rental property is producing $9,000 a year ($750 a month) in rent. Taking into account 10% for vacancy leaves $8,100. Subtracting 15% from gross rent for maintenance costs leaves $6,750.
Now let’s say the debt service is $4,800 a year (or $400 a month), including interest and taxes. Divide $6,750 (net operating income) into $4,800 (debt service) and you get a debt service coverage ratio of 1.40.
Most banks have a minimum debt service coverage ratio of 1.20. This project would pass that test.
Importantly, if you are buying a large apartment complex, they might want to conduct a stress test to see how the property would perform under 25% vacancy. Debt service coverage requirements can also vary greatly by the type of property and the leasing institution.
For instance, if you had a 15-year lease with Walmart, the bank would probably be willing to accept a lower-than-normal debt service coverage ratio.
When making your own projections for an investment property, don’t forget about contingent expenses.
Seth William from RETipster.com had this to say:
“Whenever you’re borrowing money for a potential investment property, be conservative with your projections and leave plenty of room for error. Even when you’ve done a great job of verifying a property’s current and future cash flows, don’t forget that the unexpected can still occur. Consider what your cash flow will look like if the property makes less revenue than you think, or if the monthly expenses come out higher than you planned for. If the property still shows positive cash flow and generates enough income to cover your debt service in the worst case scenario, that’s one way to know you’re looking at a fantastic opportunity.”
What is the interest rate for an investment property?
The rate depends on if you get a traditional mortgage or a commercial mortgage. The rate will also depend on LTV, income, and credit score.
Investment property mortgages are generally about 50 basis points (0.50%) higher than traditional mortgages. Commercial real-estate mortgages are around 100 basis points higher than traditional mortgages and are on a 20-year amortization.
How can I buy an investment property with no money down?
There are several ways to do this. For one example, I wrote a detailed case study of 3 multifamily properties I purchased with zero money down.
Getting a mortgage is not a mystery, but many people see it that way. So the best tip I have is to simply ask the lender what the actual requirements are when it comes to credit, debt-to-income, and loan-to-value, plus any other requirements they might have. Getting a loan is like opening a safe with a combination. As long as you get the right “combination” entered in, you’ll get in! So find out the “combination” before applying and you’ll greatly increase your chance of getting that loan!
Can I use seller assist for rental properties?
Seller assist lets sellers credit buyers with a closing fee. For example, a contract can state that the seller will cover 3% of closing costs. Realtors can assist buyers as well.
Dave Van Horn from PPR Note Co had this to say about using a seller assist:
Always use a Seller Assist, even if you pay more than asking (as long as the deal cashflows) because you’re indirectly financing part of your closing costs and have a higher yield overall on your total capital investment. If your Realtor doesn’t want to do the assist, you’ve got the wrong Realtor. Get an investor friendly realtor.
How can I buy an investment property with a low down payment?
One of the most difficult barriers to entry into real estate investing is the down-payment requirement. With property values on the rise across the country, more money is needed, which many buyers don’t have. However, as it relates to investment property, the down-payment requirement is no less than 20%, and often 25%. This pushes many of the newer investors out.
Do you realize that by walking into a transaction as an owner-occupant, you are opening up possibilities for FHA financing with down payments as low as 3.5%? Fannie Mae is available with 5% down. This is huge as it makes purchases actionable for many people without deep pockets.
The only trick is this: you have to be able to combine a home with an investment. And did you know that there are multiple strategies to do exactly that?
Ben Leybovich is a long-time investor and colleague of mine. He possesses a world of knowledge and he just came out with a fantastic book that teaches people how to do this. Plus—and this is huge—Ben and his family are House Hacking as we speak, so he’s practicing exactly what he preaches. I highly recommend his book on House Hacking.
Fannie Mae Loans
Fannie Mae currently allows up to 10 loans per investor. A little-known fact is that there are two different credit qualification guidelines for obtaining these loans. The first is for properties 1-4 and the second is for properties 5-10, listed below:
Loans 1-4: requires a credit score of at least 630
Loans 5-10: requires a credit score of at least 720
I wrote a very detailed outline on FHA Guidelines here.
According to HUD Handbook 4155.1, the FHA won’t insure more than one principal residence mortgage for the same borrower. Federally insured loans also aren’t available for the purchase of an investment property.
FHA 203k loans are a great choice for real-estate investors, as you can get a very high LTV mortgage with the benefits of a fixed rate for a multifamily property. You can even work money into the loan for renovations.
I wrote a detailed case study on an actual investor using a 203k loan to buy a multifamily property here:
For residential conforming mortgages, lenders will require you to have six months of cash reserves available per property. This means that if you own a primary residence and you’re going to acquire a rental, the lender will require you to have six months of mortgage payments (cash in the bank) for both your primary residence and your future rental.
This is probably the biggest deterrent to people using residential conforming mortgages versus commercial mortgages to grow a rental portfolio. (Note: you must have six months of cash reserves in addition to the 20% down payment.)
Another requirement for residential conforming mortgages is the cash you plan to use for a down payment must be verifiable with all kinds of receipts and tracking. For instance, if you sell a vehicle and don’t have a bill of sale, you can’t use that cash. It’s a lot of work to trace every dollar you plan to use from the past year.
Hopefully, after reading this article you will have a better idea on how to get a mortgage for a rental property.
There are a lot of moving parts in this process and every deal is different, so I highly recommend keeping yourself educated on the process of financing rental property. The more you grow your rental portfolio, the more knowledge you will need to keep financing your different types of properties with different lending products.
If you would like to discuss a deal you have, please fill out the form below.
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