Buying and Refinancing Investment Properties
You’ve likely noticed the emergence of cable TV shows that feature buying “fixer uppers” over the past few years.
There is also no shortage of real estate “gurus” that travel from city to city holding real estate investment seminars showing how you can buy with no money down, flip a home in 30 days and reap millions upon millions of dollars.
Yet while such claims are dubious at best, the reality is that real estate as an investment provides more wealth for more people over time than any other single investment. Not gold, not stocks and not mutual funds but real estate. At least that’s the claim of successful real estate investors. Property values continue to increase over time as do rental rates and with interest rates where they are, positive cash flow is easier to obtain compared to just a few years ago.
Deciding whether or not to purchase an investment property is really all about the math.
What’s the purchase price? What are the costs to repair or remodel? What could I sell it for? How much could I make? What could I rent it for? What will it be worth in 10 years?
Working the numbers at the very beginning tells real estate investors there is a potential deal, but only potentially. There’s more work to be done. Fortunately, you don’t have to reinvent the wheel here. Instead, all you need to do is follow the path already made. Buying a profitable property means some due diligence on your part as well as from others. In this article, we’ll talk about buying the right property and how to finance the transaction, whether it’s for a purchase or refinancing an existing note.
When buying real estate, once you’ve closed on the deal it’s yours. You can’t really return it to the seller and ask for your money back. That means you must do some major homework before you ever get close to the settlement table. And while investment real estate can create a positive monthly cash flow or you can find a home that will make a quick profit, there are a lot of wheels that begin to turn once you make an offer. And unless you’re an experienced real estate agent who has been in the industry for 20 years or so, there’s a lot to learn and you can’t expect to be an expert overnight. But you don’t have to.
Instead, surround yourself with industry professionals who will work with you to find, evaluate, inspect and finance your next rental property. That means you need to find a real estate agent that will hunt down potential deals for you. The agent will know what is and what is not a good deal. The agent will tell you how much money you can make when you flip the property or how much you’ll be able to rent the home for should you decide to keep it.
A general contractor and property inspector will be able to walk the property and provide estimates on what repairs are needed and how long it will take to make those repairs. The property inspector will look for any and all potential property issues you will need to deal with at some point and disclose to future buyers. You will also need a consistent source for financing these units, someone who has financing options for all sorts of transactions for both short term flips and long term holds. All of these players will not only help find the right property but they’ll also profit when you close on your next deal. It’s in their interest to do the best job they can.
Real Estate Risk
Surrounding yourself with an experienced team helps mitigate the risk involved when buying real estate. Lenders also mitigate risk when financing investment properties with the types of loans they offer.
But first, what is an investment property?
It’s any property that you do not occupy as your primary residence and is not considered a vacation or second home. Interest rates and loan terms for investment real estate reflect the additional risk associated with financing a non-owner occupied home. A lender knows that if a borrower gets into financial trouble, the rental properties will go into default before the borrower’s own home.
This risk is offset with higher down payments and higher interest rates. The down payment requirements can be as high as 30 percent or more based upon various factors including the loan amount, credit scores and cash reserve requirements among others. But let’s start out with a simple transaction—buying a single family home for the first time to be used as a rental. What can you expect?
A Common Transaction
In most areas of the country, the maximum loan amount for a single family residence in San Diego County is $580,750. Conventional loans, those using lending guidelines issued by mortgage giants Fannie Mae and Freddie Mac are the primary choice for financing this transaction. The down payment requirement for a rental property is 20 percent of the sales price but you can get a slightly better rate with 25 percent down.
Credit scores need to be at least 720 and there are also cash reserve requirements of six months or more. Cash reserves are calculated as the number of months of house payments that include the mortgage, taxes and insurance costs. If the total mortgage payment is $2,000 and the reserve requirement is six months, borrowers must be able to show liquid accounts of at least $12,000. Liquid accounts include checking and savings as well as a percentage of retirement funds the borrowers can access.
Interest rates for a rental property will be about 0.25% to 0.375% higher than a similar loan for a primary residence. That’s really not very much, especially in the current environment. Let’s look at a typical example of monthly income in a sample transaction where the sales price is $250,000 and the down payment is 25 percent and closing costs approximately $3,000.
Sales Price $250,000
Down Payment $ 62,500
Loan Amount $187,500
With a 30 year fixed rate at 4.25% (4.38% APR) , the principal and interest payment is $922 per month. Now figure a monthly amount for property taxes of $200 and insurance $100 for a total of $1,222. You’ll also need to consider maintenance costs and repairs of 2 percent of the value of the property, or $5,000. This is a bit on the high side, but a general rule suggested by Fannie Mae. That works to an additional $416 per month for a grand total of $1,638. If market rent for this property is $2,200 per month, there’s a positive monthly cash flow of $562. That’s the math and in this example it looks like a good deal.
Basic Qualifying For Buying a New Home
You’ve no doubt heard the phrase, “Buy rental property and let the tenants pay your mortgage!” That of course means the rental income received each month is more than enough to cover financing costs and associated expenses. But with the first transaction, lenders won’t allow you to use this rental income to help you qualify. Why?
Lenders want to make sure you can handle the job of being a landlord while making the mortgage payments on time. As well, to validate the property does positively cash flow and lenders use filed federal income tax returns to make this determination. There are tax deductions available for rental properties that can’t be applied to a financed primary residence. Beyond the mortgage interest deduction is a deduction for expenses such as repairs to the property and maintenance costs. Property management company fees, taxes and insurance may be deductible and the home’s physical depreciation can be deducted from taxable income. Too many deductions and the tax returns show a negative, not a positive, even though the property does in fact cash flow each month.
For the first home, buyers will need to be able to qualify using the total housing payment on the rental property without the benefit of the rental income as well as other monthly debt including the house payment for the primary residence and other credit obligations such as an automobile payment and credit card payments. Regardless of any positive cash flow from a future purchase, the income can’t be used to help qualify.
That is until the second purchase comes around. When borrowers can show they’ve successfully owned a rental property and have the federal income tax returns to prove it, the rental income can then be used to offset all or part of the mortgage payment. This is why it’s not uncommon to meet a real estate investor who owns 10, 20 or even 30 rental properties or more because the qualifying process becomes much easier as long as the properties cash flow and the borrowers can show sufficient income to qualify.
But once a borrower exceeds four properties, financing becomes a bit more difficult, at least with conventional financing.
There are mortgage products available for investors who wish to put down less than 20%. Interest rates are slightly higher compared to a conventional loan to finance an investment property but not by much. For buyers who wish to purchase with less than 20%, there are programs available that combine a first and a second mortgage to reduce the buyer’s exposure.
Buying Multiple Properties
Most conventional guidelines allow a borrower to finance a subsequent rental up to four financed properties. If a buyer owns five properties and only one is financed, the next financed purchase would mean the buyer could still buy and finance two more homes as four existing rentals in this example are owned free and clear. It’s not the number of properties, but the number with a mortgage on them.
There are allowances under certain Fannie Mae guidelines that allow for a buyer to finance up to 10 homes however and still have competitive interest rates. Standard guidelines for this program include—
- 720 Minimum FICO Score
- Minimum Down Payment 25%
- No Cash Out Refinance Allowed
- Six Months Reserves
Remember this program allows financing for up to 10 separate properties, not just owning 10. An investor who seeks financing for a property with 10 financed properties may take available cash and pay off an existing mortgage(s) leaving at least one property without financing and financing the next purchase. For investors who want to finance additional homes beyond the 10 financed property limit will seek other types of financing.
Financing Multi-Unit Properties
Real estate investors often find a niche they feel comfortable in and will find their portfolio is heavy in one particular class of real estate. This isn’t necessarily a good or a bad thing at all but simply an investor preference. This often happens as a real estate investor becomes savvier as it relates to the type of property, cash flow and demographics of the neighborhood where the property is located.
For example, a real estate investor finds that investing in a duplex provides more “cash flow for the buck.” A duplex, called a two-unit, provides two income streams each month, one from each side of the duplex. Multi-unit properties, from 2-4 units, provide additional cash flow and can be easier to evaluate as typical zoning codes won’t allow a developer to build just one duplex surrounded by single family homes. Instead, there will be allowances for several multi-unit properties. When there is more of a single type of rental type of property in the area, both purchase price and market rents are more easily validated with current and recent data readily available.
Another opportunity exists when the real estate investor buys a 2-4 unit property and lives in one of the units. This option opens up the possibility of obtaining government-backed financing with loans using FHA and VA guidelines. VA requires no money down and FHA only 3.5 percent but you must occupy one of the units as your primary residence. In fact, you can expect a post-closing audit from the lender who will certify that you are in fact living in the financing property.
Okay, so what if a real estate investor does own 10 financed properties and another ideal opportunity comes up?
Does the investor simply walk from the potential purchase and if not, how do some real estate investors own and finance more than 10?
There are mortgage programs available that do not care how many financed properties you own but do care how many financed properties you own that are financed with that lending institution. This means you can have 20 financed homes and as long as you don’t have more than three more financed using the same loan program, you can in fact finance the next transaction. It’s not the number of financed properties, just the amount of exposure a particular lender has with one owner.
Let’s now recall those cable TV programs that document the purchase of a run-down property that is soon turned into a real gem after quite a bit of work. Standard lending guidelines actually make two approvals, one for the borrower and another for the property. Both have to meet minimum guidelines and sometimes a property is in such poor condition a bank won’t place a loan until the repairs have been made.
For example, a home is listed at $100,000 but when repaired would be worth $175,000. However, the repairs include fixing the foundation. If a property needs such major work, a standard loan won’t work. The lender wants to make sure the collateral (the property) is in marketable condition. This is where a private lender comes into play.
A private lender may be an individual, a group of individuals or a private company that issues short-term loans to buy and rehabilitate a property. Sometimes these loans are called “hard money loans” due to the terms of the mortgage. Using the scenario above, a buyer could buy the $100,000 home along with the funds needed to repair the property and bring it up to shape. If the cost to repair the foundation was $20,000, the real estate investor could borrow funds to buy the property and finance the repairs.
Private loans do however come at a premium. Buyers can expect down payments of up to 50 percent of the sales price, higher interest rates up to 14 percent or even higher and of course higher closing costs. Loans are only issued for the time needed to buy, repair and sell the property, say for only six months. So, given the substantial down payment, high rates and closing costs, who would want to take out such a loan? Again, if the math works, it might be a deal. Let’s look at this same transaction with $25,000 for repairs–
Sales Price $100,000
Repairs $ 25,000
Down Pymt $ 50,000
Loan Amount $ 75,000
Selling Price $175,000
Closing Costs $ 10,000
Selling Costs $ 15,000
Interest (14%) $ 5,250
Net to Buyer $ 19,750
After considering the closing costs on the initial loan, selling costs which include such items as real estate commissions, title insurance and other fees and six months of interest at 14 percent, the buyer in this transaction made $19,750 in six months on one deal. It doesn’t matter as much the terms of the mortgage but whether or not there is any profit to be made. Certainly the best loan program must be found but sometimes a private loan is the one of the few options available. Hard money loans don’t make sense for everyone but in the right situation they’re a perfect fit.
Fannie Mae Homestyle Renovation Loan
This program is unique in that it allows for a buyer to buy a property that is in need of repair and the buyers can occupy the completed unit as primary residence, a second or vacation home or a rental property. And while Fannie promotes this loan program to its approved lenders, not many conventional lenders offer the program as it does require more support and oversight compared to a traditional mortgage used to finance an existing property or new home that does not need repairs.
We cover this special program in detail in another article but if someone is thinking of buying a home that could use some renovations; they probably should look no further than this program. The loan can be used to buy an existing property and finance the improvements up to $150,000 or 50% of the “as completed” value.
There are specific steps borrowers must follow but it’s important to work with a lender that has experience working with this special program. Most lenders aren’t equipped to issue and monitor a renovation program. Why? Just like getting a construction loan from a bank to build a new home, the renovation loan requires periodic draws to the contractor and must be monitored by the lender to gauge the progress of construction. The contractor used to perform the renovations must also be approved by the lender who approved the renovation mortgage.
Usually when someone wants to buy a home and make improvements on the property, financing is obtained to first buy the home and then a second home improvement loan is obtained to complete the renovations. Yet with this approach the total monthly payments will be higher as home improvement loans carry higher rates than those reserved for a first lien mortgage. In addition, using a renovation loan means having only one closing instead of two separate ones to buy and renovate the home. The renovation loan can be used to purchase a property or to replace an existing mortgage on a property currently owned.
Second Homes, VRBO and Airbnb
Just over the past couple of years the real estate investment industry has witnessed the phenomenal growth of peer-to-peer real estate investment strategies. Real estate investors can now purchase a rental property and instead of having a tenant sign an annual lease the property is rented on a short-term rental basis, typically meaning a stay of three days or longer. The returns compared to a long term rental are indeed significant, sometimes resulting in an increase in revenue of 200% or more compared with a 12 month lease. This strategy works in areas frequented by tourists who seek a more relaxed, home-style property instead of staying in a hotel. The properties are marketed by companies such as VRBO and Airbnb and they collect rental payments and screen tenants for the property owner for a fee.
Additional cash flow is gained when the property is designated as a “second home” instead of an investment property. We can provide you with the specifics on the differences between a second home and an investment property but the main advantage is the lower rates associated with a second home. Our second home financing in the jumbo sphere requires only a 10 percent down payment up to $1.1 million and with a down payment of 30% or more we can finance a second home up to $5 million.
The term “hard money” is derived from the terms of a loan provided by a private individual or group of individuals to a buyer wanting to acquire a property that is in some sort of distress or otherwise not eligible for traditional financing. The terms of a hard money loan mean much higher interest rates and fees and the loan is only for a period long enough to buy and renovate a property, typically either for a quick sale upon completion or holding the property long term.
For example, an investor discovers a single family home in an established neighborhood that has been listed for quite some time due to its current condition. A bank won’t make a loan on the property due to some serious structural issues. However, if the issues were fixed a loan could be placed. The investor contacts a private party for a hard money loan that will be enough to buy the property as well as make the needed repairs. The investor intends to sell the property once completed and provides the hard money lender with the exit strategy showing how and when the lender will be paid off. Many investors also find a buyer prior to soliciting hard money funds. The hard money lender reviews the proposal and agrees to fund the project. Once finished, the buyers complete the transaction and the investor uses a portion of the proceeds to retire the hard money loan.
Sometimes however a project doesn’t go as planned and the investor sees the due date on the private note looming and needs to replace the existing hard money note. Our role here is to provide the financing needed to retire the existing hard money loan for an extended term and for a lower rate.
Lines of Credit
A real estate investor may also acquire investment properties using an established line of credit. This is the common form of financing for builders who work with their bank to build a new home with the intention of selling the property once completed. The builder or investor may or may not have a buyer already lined up but for investors that do not have a long term relationship established with a bank the bank may in fact require the investor to provide an approved builder before approving a line of credit. Once the home is sold and the buyers provide their financing, the investor replenishes the line of credit and proceeds to build the next unit.
Buying With Cash
Investors also use their own cash when buying real estate. Most every real estate agent appreciates an “all cash” offer because the agent knows there won’t be any complications as escrow moves along due to a loan application or worse, the buyers can’t obtain financing after all and the home had been needlessly taken off the market or otherwise listed as “Pending Sale.” Real estate investors know that cash is king and can help obtain a lower price knowing financing won’t be an issue. But of course, real estate is not a liquid asset and once cash is used to purchase a property the investor’s funds are locked into the property until sold.
Or, the investor uses proceeds from the sale of an existing property or pulls cash out of a property in the course of a “cash out” refinance. The problem with the strategy comes in to play when investors own more than 10 units, which is common.
Delayed Financing is a solution to this problem when an investor pays cash for a property and shortly thereafter refinances the property up to 75% of the current value of the home. This strategy needs a significant amount of initial due diligence but it’s a proven method of turning equity back into cash quickly.
A 1031 exchange refers to an IRS code that addresses taxable, capital gains when selling real estate. Instead of selling a property and then using the proceeds to buy yet another, buyers and sellers can enter into a 1031 agreement. There is a specific protocol to be used in such a transaction but is very common in the real estate investment arena.
There can be a bit of a complication when an investor needs more funds to complete the 1031 exchange as it relates to a corporation. For example, a property in a 1031 exchange is in a corporation which means 3the buyers of the property must also be in the same corporation. Most lenders do not lend directly to a corporation however we have investors that do in fact lend into a Limited Liability Corporation, or LLC along with a personal guarantee by the individual. This then validates the 1031 exchange.
Buying and refinancing an investment property really isn’t all that different compared to buying and refinancing a primary residence. Buyers can expect a slightly higher down payment and interest rate on the property and there are income and credit requirements but overall, the process is much the same compared to buying and financing an owner occupied property.