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Buying a Multi-Unit Property with an FHA Loan? These are the Facts You Need to Know!

Updated December 6, 2023

Investing in rental property is one of the most reliable and profitable investments you make. Of course, it’s never a sure thing (nothing in investments ever is), and you can certainly lose a lot of money when you purchase the wrong rental property, but you can find numerous examples of people building a foundation of wealth and financial stability based entirely, or in part, on rental property, including multi-units.

But rental property can have an expensive entry point. Most people simply don’t have the money to buy a rental outright; they need a loan to make the purchase. While the FHA is mostly involved in promoting single-family homeownership, they do support loans for rental properties, as long as it is a multi-unit.

However, if you plan on buying a multi-unit property with an FHA loan, you have to understand these important facts…

Fast Facts: Buying a Multi-Unit Property with an FHA Loan

The Property Can Be Up to Four Units

One of the most important facts for FHA loans on multi-unit properties is that you can purchase a property that has up to four units. This means duplexes are allowed, as well as three- and four-unit properties. All of these properties are considered single-family homes, but anything with five or more units will not qualify. A “unit” is essentially a stand-alone section that has its own facilities, not a shared space. So a room that is rented out is not considered its own unit.

You Have to Occupy the Property

This is one of the essential facts of using an FHA loan to purchase a multi-unit property, and it’s one that may cause some real estate investors to seek a different type of loan, such as a conventional loan. If you use an FHA loan, you must occupy one of the units. Again, the FHA is focused on providing homeownership, so they require that you live in the property for a certain period, although you can eventually move out and keep the property in you financial portfolio.

Only Certain “Mixed-Use” Properties Are Eligible

For FHA loans, the primary focus is residential properties, which fit with the administration’s agenda. So in almost all cases, the multi-unit property you purchase needs to be exclusively residential property. However, there is a small exception to this rule. “Mixed use” simply means property that is used for multiple purposes, such as housing and business.

It can include commercial, residential, retail, office, or even parking space, and mixed-use properties are eligible for FHA loans, but at least 51% of the square footage must be used for residential purposes. Also, the commercial activity cannot impact the health or safety of people living at the property.

There Are Different Reserve Requirements for Different Properties

Before buying a multi-unit property with an FHA loan, talk with a professional about the risks of real estate investments.

Lenders require cash reserves, which is basically cash on hand that the borrower has available in case of a financial emergency. How much the borrower needs in cash reserves depends on the loan, the lender, the terms, and the borrower’s credit history, but with FHA loans, there is usually a specific number.

For two units, the borrower will need to have one month of “PITI” expenses. PITI stands for Principle, Interest, Taxes, and Insurance, and it’s basically a summary of the total monthly cost of the loan. For three or four units, you will need to have three months of PITI. Regardless of unit count, the PITI will need to be documented and verified by the lender.

Properties with Three or Four Must Pass “Self Sufficiency” Test

To qualify, all properties with three or four units will need to complete the “self-sufficiency” test. This refers to the rental income produced by the property over and above the PITI costs.

The Federal Housing Administration (FHA) self-sufficiency rule refers to a guideline set by the FHA for certain types of FHA-insured loans, particularly those related to multifamily properties. The purpose of the self-sufficiency rule is to ensure that properties financed with FHA-insured mortgages have sufficient income to cover their operating expenses.

The rule requires that the property must demonstrate an ability to generate enough income to cover its operating expenses, including mortgage payments, property maintenance, and other associated costs. This is intended to reduce the risk of default and financial instability for FHA-insured loans.

Rental income for three or four units is calculated with the appraiser’s estimate of a fair market rental rate, which is calculated for all units, including the unit that you will occupy. The estimate is the subtracted by 25%. This is the self-sufficiency test. For PITI, the monthly net-self sufficiency income cannot exceed 100% of three or four units.

Here’s a simplified example to illustrate how it works:

Let’s say an investor is interested in obtaining an FHA-insured loan to finance the acquisition of a multifamily property. The FHA self-sufficiency rule requires that the property generates enough rental income to cover its operating expenses, including the mortgage payment.

  1. Calculation of Rental Income:
    • The property has a total of 10 rental units.
    • Each unit is rented out for $1,000 per month.

Total Monthly Rental Income = 10 units * $1,000 = $10,000

  1. Calculation of Operating Expenses:
    • Operating expenses include property taxes, insurance, maintenance costs, and property management fees.
    • Let’s assume the total monthly operating expenses amount to $5,000.

Total Monthly Operating Expenses = $5,000

  1. Calculation of Net Operating Income (NOI):
    • Net Operating Income is the difference between the total rental income and operating expenses.

NOI = Total Monthly Rental Income – Total Monthly Operating Expenses = $10,000 – $5,000 = $5,000

  1. Calculation of Debt Service (Mortgage Payment):
    • The FHA-insured loan has a monthly mortgage payment of $4,000.

Debt Service = $4,000

  1. Verification of Self-Sufficiency:
    • The property’s Net Operating Income (NOI) must be greater than or equal to its Debt Service to meet the FHA self-sufficiency rule.

$5,000 (NOI) >= $4,000 (Debt Service)

In this example, the property meets the FHA self-sufficiency rule because the Net Operating Income is sufficient to cover the mortgage payment. This demonstrates to the FHA that the property is financially viable and has the ability to generate enough income to cover its expenses, reducing the risk of default on the FHA-insured loan. Keep in mind that these figures are simplified for illustrative purposes, and actual calculations may involve more detailed financial analysis and considerations.

Potential Rental Income Can be Used for Approval

If you are planning on purchasing a multi-unit property with an FHA loan, you can actually use your potential rental income for qualification purposes. However, the potential income will need to be verified by the lender, who will obtain a proposed rental income that shows the fair market rent by the appraiser. If there is little or no history of rental income, the lender will use Form 1025 from Fannie Mae or Form 72 from Freddie Mac. Small Residential Income Property Appraisal Report will be required and they can be completed with the help of a qualified lending professional.

FHA Loan Limits for Multi-Units Vary by Area

The FHA is not in operation to support the purchase of expensive or luxury homes; rather, they focus on supporting reasonable homeownership for low- and moderate-income earners. As such, there are specific limits on their loans, and these limits vary by area.

Currently, the standard FHA loan limits are $294,515. However, the number can go up if you live in a moderate or high-cost area. In high-cost areas, the limits are:

  • Two Units: $870,225
  • Three Units: $1,051,875
  • Four Units: $1,307,175

There are also special exceptions that may allow you to use a loan up to $1.96 million. This high limit may be available if you are purchasing a home in certain parts of Hawaii, Alaska, Guam, or the U.S. Virgin Islands. Generally, there are higher construction costs in these areas, so limits are raised to offset this expense.

Work with San Diego’s Expert in FHA Loans

If you are seeking an FHA loan for a multi-unit property, contact San Diego Purchase Loans today. We’ll help you find the right loan for your specific needs, allowing you to increase your investment potential and build a strong financial future.