Financing Investment Property

One of the biggest concerns that a lender has
is the risk of payment default to the lender is higher –
let’s be realistic, if you get in real financial trouble are you going to pay the mortgage on rental property or on your own home? The lender knows this,
thus the perception of greater risk and therefore higher interest rates than
you would receive for an owner occupied property.

So what does the lender’s underwriter, the one who actually makes the decision about your loan, look at to make the approval decision?

1) Your credit - You need to have paid your other financial obligations as agreed. This usually means a middle credit score of at least 620. It is possible to get financing if your credit score is lower, but expect substantially more documentation to explain any negatives on your credit report, significantly higher rates and a larger up-front equity investment in the property.

2) Your experience as a property investor –

a) Lenders generally look for at least 2 years of “property management” experience. If you haven’t filed a Schedule E, you will be considered a “first time” investor.

b) Experienced investors can have a lower credit score than a “first time” investor.

c) Stated Income financing programs are available for experienced investors with good credit.

d) A “first time” investor will probably have to have enough income to cover the entire PITI for the subject rental property with no credit for any income received.

e) Most lenders will limit the number of investment properties to 10 per investor.

3) The Loan Application Process - In a nutshell it is more involved and will take longer than what you experienced buying your own home. Let’s look at some specifics:

a) It is a TEAM EFFORT – you need a realtor, property manager and lender who understand the unique aspects of the investment property market.

b) Closing timeframes can be longer because the whole process just takes longer, 45 days is probably more realistic than 30 days for owner occupied property.

c) Appraisal costs are about twice as high, $600 -$700 vs. $350 because the lender requires a “Small Residential Income Appraisal Report”. This is an important document that establishes for both you and the lender information about the realistic rental income you can expect to receive from the subject property and the sales of comparable properties.

d) The lender will limit seller paid costs, known as concessions, to no more than 2% in most cases.

e) 100% financing is available for investment properties

i) You must have good credit to qualify!

ii) Rates are higher than 80% financing

iii) Cash flow is worse because of higher Principal, Interest, Taxes and Insurance or PITI

iv) Potential return on investment is higher.

f) Lenders look for investors to have at least six months of cash reserves. Cash balances in checking, savings and money market accounts all are considered cash reserves, in addition to IRA’s, 401K’s and unused balances on Home Equity Lines of Credit. The cash reserves are what the lender relies on in the event in their analysis of the property’s cash flows show negative cash flow. Reserves = PITI X 6mos.

g) Analyzing cash flow from a property – There are many ways to analyze cash flows, but ultimately the one that will determine your loan approval is how the lender looks at cash flow. The following chart outlines these differences. Because the lenders have the money, their analysis is the one that will be decisive in the loan process. The analysis presented under “Your View” is simply coming from a different perspective, albeit a generally more optimistic approach.

Analyzing Cash Flow –

The Lender’s View and Your View

My Monthly Rental Payment Expectation	My Annual Investment Income	Lender’s View of Property’s Income/Expense	The Difference
Income $500/mo.	$6,000 (Yearly gross rent)	70% of $6,000 = $4,200	Your property may not always be rented, the 30% discount allows for the potential of vacancies in any given year. In addition, the lender knows that you will incur property management expenses that might included re-painting, re-carpeting, new appliances, advertising for renters and cleaning services. The 30% gross income reduction provides a financial cushion to cover these items.
Projected Costs
Principal, Interest Taxes & Insurance (PITI) $450/mo.	$5,400	$5,400	No difference
Operating Expenses – Management fees, advertising, permits, maintenance, supplies, cleaning, utilities, payroll & payroll taxes ????	????	n/a	The lender has allowed for these when the gross income was reduced by 30%.
Net cash flow Income of $500 minus PITI of $450 = monthly cash flow of $50 – It’s really less because of your operating costs	$6,000 minus PITI of $5,400 = cash flow of $600 It’s really less because of your operating costs	Adjusted annual income of $4,200 minus PITI of $5,400 = negative annual cash flow of $1,200 or $100 per month	Because the lender is looking at "the worst case" scenario, they will want to make sure that you have income from other sources to be able to offset this potential negative cash flow. The lender will add the $100 per month to your other monthly financial obligations to calculate your total debt to income ratio.

4) What is your investment time horizon and how will this impact your acquisition
and financing strategies?

a) Short term holdings – 2 to 5 years

i) Focus is more on prospective price appreciation or meeting a non-financial objective such as graduation of a college age student.

ii) Higher loan to value minimizes up-front investment, maximizes returns and results in a higher interest rate.

iii) Need to have the cash reserves and other income to meet any negative cash flow as defined by the lender on the property in order to get approved.

iv) Define objectives, i.e. hold until my college age student graduates. This may dictate the location of potential properties.

v) You can probably assume somewhat lower operating costs because you will be less likely to have to replace major items such as a roof, heating system or appliances if the property was relatively new to begin with.

vi) Operating costs are REAL costs and THEY WILL REDUCE your bottom line, budget carefully for them.

vii) Ultimately limits the number of properties the investor can acquire because of the cash reserves and debt to income requirements.

b) Longer term holdings – over 5 years

i) Focus is more on the property’s cash flow, trying to keep it as balanced as possible with the goal of providing income as rents increase.

ii) Usually requires larger equity investment to keep income and expenses more balanced. Interest rate will be lower.

iii) Reduces investment return on sale because of greater up-front investment.

iv) You can probably assume some what higher operating costs because you will be more likely to have to replace major items such as a roof, heating system or appliances because your holding period is longer and natural wear and tear will take its toll.

v) Cash reserve and other income requirements will be less

vi) Greater flexibility to acquire additional properties.

vii) Define objectives - This may dictate the location of potential properties, ie. buy properties in locations that will attract longer term renters versus short term such as college students.

viii) Operating costs are REAL costs and THEY WILL REDUCE your bottom line; budget carefully for them.