Financing an Investment Property
Rhonda Porter on 05 12, 2008
Obtaining a mortgage for a non-owner occupied propery is much different than buying one you will reside in. For starters, qualifying is tougher and mortgage interest rates are higher as it’s a riskier transaction for the lender. Here are some quick tips to help get you started if you’re considering buying an investment property.
Plan on using at least 20% for your down payment plus closing costs. With a 25 or 30% down payment, you will receive a slightly better interest rate. Just to give you an idea, here is a sample of some current rates based on a single family dwelling with a sales price of $450,000 for a 30 year fixed mortgage and a minimum 720 credit score:
Owner Occupied with minimum 20% down: 5.75% priced with 1% origination/discount point (APR 5.904%)
Non-Owner Occupied (NOO) with 20% down: 6.375% with 1% point (APR 6.537%)
NOO with 25% down: 6.250% with 1% point (APR 6.413%)
NOO with 30% down: 6.125% with 1% point (APR 6.289%)
Of course, you can always pay more in points to have a lower rate. This is just to provide you with an apples to apples comparison.
There are two camps for qualifying for an investment property: those who are proven at managing rentals and those who are buying a rental for the first time or who have less than 2 years history. If you have less than a 2 year history, then it’s likely that you will not be able to use rent credit from the proposed purchase. Lenders allow 75% of the rent to be used for qualifying purposes. Proving you’re a financially successful landlord to the underwriter will take your last two year’s complete tax returns including the Schedule E’s. If you can qualify for the full PITI payment on the investment property along with your current PITI payment on your residence, then the underwriter may only require a regular appraisal. Otherwise, count on the appraisal costing almost twice as much as a typical appraisal for conventional financing. Fannie and Freddie also require a minimum of 6 months reserves (cash assets after closing) for NOO borrowers.
Odds and Ends
- FHA can be a great way for first time buyers to get into the investor market when they’re buying a 2-4 unit home. The buyer must occupy in one of the units and the mortgage will be treated as an “owner occupied” transaction. You will have upfront and monthly mortgage insurance and can buy with as little as 3% down payment.
- Second homes are sometimes treated as investment properties. This is really up to the underwriter. Typically if the home is located within 50 miles of the borrowers residence or if it does not make sense as a second or vacation home, the underwriter may determine that it’s an investment which means tougher underwriting and the NOO rate.
- Fannie Mae programs exist that help family members buy properties that don’t meet the second home requirements without treating it as an investment purchase (Family Opportunity Mortgage).
As always, I highly recommend that you meet with your local Mortgage Professional as soon as possible if you’re even just considering obtain a mortgage for any reason (investment property, residencial purchase or refi, vacation home, etc.).
About the Author: Rhonda Porter
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If the investor wants positive cash flow for a Seattle address, then plan on a down payment of 45%-65%.
Real estate is just another investment asset class with stocks, bonds, companies, etc. the same accounting and finance theory applies. The same financial statements are used. The same financial analysis techniques are used for a duplex, 200 unit apartment building, retail, office, industrial, etc.
The biggest mistake investors make include failing to create realistic financial statements estimating the real property assets future cash flows. Worse, many investors fail to calculate the assets yield or Return on Investment (ROI) using proper discounted cash flow techniques such as IRR or NPV. A failure to calculate the yield results in the inability to compare the assets effective yield to the yield of alternative investments such as another multi family property, Boeing stock, mom and pop min mart, tax free bonds, franchise XYZ, etc. Relying solely on capitalization rates is a mistake. Capitalization Rates describe the assets ability to generate operating income before financing and depreciation as a component of the sales price. That isnt a ROI calculation as it does not address all cash flows.
When creating financial statements under budgeting real operating costs and capital improvement reserves is a very common mistake of inexperienced (and sadly with a few experienced) investors. Operating costs include much more than property taxes, insurance and utilities. If the investor decides to manage the property, then pay yourself for being the property manager. If it doesnt cash flow with property management today, then it likely wont cash flow with property management five years from now. A few investors may argue that the capital asset growth or appreciation is their payment for managing the property. No, this is incorrect. Net cash flows received from operations (rent less all expenses) and cash flows received from capital asset growth or appreciation upon disposition of the asset (sale price less all selling costs, retiring all debt, excise taxes, etc.) are investor returns for investing capital. This is the investors return of capital and return on capital. If the capital asset growth is paying the investor to be a property manager, then it isnt paying to be an investor. Property management costs need to be accounted for as operations costs.
Because prices are very high compared to the rent received a higher down payment or more cash at risk will lower the investors yield with a larger denominator in the yield equation. An investor can acquire property with a lower down payment and accept the negative cash flows. Negative cash flow adds risk that must be accounted for. The negative cash flows effectively become more cash at risk in the future. The timing of contributing more cash to fund the operations is delayed and effectively becomes more cash at risk or an increase to the “down payment”. In the past many investors accepted advice that negative cash flow is OK because of appreciation. Maybe and maybe not. The additional risk should include additional reward. Each decision has an opportunity cost and risk. Relying on capital asset growth every year of five years is far riskier than relying on receiving rent next month that provides cash flow after all expenses. This is easily explained with the financial concept of the Time Value of Money. A dollar today is worth $.98 a year from now because of inflation. The longer the investor waits to receive the cash flow the more risk is associated with the cash flow.
Suppose an investment costs $1000. The investor will receive net cash flows for $250 a year for five years for a total of $1250.
CF 0 = -$1000
CF 1-5 = $250
IRR = 7.93%. The yield or ROI is 7.93%
What if the return of capital and return on capital was a lump sum of $1250 in year five?
CF 0 = -$1000
CF 1-4 = $0
CF 5 = $1250
IRR = 4.56%. The yield is 4.56%. significantly less than the first example.
How much does the year five lump sum payment in the second investment need to be to equal the first investments yield of 7.93%?
PV = -$1000
PMT = 0
PMT/Yr = 1
Yrs =5
I = 7.93%
FV = $1464.57
Because the risk of receiving all the cash in the last year is higher, the investor must receive $1465 to achieve a yield of 7.93%.
Why is this so important? “Is this duplex pretty?” is NOT financial due diligence. When investing in real property the investor must have a real estate professional who has the skill set to prepare accurate financial statements and the necessary financial analysis to determine the appropriate down payment (from an investment point of view), risk, and yield options.
Thanks, Michael. I’ve seen many people who assume that getting into investment property will make them rich quick and they don’t understand what they’re getting into or, as you mention, how to compare it to another investment.
I am seeing quite a few 2-4 units properties in the MLS that indicate they are a short sale. Even at the short sale price they don’t make sense as investments. there is no “Easy Button”.
Nice article Rhonda, and timely too.
I would add that underwriter are acting much more stringently on ALL fronts, so expect no leeway on the 2nd home (owner occupied) vs the investment property distinction.
I have had to break the news to several potential investors, who were still operating under the old assumptions.
One more thing, FMA recently increased it’s “hit” to price on investment property, which has increased the gap between owner occupied and investment rate/costs.
Thanks, Roger
I recently closed a transaction where my client was buying a condo in the same building she all ready owned a unit in. The new condo was a two bedroom and was larger than her one bedroom that she was going to keep for a rental. Pre-mortgage-meltdown, this would have only taken a letter of explanation from the borrower since this makes sense… in this climate, the first lender pretty much wanted blood from the borrower and really wanted to treat the purchase as a NOO when it was not. I ultimately had to switch lenders/underwriters so that my client could do as she planned: keep her 1 bedroom condo that she currently had and convert it to a rental and buy the 2 bedroom to live in.
[...] out how you’re going to finance the property. Rhonda Porter put together a great piece on Financing an Investment Property, where she gives some good examples of the applicable loan rates that might apply to your [...]
Just a quick note, the rate examples above are based on a single family dwelling. 2-4 plex have higher rates and may require a larger down payment.
As of October 10, 2008, private mortgage insurance is no longer available for investment properties. (When I wrote this post, I recommended a minimum of 20% down…so this shouldn’t impact those who read my posts).
Also, FHA is still available (quite a hot deal, actually) if–BIG IF–the borrower is going to occupy on eof the units (must be 2-4 plex).
Lenders are all ready pricing in a new rate hit of 3% for LTVs over 75% for single family NOO.
There are also new guidelines on converting existing residences to an investment property.
I’m curious what the local experts think of the following deal: I’m considering buying a duplex. The owner is asking $50K (so obviously it is not in the best part of town). Both units are currently rented for a total of $1200 /month.
On the surface it looks like good cash flow.
Am I missing something?