Financing a rental property: a primer

Editor’s note: This article is reposted with permission of Zillow. View the original post: "How to Get Financing for Rental Properties"

By Leonard Baron

These days, many people hear in the news that it’s a good time to buy rental property, and so they’ve decided that they would like to get started in the property rental business, (a.k.a. being a landlord).

But, in order to get into the rental property investment business, how do you obtain mortgage financing to purchase your first rental property? It’s true that it has become a lot harder to get financing these days, but for people with decent credit and sufficient income there is still plenty of money available to borrow. For terminology purposes, when you borrow for a rental property, it is called non-owner occupant (NOO) financing. Let’s run through some financing issues, items and suggestions that may help you.

Buy as an owner-occupant

The best way to get into the landlord business is to buy a home that makes sense as a rental property, but you buy it as a personal residence, and live there for the required 12 months that an OO loan requires a borrower to do. As an owner-occupant, you get the best financing terms and you may be able to put down as little as 3.5 percent with FHA financing. The loan stays in place with the original terms when you move out and make it a rental. It’s the best way to go!

Other reasons this makes sense:

You move into the property and learn the property specifics, issues, kinks, etc. and have them fixed before you move out and make it a rental property.
You also do any renovations and upgrades you need while not making two housing payments like someone would do if they bought a property and were simply rehabbing it to rent it out.
Lastly, you are more selective and only buy properties that you are willing to live in, and that’s a smart way to go for investors; don’t buy properties that you wouldn’t live in.

Then, after 12, 24 or 36 months, buy your next owner-occupant property and rent out the original one. Then repeat, and repeat, and repeat again once every one to three years.

Buy as a straight rental property

Let’s say you just want to buy it as a straight rental property. First up, you need a 20-25 percent down payment for most lenders (Fannie Mae and/or Freddie Mac may have some 10 percent investor properties, so check those out, too). And that 20-25 percent, plus closing costs and renovation costs, might add up to 30-35 percent cash upfront to close escrow and get a property rental ready. So, for a $120,000 property, that could easily be $40,000 cash needed. That owner-occupied 3.5 percent FHA loan sounds pretty good right now, huh?

As noted above, you also need to have good credit and qualify for a bank’s financing for an investment property. One nice thing about rental properties is that the bank may include some estimated net rental income from the property to help your debt-to-income ratios, especially if you buy something with a tenant already in place. Discuss this with your lender.

Speaking of tenants already in place, there are some significant advantages therein, too! For example:

You get the security deposit from the seller at closing and some pro-rated rent
You probably collect the first month’s rent a month before your first mortgage payment is due
There is no vacancy, so you don’t need to find a tenant, and
You probably won’t have to rehab the property until they leave.

The negative could be a lower-than-market rental rate or a tenant who pays late, doesn’t pay, or doesn’t take care of the property. But he or she could be a great tenant, too! Once in escrow, do a little looking around the apartment and talk to the tenant to make a determination if you want to keep them or terminate their lease when it ends. Convey this to the listing agent so that agent can alert the tenants either way.

Rates, costs, fees on investment properties

The costs of doing any mortgage loan these days are much higher than they used to be just a few years ago. And non-owner-occupant (NOO) investment properties are even higher. Small dollar loans, like under $100,000, have very high fees as a percentage of the loan amount. Possibly up to 5 percent when you add in the loan origination points, fees, appraisal, underwriting, title insurance, escrow costs, etc. But the present rates are really very competitive and you can get NOO financing at 4.5 percent on a 30-year amortizing loan these days. And that is dirt cheap, locking in a 30-year low-interest-rate loan on a rental property.

Where can you find loans?

Right when you start you should meet with two to three lenders and see what NOO loan programs they have for what you plan to buy. Try a bank or two, plus a mortgage broker or correspondent lender, and an online lender. Different lenders have different programs, and a bank may reject you but a mortgage broker might have a program that works for your situation, so check around. Loan costs and rates will also vary, so get a couple of estimates and compare them to find the best deal.

How many properties can you buy? If you have the credit score (estimate your credit score), and the debt-to-income ratios (which change with each property you buy), you can pretty easily finance up to four properties. Once you go over four and up to 10, the number of lenders who can finance you gets much lower, but they are still out there. The underwriting criteria also may get much tougher, but still possible. Once you go over 10 loans, it’s really hard to find lenders who will finance, and the loan costs, interest rates, and terms will be less appealing, but still relatively reasonable. Lenders who do over 10 loans are called portfolio lenders.

In summary, this is a very good time to buy property, but you must educate yourself on rental property ownership, do your due diligence, and don’t think everything is going to be rosy and hassle-free, because real estate is hard work! Hopefully, the hard work you do and issues you have to handle over the years will just be distant memories when you retire with a nice rental property income stream.

(Note: Many thanks to Robin Hill who contributed her guidance for this article. Robin is a San Diego-based mortgage lender for First Cal. She specializes in residential purchases and refinances for owner-occupied and non-owner-occupied properties. She’s been in the mortgage business for the past 14 years).

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