Financing for investment properties – A Primer

Fair warning – this will be a long one because it needs to be. Financing is a crucial component to investing in real estate long term because it impacts both your returns on investment and your investing experience. If you opt for the wrong kind of financing, that could mean that a great investment property isn’t cashflowing like it should due to your interest rate being too high. Or if you go with an inexperienced Lender, the process to obtain financing will be so tedious you won’t want to do it again. So, this post will go over the different financing options for investment properties in succession – meaning, we will start with the most optimal option for long term investing and then cover alternative options once the former is no longer available.

Conventional or conforming financing

As long as it’s available, conventional financing is the recommended route for long term real estate investing. Conventional loans have to abide by Fannie Mae/Freddie Mac guidelines. At the time of this writing, the guidelines allow for any qualified borrower to carry up to 10 conventional mortgages at a time, including the mortgage on their primary residence. So if there’s still a mortgage on your home, you can purchase a maximum of 9 investment properties with this type of financing. This of course has been and will continue to be subject to change just like anything else that’s dependent on a government entity. At times investors have been able to purchase an unlimited number of investment properties, as long as they had the income to support them. At other times, the number has been arbitrarily shrunk to as low as 4 mortgages. Up to the first four properties, conventional investment property financing allows a minimum down payment of 20%. On the next 6, the down payment requirement escalates to 25% and the cash reserve requirement increases as well. Loan terms can be as high as 30 years or as low as 10 years. As a rough rule of thumb, interest rates for investment properties are generally 1 percent higher than your primary home loan rates. They fluctuate from day to day but at the time of this writing they have been in the 4.25-5.25% range.

The biggest advantage to this type of financing is that it offers the lowest fixed interest rate and closing costs of any other option. It does require excellent credit (generally scores above 700) and substantial down payment. But over the long term, properties acquired with this type of financing will cashflow better due to the low interest rates and lower loan amount as a result of the higher down payment.

When shopping for a Lender to provide this type of financing it is recommended that you work with a company that specializes in financing investment properties. Most Lenders you speak to will tell you that they do provide this type of financing but most of them are just home loan lenders. Here’s a question you should ask them to help you determine if you are working with a pro or not:

“I’m planning on purchasing multiple investment properties this year. When you finance my third or fourth home for the year, what percentage of the rental income from my other properties do you count?”

If you’re dealing with a run of the mill home loan lender, they won’t be able to count any of your rental income until it shows up on your tax return the following year. This would be a major obstacle as it would constrain you to purchasing one property per year. But even if you aren’t planning on purchasing multiple properties that year, this is a great litmus test to filter lenders. Because, if they aren’t setup to handle investment properties, their guidelines will be much stricter as well which will increase your hassle factor.

In addition, you want to use a Lender that has in-house underwriting – not one that’s just a middle man, brokering your loan to some other Lender halfway across the country. Lenders that handle the entire process in house generally offer a smoother process. As they say in Texas, a good lawyer knows the law, a great lawyer knows the Judge.  Lenders with in house underwriting know the decision makers, what they look for in a file and how they want things presented. That means your loan gets approved faster and with less hassle.

Last but not least, what truly separates the cream of the crop Lenders is the ability to service their own loans if need be. See most Lenders use an “originate then sell” business model – meaning, they make a loan that conforms to certain guidelines then sell it to big banks buying loans on the secondary market. However, some Lenders have the capacity and the muscle to service some of their own loans – in other words, take payments from their customers for some time. That’s a huge advantage to the investor because if for some reason their loan doesn’t fall within the “box” of conventional guidelines, these Lenders can still approve the loan and keep the loan in their portfolio.

Portfolio Loans

Let’s say you are maxed out on the number of conventional loans available to you for investment property purchases but you need to acquire more assets to reach your retirement goals. What are your financing options?

Enter portfolio loans – these are commercial loans offered by small to midsize local or regional banks. The terms can vary substantially from bank to bank but the best banks offer 15 year loans, 20% down with 6.5% interest fixed for 5 years, then adjusting to Wall Street Journal Prime plus 1% (but no lower than 5.5%). That’s a mouthful, I know but it’s pretty simple. First five years, it acts just like a fixed rate – afterwards, it adjusts based on where interest rates are at the time. There is no arbitrary limit to the number of properties you can buy as long as your financials support them. Loan fees are comparable to conventional mortgages – and in some cases they are even lower. The process to get approval takes a little longer than a conventional mortgage so you should allow 45-60 days for closing on your investment property to be on the safe side. The rate isn’t fixed for the entire term of the loan but you can drastically reduce the risk that rate adjustment poses by paying off your portfolio loans ahead of your conventional loans as part of your domino strategy. So in five years time, that mortgage won’t have a chance to adjust as it will no longer exist. And after the last properties purchased with conventional loans at 25% down, the 20% down requirement should provide some relief to your capital investment and allow you to acquire more properties in the long run.

Lines of Credit

At times, when a real estate investor has solid long term relationship with a local bank, they will grant him a line of credit to be used for purchasing investment properties. I know what you’re thinking: People still have strong relationship with banks?! But local institutions that do banking the old fashioned way, that grow as their customers grow are rare, but they’re still out there. Typically these lines of credit carry variable interest rates so the investor assumes all risk of a spike in rates. Also, the bank usually reserves the right to review and pull their lines of credit as they see fit. When that happens, the investor has to pay back everything owed on the line of credit on the spot. So definitely not an option for those of us that don’t take kindly to risk.

The positive of using a line of credit is that it gives the investor a lot of control over how to use the money. The negative of using a line of credit is that it gives the investor a lot of control over how to use the money. 🙂 When there’s OPM (other’s people money) at your disposal, many strategies that would feel too risky to invest your own money on start to seem attractive. All of a sudden you might get an urge to flip a thousand homes a year like that fine fellow on the TV infomercial. Remember you still have to pay it back – it’s far from FREE money.

Last words

If you are thinking about investing in real estate long term, your success depends on securing high quality financing with low interest rates and good terms from a seasoned pro. Anything less and it will show in your results – that is if there are any results left. For your sake, get this right from the beginning. We help our clients source financing for their properties every day and we can do the same for you. If you need a recommendation or have a specific question, call my cell at 713-922-2702.

Philip Taylor via Compfight