Financing an investment property isn’t exactly the same as getting a mortgage for your own home – the rules are different and so are the rates and fees. In this month’s Mortgage Minute, we take a look at what the differences are and how you can get the most out of your money when purchasing an investment property.
The rules are different when you’re buying an investment property. The financing is more expensive, and lenders want you to “have some skin in the game.”
Last week I spoke with a handful of lenders that told me mortgage rates for an investment property are anywhere between .5% to 1.5% higher than the rate you’d get on a mortgage for your primary residence. And, across-the-board, they said the down payment requirements were stricter when you’re buying a property that you plan to rent out or flip. You’d need to come up with a down payment of a least 20% (often even more) when mortgaging an investment property, while there are multiple loan programs that allow for 95+% financing against a primary residence.
So, why is it more expensive and why are the rules tougher when you buy an investment property?
Lending is all about properly assessing risk — AKA analyzing and forecasting whether or not a borrower is likely to pay back their debt. Lenders believe, and have statistics to back up those beliefs, that a mortgage holder is more likely to default on a mortgage against an investment property before they’d put their personal home at risk. In other words, given the choice, most people would rather have their investment property taken away than the house they’re living in. It’s also important to point out that a lender will often use projected rental income from an investment property to qualify an applicant; a loss of rental income for any reason could hinder the homeowner’s ability to repay that mortgage, which is another element of risk for the lender to consider. The investor’s ability to repay might hinge on their tenant’s ability to pay rent.
When applying for a mortgage, an applicant must declare their intent for the property. That declaration can be categorized one of three ways – 1. A primary residence. 2. A Second/Vacation Home. 3. A non-owner occupied/Investment property.
Occupancy isn’t something a lender will gloss over. An experienced loan officer or an underwriter will first consider whether or not an applicant’s stated occupancy passes a basic “smell test.” Donna Attili, a Loan Officer at Citizens Bank, explained that an underwriter would want a written explanation, and perhaps even more evidence from an applicant who listed “Primary Residence” in a non-traditional scenario. For example, an applicant who lives in and owns a single-family home wouldn’t likely buy a 3-family home in the same neighborhood and move into it, especially if they’re not selling the single-family home.
“Determining occupancy isn’t always black and white,” Attili said. “Upfront we need to be sure we are asking the right questions and getting a clear picture of the borrower’s intentions.”
There are quite a few simple “tests” an underwriter could use to see if the occupancy listed on an application makes sense. For example:
- Is the property being purchased “superior” to a property or properties an applicant already owns?
- Is the property being purchased the type of property traditionally used as a rental property?
- Does the applicant have a history of purchasing investment properties in the same area?
Attili pointed out that there are exceptions to every rule. For instance, an applicant might be an “empty-nester” who is downsizing. The subject property might be much closer to the applicant’s employer. An applicant might be taking in family members who are in need and it might make more sense to live in a 2-family home instead of a 1-family home. “In situations like these, typically a written explanation will suffice,” she said.
Mortgage applicants typically would NOT pay a premium when purchasing a second home or vacation home, however the down payment requirements might be slightly stricter compared to a primary residence situation. Applicants must be able to demonstrate the ability to repay (ATP) without the benefit of rental income when seeking a mortgage against a 2nd home. For a long time, lenders preferred categorizing properties as 2nd homes when they were in traditional vacation destinations like Florida, the Jersey Shore, or the Hamptons. Their guidelines included specific distances a 2nd home should be from the applicant’s primary residence. But Attili pointed to a growing segment of young New York City professionals who have looked for weekend getaway homes in areas like Westchester, Putnam, and Dutchess Counties that wouldn’t normally be categorized as vacation areas. The reverse is also true, she said, citing examples of residents in the suburbs who want an apartment in the city so they can take advantage of the culture and attractions that the Big Apple has to offer.
In refinance situations, determining occupancy is fairly straightforward. If an applicant’s tax returns show rental income has been collected from tenants living in a house, that house would almost always be categorized as an investment property. If bank statements, pay stubs and utility bills were consistent for an applicant, it would be difficult for the applicant to justify calling a different property their primary.
Occupancy is One of Many Layers of Risk
Certainly, Occupancy isn’t the only layer of risk that lenders consider. Examples of other risk types:
Credit – In almost every instance, a lender would obtain a credit report for the individual(s) applying for a loan. The credit report included the applicant’s entire payment history for as long as they’ve been “on the grid.” Applicants that have demonstrated a history of making late payments or not making payments at all would certainly be categorized as higher risk applicants.
Ability to Repay – Some applicants have a long history of earned income that is expected to continue indefinitely. The income is verifiable and is enough to comfortably cover the costs associated with a mortgage. But others might have a shorter track-record for earning or they might not show enough income to satisfy a lender’s requirement to demonstrate their “ability to repay” (ATP).
ATP is a widely used acronym in mortgage circles right now. The Ability to Repay/Qualified mortgage rule was enacted by the Consumer Financial Protection Bureau (CFPB) after the financial crisis. It requires lenders to compare an applicant’s debts to their income to ensure they are capable of repaying the loan. The standard was set at 43%, which means an applicant’s monthly debt obligations (including the new mortgage) would account for 43% or less of the applicant’s gross monthly income. There is a lot of buzz right now that the CFPB might adopt an updated metric for determining ATP. (I’ll pay attention to that for you if you’d like).
Property type – Most lenders would classify a co-op as higher risk compared to a single-family home. Why? Because the health of the co-op itself — the building, the management, its finances, etc., are not completely within the control of any individual unit owner that might be applying for a mortgage there.
Investing in Residential vs. Commercial
When considering finance options, it’s also important to note that there’s a distinction between a residential property and a commercial property. For the most part, residential properties include co-ops, condos, and 1-4-unit properties. Other property types like retail buildings, warehouses, and multi-family buildings with five or more units would be considered commercial properties. A buyer trying to finance a commercial property would likely apply for a commercial loan.
When comparing residential mortgages to commercial mortgages, almost everything is different.
- The lender and loan officer with whom an applicant applies would likely be different.
- The way an applicant gets qualified is different.
- Guidelines are different.
- Terms and conditions offered are different.
Robert Withers, President and CEO of m1 Capital Corp. said more emphasis is placed on the income and the expenses of the subject building in multifamily financing, whereas the focus in residential financing is hyper-focused on the applicant’s debt-to-income ratio and their personal ability to repay a debt. Commercial lenders calculate Debt Service Coverage Ratio (DSCR) to ensure that after operating expenses are deducted the cash flow that is left (from projected or actual rent rolls) is sufficient to “service” the debt associated with the loan request. In commercial real estate financing, Withers said bank financing is referred to as debt, and the borrower’s cash is referred to as equity.
Even though a particular building’s finances is the most important factor in commercial lending, Withers said that commercial lenders definitely consider other information as well. He specifically mentioned:
- A personal financial profile (PFS) that provides details about an applicants income and liquidity
- A credit score profile
- The condition of the building
- The type and length of leases that might be in place
- An applicant’s experience as a landlord is becoming more important. In the absence of that experience, Withers said engagement with a professional real estate management company can be an alternative.
Another element could bolster an application for financing a commercial property, according to Withers. “The potential purchaser should prepare a well-articulated business plan, laying out their vision on how this property would be run, how it would be improved, and how maximum valuation can be achieved with their plan,” he said.
With regard to typical terms and conditions offered by commercial lenders, Withers offered the following:
- Most lenders require a 20-25% minimum down payment
- Most commercial loans are designed as Adjustable Rate Mortgages (ARM) with a rate lock period of 3,5,7, or 10 years, with a 10-year lock period as the most popular. (Withers said fixed rate commercial loans are rare because income generated by leases is always subject to change, so lenders hedge those changes and market fluctuations by offering ARMs.)
- Most commercial loans are amortized (payback schedule) over 25 or 30 years.
- Mortgages with balloon payments (the entire balance comes due after a specified period of time) are less common with multi-family properties. The balloon feature is more common for retail, industrial and special use type properties.