One of the topics that we spend the most time discussing in the ROI Inner Circle is financing strategy. Specifically, how to not run out of capital, how to finance multiple rental properties in a year, the acquisition strategy for buying BRRR deals, and how to continue to finance properties after you’ve “retired-early.”
When I was just getting started investing in real estate, I faced some financing challenges. 1) I had just quit my 9-5 job to pursue real estate investing and a career in real estate sales 2) I wasn’t sure how other investors were able to finance multiple properties in one year without running out of funds 3) I was unsure how the refinance process worked when buying fixer-upper properties (also known as BRRRR) and how I would be able to use the new appraised value immediately.
So, I sought out the best investor-focused lenders to learn how I could put together my own financing strategy that would allow me to take advantage of 30-year fixed mortgages with minimum down payments and low-interest rates.
What I learned throughout the process was that very few lenders understood financing strategy for real estate investors. Very few had ever closed on non-owner occupied properties; therefore, they were unfamiliar with the rules.
What I learned from them and through my own experience over the past 13 years of investing in real estate is what I am sharing with you today so that you, too, can determine the best financing strategy for building your own rental portfolio.
1. Find a lender that has experience with investment property loans.
You’ll save yourself time and headache by working with someone who has experience in rental property loans. Like any profession, not all lenders are created equal, and I’ve seen some errors made by experienced lenders who did not understand the rules of investment loans.
How do you find lenders that specialize in this area? By referral. That’s why we created a resource section in the ROI Inner Circle dashboard and invited our friend Cody Touchette into the group. We even have local lenders in many of the markets we have teams in and share with our members.
I recommend that every investor first have a strategy session with an investment-focused lender to go over their goals and get a plan. It’s never too early to determine your financing strategy and get pre-approved. You do not want to miss out on a great deal by not being pre-approved to buy.
If you are looking to start with 1-4 unit properties, do yourself a favor and steer clear of the bigger banks like Bank of America, Wells Fargo, Chase, and do not use credit unions. The big banks have bank employees that have to work inside a box, and it is likely they have minimal experience with investment property loans. You may be able to get by with one single-family rental property loan. Still, after that, they usually have trouble structuring the next loan and applying rental income to qualify. Credit unions are worse; they are great for personal and auto loans, though terrible for investment property loans.
Larger banks have their place when it comes to portfolio and commercial loans; we’ll cover that topic later in this article.
2. Pick a lender and stick with them for the long haul.
If your goal is to get multiple rental property loans, don’t worry about shopping around for rates every time with different lenders. There are very few experienced lenders who specialize in rental property loans, and once you find a good one, you’ll want to stay with them.
An experienced loan officer will save a file with your information so that the next time you get a new property under contract, all you have to do is update them with your pay stubs and bank statements. They should save your tax returns, lease agreements, and all other paperwork.
Ideally, you would work with a lender who can finance properties in multiple areas, assuming you plan to shop for properties in several markets. This is something we look for when recommending lenders to our ROI Inner Circle members.
3. Create a financial folder to save time.
When going through the pre-approval process, be prepared to send your lender a lot of documentation. At a minimum, they will need:
- All lease agreements for all properties owned.
- Two years of tax returns, all schedules along with W-2’s, 1099’s, and K-1’s
- Two months of bank statements
- Retirement account statements
- Most recent mortgage statements
- and more.
I recommend creating a financial folder with copies of tax returns, lease agreements, etc. that you can easily access each time you need to update your file. These days most lenders have secure online portals for you to upload your documents to, and it helps to have everything in one place online. When I buy a new property, all I have to do is drop in some updated bank statements and paystubs. When using the same lender each time, they should already have tax returns, lease agreements.
4. Keep your down payment funds in a separate bank account.
This is another time-saving tip. If you dedicate a separate bank account for downpayment/reserves, you will only have to share updated bank statements from one account instead of many. For example, I have over 15 bank accounts; if I were pulling downpayment funds from all of these accounts, it would take a very long time and might even increase the chance of something getting missed. By keeping the bulk of my funds in one account, it is much simpler.
Also, keep in mind the down payment funds need to be seasoned in your bank account for at least two months, or it needs to be sourced from a qualifying event such as the same of another property (and you’ll need to provide proof).
While family members cannot gift down payment funds for conventional loans, they can provide gift funds as long as those are seasoned.
For example, let’s say your parents are nice enough to give you a $14,000 gift, which is the maximum amount exempt from tax per the IRS. If you wanted to use that to purchase a property, you need to have the funds in your bank for at least two months before purchase, AND the funds have to be treated as a gift with no repayment.
5. If you are married, do not finance properties together.
What I am about to suggest may sound controversial, but there is a financial strategy behind financing properties and debt separately.
The first reason is the ten conventional loan limit per person. Meaning one person, if qualified based on their DTI, can have up to ten conventional loans. In the case of a married couple acquiring rental properties, if each person, if qualified, puts a loan in their name solely, together the couple could have up to twenty conventional loans.
How powerful is this? Considering that conventional loans go up to four units, a married couple could secure up to 80 units together, in this example, purchasing fourplexes, individually.
Another reason to consider financing properties separately is to maintain lower debt-to-income ratios. For example, two partners work full-time and earn W-2 wages. Both have auto loans, and both partners have signed for both loans. If the couple were to finance individual investment properties in their own names, they would both be required to qualify using both auto loan payments. Alternatively, if both were to refinance auto loans into one of their names, then said the auto loan would only be counted once.
Let me share a personal example with you. My husband is “retired” he no longer earns a W2 income, but he earns rental income from properties purchased when he was earning W2 wages. He is not on a primary residence, which is in my name personally. This allows him to qualify for additional rental property loans because his DTI is so low. If he had been included on the primary residence mortgage, he would not have been able to qualify for additional rental properties.
6. Know your DTI ratio and keep it low.
DTI stands for debt-to-income ratio.
Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number is one-way lenders measure your ability to manage the payments you make every month to repay the money you have borrowed.
If your debt-to-income ratio is too high, you will not be able to qualify for additional conventional mortgages. Most lenders require a debt-to-income ratio of 43% or less, including the new mortgage payment. Keep in mind that the new property’s rents will be added to your income to help qualify.
Too high of a DTI is one of the most common reasons why investors have qualifying challenges. Expensive car payments and even a 15-year mortgage on a primary residence would cause the DTI ratio to be too high.
There are straightforward solutions for maintaining a low DTI ratio:
- Increase income: If you happen to love your job though the job does not pay as much, consider one or several side hustles for additional income. Keep in mind. Most lenders may want to see two years of tax returns showing consistent income with these businesses to count it for qualifying for a mortgage.
- Get a second job with a regular paycheck: Most lenders may require between 30 days to 6 months of paychecks to count this second job income, though if you want to be able to retire by 30 or 40 and a second job can help you get your debt to income ratio in check, I suggest you do it. I did… several times in my younger years.
- Consider financing with the most extended term possible. For example, you may pay a slightly higher interest rate, but the payment difference between a $40,000 auto loan financed for 72 months versus 48 months is $277 per month, directly affecting your DTI ratio.
7. Avoid the 15-year mortgage trap.
As mentioned above, conventional lenders use DTI to qualify for new mortgages. Mortgages on investment properties count against your DTI ratio, but the rental income it produces is included. If you are buying properties that cash flow, then you may even improve your DTI ratio. But, be careful with 15-year mortgages.
The payment on a 15-year mortgage is much higher due to the amortization schedule of 15-years versus the traditional 30 years, which ultimately increases your DTI ratio and decreases your ability to finance additional properties.
If you want a similar result as a 15-year mortgage (assuming the intent is early payoff), consider using excess cash flow and apply it to the principal reduction payment.
8. Have your CPA create a draft version of your tax return and have your loan officer review before you file.
A good CPA can find deductions and ultimately save you in the amount of tax owed. A great CPA saves you tax and structures your return to qualify for additional mortgages. This is why we recommend three investor-focused CPA’s in our ROI Inner Circle resources.
For example, we have a business owner client who’s CPA had done an excellent job saving them taxes over 20 years. But, when they went to purchase a new rental property, they did not qualify, even with 800+ credit scores and over $1M in the bank. Why? According to their tax returns, the business “lost money” due to the write-offs and deductions they were taking.
We covered this topic in a live masterclass in the ROI Inner Circle; there are ways to reduce your tax liability while maintaining your ability to get loans.
Start by having your current CPA send you a draft version of your tax return and send it to your conventional lender for feedback. It may make sense to move some deductions and reallocate for qualifying purposes.
9. For self-employed/business owners – consider paying yourself a W2 wage.
I am in Real Estate, and my income varies each month, so I had to figure out a way to keep my income consistent. I also knew that the underwriters had differing methods of calculating 1099 income. I wanted to make sure an underwriter correctly calculated my income, so I worked hard my first two years in real estate to earn a high income and justify creating an S Corp. The S Corporation allowed me to pay myself a salary for a consistent W-2 income and monthly paychecks. Even though I still needed two years of income, it was much cleaner with the S Corp and paychecks, and there were fewer questions from the underwriters when I was able to provide them with a W-2. I also enjoyed some tax savings.
Anyone who receives W-2 income and paychecks will not have this problem, though business owners should note this and know there are many options.
It’s also important to note that part of the loan approval includes the lender adding in the new property’s income, which offsets the mortgage payment. So if a new mortgage payment on a new rental property is $1000 per month and the rental income is $1500, the lender will use 75% of rents, or $1125 to qualify, and this new property will be a positive income contributor to the investor which makes it easy to qualify for more.
10. Lenders prefer landlord experience.
Every lender prefers to see some experience in a borrower being a landlord, and more recent guidelines have changed how rental income is calculated based on experience.
The easiest way to get a loan and gain experience for the next property is to owner occupy a duplex or multi-family property, exactly what I did early on. While you would be required to owner occupy the property for a year, a year goes by fast, and you’ll be happy you did it.
Already own a home you occupy, and you want to buy your first investment property? You’re perfectly fine to get a mortgage if you qualify, though the lender will most likely use 75% of the potential rental income for you to qualify for the new payment.
If you want to turn an existing owner-occupied home into a rental and buy a new primary home, the rules are more strict for non-experienced potential landlords. The lender will often want to see 30% equity in the current home in order to use fair market rental rates to offset the current mortgage and qualify you for the next property.
11. Once you have over four financed properties, be prepared to have more in reserves.
Some lenders will require six months of mortgage payments per property in your bank account as you get over four loans. So while I would rather spend my money on acquiring cash flowing rentals, I do save enough to make sure I have sufficient lenders’ reserves.
For the first five years of investing, we saved all of the cash flow for reserves to qualify for additional properties.
12. Find a trusted hard money lender and stick with them.
If you plan to purchase properties in need of repair or requiring a quick close, your options are to either pay cash or find a trusted hard money lender. Hard money lenders will loan on properties that do not qualify for conventional loans, and you’ll need to make sure that you can refinance to a conventional loan after the repairs are made. I used this strategy for most of my investment property acquisitions, and it worked great.
Also, be prepared to pay a high-interest rate and between 1-5 loan origination points for hard money loans. These may be deductible expenses.
In a single year, I paid around $14,000 in hard money loan fees between two properties, allowing me to take advantage of great deals that I otherwise would not have been able to purchase had I not had access to hard money loans.
13. It may be easier to qualify if you buy several properties in a single year versus allowing a few years in between.
When I first heard this from an investor-focused lender, I was confused. It finally clicked when I thought about what the tax returns look like when I do a significant rehab.
Earlier I mentioned that we were purchasing fixer-upper properties in the beginning. This was great, except that we had many deductible expenses when we filed our tax returns due to the remodel and hard money loan expenses, resulting in a tax return loss. This was to our benefit for tax purposes but posed a new challenge to the underwriters qualifying us for additional loans.
The underwriter doesn’t always know if tax return expenses are one-time or on-going (expect that a great CPA can structure this). Depending on your timing, expensive renovations may negatively affect your DTI.
Fortunately, my DTI was low enough that it didn’t matter, though this is something for those who decide to use the BRRR strategy to consider.
On the flip side, let’s say you purchased an investment property in need of a rehab in January and finished it in March. Then in June, you bought another; since the underwriter doesn’t have a tax return showing the rehab expenses on the January property, they will only be able to use the income from the leases and the PITI expenses.
14. Understand the financing side of the BRRR strategy.
Once you have found an investor-focused conventional lender and a hard money lender, you need to determine how you plan to structure your BRRR deals’ financing strategy. There are many options for how to set this up.
The BRRR Strategy stands for buy-rehab-rent-refinance-repeat. The strategy including buying a property for less than fair market value, completing any necessary renovations or repairs to increase the value, renting the property out, and refinancing using a higher-appraised value. Ideally, you would be able to refinance most, if not all, of your initial investment, leaving none of your own capital into the deal.
Most of the time, the property requires renovations; that’s why it’s undervalued to begin with. Properties that require renovations typically do not qualify for conventional financing. That’s where hard money or private lenders come in. Alternatively, you could pay cash.
How you buy the deal determines how you can refinance it (for conventional 1-4 unit loans.)
But first, you want to make sure you qualify for a conventional loan once the condition is suitable for a conventional loan. If not, you have to sell because no one wants to be stuck with a 12% interest hard money loan.
When the property has been rehabbed, and the new tenant has moved in, the lender will call for an appraisal on the property. You will then cross your fingers, hoping that it appraises at least 20-25% more than what you are into the property.
If you paid cash for the deal, you can use the delayed financing exemption and use 70% of the new appraised value for 2-4 units, or 75% of the new appraised value for single-family, BUT the new loan will not repay you more than what you paid for the property + refinance costs. There’s a bit of a work-around if you add renovation costs to the closing HUD and have funds paid directly to a property manager or contractor, but otherwise, the intention is this is not a cash-out refinance.
If you use a private or hard money lender to finance the property, and they require you to put money down, then you could either do a rate and term refinance or a cash-out refinance.
A rate and term refinance is similar to the delayed financing exemption in that you can use the new appraised value right away and refinance existing loans, but this new loan will not pay you back for the funds you have into the deal. Rate and term allow 80% loan to value on single-family, and 75% loan to value on 2-4 units.
If you can convince a hard money or private lender to finance 100% of the deal plus the renovations, either by getting a first and second loan, or collateralizing equity in other properties or funds in an account, this is an option that would allow you, if the appraisal came in where it needed to be, to refinance using the maximum permitted LTV without having to wait for six-months.
The next option would be a cash-out refinance. This is the only option where you could pay yourself back additional if you put money down in the beginning. Cash-out refinances require a six-month seasoning of ownership before a lender will allow the use of the new appraised value. The LTV is limited to 70% for 2-4 units and 75% for single-family homes.
15. When to use portfolio or commercial lenders.
As mentioned, conventional loans are available for 1-4 unit properties, typically have lower interest rates, and require less down; they also offer fixed rates and a 30-year amortization schedule. That’s why these first ten loan spots are very valuable and to be used wisely. They require the loan to be in an individual’s name, not as an LLC or Corporation. As mentioned earlier, you can get to 20 for a married couple, and I suggest you consider using this strategy when just starting.
For properties over five units and for investors who have met their ten conventional loan spots, the financing options are limited to commercial or portfolio lenders. But first, what’s the difference?
There’s not much difference between a portfolio and a commercial loan. You can get a portfolio loan on a 1-4 unit property. To put it simply, a portfolio loan is a loan originated by a local bank that is not sold on the secondary market; it stays on their books. That means the local bank needs to make sure they are not taking on a risk by loaning you the money, so their terms are often five year fixed rates with a 25-year amortization, and they require higher debt coverage ratios. If you establish a solid banking relationship with a smaller bank that offers portfolio loans, these will be pretty easy to get. They will also do 1+ unit loans, whereas conventional will only go 1-4 and commercial 5+.
The terms and rates vary from bank to bank, along with their ability to get creative.
Both portfolio and commercial lenders loan to entities, not individuals. Whereas with conventional loans, the loan is required to be in an individual’s name. Commercial and portfolio loans do not count against your conventional loan limit.
A commercial loan is held by a larger bank, and they often have similar terms as a portfolio loan with a 5-year balloon and a 25-year amortization. They will not offer loans on properties under four units, and they will allow loans in an LLC or Corporation. Commercial loans also use a debt coverage ratio, and for qualifying, the lenders focus more on the property’s income than the guarantor(s).
While I feel pretty savvy about getting loans, keep in mind that different lenders have different guidelines, and each individual has a unique situation. This article is not meant to be used as legal, tax, or financial advice. It is highly suggested that you seek the advice of a qualified CPA, Attorney, or Financial Planner regarding your situation.