ARM loan smart for investment prop in todays economic climate?

[Griffin Pratt]

I'm a St. Pete based RE agent looking at purchasing rental property in the area. I'm having trouble making the numbers work due to the surge in home values following the pandemic paired with higher interest rates is making cashflow difficult. (although I've still been able to find a few diamonds in the rough). I am considering alternative financing options to help decrease mortgage payments and allow my margins to hit my targets. One such financing option that caught my eye is an Adjustable Rate Mortgage (ARM). My general plan would be to utilize a 5, 7 or 10yr ARM for the temporary lower interest rate and then sell/1031 or refi and lock in a lower fixed rate based on market conditions at that time.

My questions are, does this seem like a sound strategy and, while I have a general understanding of how the 3/5/7/10yr ARMs work, are there major or hidden drawbacks to be concerned about when financing with an ARM? Will I be able to refi as easily as I'm thinking or ae there hidden conditions that can prevent flexibility at the end of the fixed-rate period? Open to any advice, good or bad, from anyone with some experience financing with ARMs!

Thanks BP family,

Griffin

[Jon Puente]

Hey Griffin,

You may absolutely use an Adjustable Rate Mortgage to purchase a rental. The only drawbacks right now is that lenders are not really being as aggressive on ARM products as they used to be. Meaning, a 30YR fixed often can get you the same rate as a 5YR or 7YR ARM, depending on the deal (credit, DTI, loan size, etc...)

A 10YR ARM will never beat a 30YR fixed with rates the way they are, so that would be off the table. Most lenders do not have a prepayment penalty on ARMs, but that would be something to find out upfront because that could be expensive if they do.

ARMs are a solid way to buy properties and are much more popular in the JUMBO space because of large loan amounts. The biggest thing I would be doing is negotiating seller credits in any scenario and using those to buy down your rate. I think that will have more affect on your than going ARM vs Fixed.

Hope this helps and great question! 

[Robin Simon]

Quote from @Jon Puente:

Hey Griffin,

You may absolutely use an Adjustable Rate Mortgage to purchase a rental. The only drawbacks right now is that lenders are not really being as aggressive on ARM products as they used to be. Meaning, a 30YR fixed often can get you the same rate as a 5YR or 7YR ARM, depending on the deal (credit, DTI, loan size, etc...)

A 10YR ARM will never beat a 30YR fixed with rates the way they are, so that would be off the table. Most lenders do not have a prepayment penalty on ARMs, but that would be something to find out upfront because that could be expensive if they do.

ARMs are a solid way to buy properties and are much more popular in the JUMBO space because of large loan amounts. The biggest thing I would be doing is negotiating seller credits in any scenario and using those to buy down your rate. I think that will have more affect on your than going ARM vs Fixed.

Hope this helps and great question! 

This is accurate. The market expects rates to come back down fairly quickly (no more than a year or two) so that is generally being reflected in ARM vs. 30-year fixed pricing, your just not getting much benefit in rate to take on the ARM risk

[Ned Carey]

@Griffin Pratt We are at historically low rates which have been declining for decades. Even today we are only at or still below the long term averages. If you believe in the theory that "all things return to the mean" then expect rates to rise not drop. 

@Robin Simon said "The market expects rates to come back down fairly quickly". He is correct that is what the market expects. The market is not necessarily right. We've had 30 years of declining rates, we could have 30 years of rising rates. 

I suggest you do a risk analysis looking at the savings vs risk of the rate increasing on your ARM. Most ARMs have limits to how far and how fast they can increase. Depending on hold time your risk might be close to zero and may have some savings locked in.

What I believe we are seeing is that rates will NOT be dropping close to previous levels for the foreseeable future, But the market has not yet adapted to the higher rates in terms of price expectations of sellers. Many deals simply don't work at today's rates like they did in the recent past. I think many investors are going to force poor deals instead of waiting for deals that make sense. 

The market will adapt. Don't force deals in a poor market. 

[Nick Belsky]

@Griffin Pratt

I posted this recently on another poster's question so am reposting here as well.

I will say that I have never brokered an ARM or I/O loan until after March of 2022. Now, they are easily 75% of what I broker.

ARMs with I/O are highly desired in this market for a few reasons:

Increased Cash Flow - The most popular that I broker are 5/1 ARMs with I/O for 5 years, then 25yr Amortization behind it. The Caps are 2/2/5 and comes with a 3-2-1 step-down prepayment penalty. For 5 years, you have a fixed rate, that is lower than most Fixed Rate private money or Non-QM by the way, and get the benefit of increased cash flows. The interest only payments are fully tax deductible in most cases too.

More Competitive Rates with Lite Doc Loan Qualification - Many ARMs are lower than Non-QM and Private Money rates right now. Conventional is still better, for now, but my lenders are still in the mid-7's and upper 7's at par pricing, meaning no buy downs or rate adjustments.

Flexibility - Many believe that rates will recover in the next 2-5 years... or thereabouts... the 3-2-1 prepayment gives a lot of flexibility compared to FRM lenders where 5-5-5-5-5 or 5-4-3-2-1 are nearly standard prepayment penalty structures. This structure gives the investor a chance to get out of the ARM with little or no penalties after year 2 (1% is almost negligible in most scenarios) and essentially gives a 3 year window to refi before any adjustments ever occur. The flip side of that is if rate are lower at the end of year 5, the first adjustment could go down and you'd get a lower rate without having to refinance. If rates, skyrocket by then, you have a 2% cap year over year and have some saving grace if better terms are not available to you. Lastly, once your PPP period expires, you are free to pay down on principal all you'd like with no penalties.

Non-Recourse Lender - offers an SOS if things do go south and you can't make payments. The lender will recover the collateral and not come after personal assets. Another perk with non-recourse is, that so long as your insurance and taxes are in an entity's name, you will NOT have to count that property towards DTI constraints on Conventional loans underwritten with Freddie Mac. These properties do NOT count towards your 10 slots either.

At the end of the day, these loans are not typically meant to be stayed in long term. They are meant to weather the market until conditions improve. Meanwhile, investors can benefit from the above perks and securities with mitigated risks. I suspect that once the market conditions improve, we will see a shift back to FRM and very few ARMs or I/O as before the market turned. If you are planning to hold long term, appreciation is a moot point in these times as you need rental income to be consistent enough to cover your loan and keep cash flows up. As history has shown us, the appreciation will bounce back just as it does in any down turn. If you plan to sell or refi in a few years, then appreciation may be a more concern, but as long as you have a tenant and rental income that covers your loan, it is not as important at all.

Also, these points are in reference to 1-4 units only.

Cheers!

[Erik Estrada]

Quote from @Griffin Pratt:

I'm a St. Pete based RE agent looking at purchasing rental property in the area. I'm having trouble making the numbers work due to the surge in home values following the pandemic paired with higher interest rates is making cashflow difficult. (although I've still been able to find a few diamonds in the rough). I am considering alternative financing options to help decrease mortgage payments and allow my margins to hit my targets. One such financing option that caught my eye is an Adjustable Rate Mortgage (ARM). My general plan would be to utilize a 5, 7 or 10yr ARM for the temporary lower interest rate and then sell/1031 or refi and lock in a lower fixed rate based on market conditions at that time.

My questions are, does this seem like a sound strategy and, while I have a general understanding of how the 3/5/7/10yr ARMs work, are there major or hidden drawbacks to be concerned about when financing with an ARM? Will I be able to refi as easily as I'm thinking or ae there hidden conditions that can prevent flexibility at the end of the fixed-rate period? Open to any advice, good or bad, from anyone with some experience financing with ARMs!

Thanks BP family,

Griffin

 What kind of property are you looking to purchase? 

If it's a 1-4 unit and your goal is strictly cashflow for those 5-10 years, an IO ARM could make sense.

But if you can qualify for a conventional investment property loan, you will get favorable terms and better pricing, with a 30 yr fixed loan. 

[Rosie Small]

Quote from @Nick Belsky:

@Griffin Pratt

I posted this recently on another poster's question so am reposting here as well.

I will say that I have never brokered an ARM or I/O loan until after March of 2022. Now, they are easily 75% of what I broker.

ARMs with I/O are highly desired in this market for a few reasons:

Increased Cash Flow - The most popular that I broker are 5/1 ARMs with I/O for 5 years, then 25yr Amortization behind it. The Caps are 2/2/5 and comes with a 3-2-1 step-down prepayment penalty. For 5 years, you have a fixed rate, that is lower than most Fixed Rate private money or Non-QM by the way, and get the benefit of increased cash flows. The interest only payments are fully tax deductible in most cases too.

More Competitive Rates with Lite Doc Loan Qualification - Many ARMs are lower than Non-QM and Private Money rates right now. Conventional is still better, for now, but my lenders are still in the mid-7's and upper 7's at par pricing, meaning no buy downs or rate adjustments.

Flexibility - Many believe that rates will recover in the next 2-5 years... or thereabouts... the 3-2-1 prepayment gives a lot of flexibility compared to FRM lenders where 5-5-5-5-5 or 5-4-3-2-1 are nearly standard prepayment penalty structures. This structure gives the investor a chance to get out of the ARM with little or no penalties after year 2 (1% is almost negligible in most scenarios) and essentially gives a 3 year window to refi before any adjustments ever occur. The flip side of that is if rate are lower at the end of year 5, the first adjustment could go down and you'd get a lower rate without having to refinance. If rates, skyrocket by then, you have a 2% cap year over year and have some saving grace if better terms are not available to you. Lastly, once your PPP period expires, you are free to pay down on principal all you'd like with no penalties.

Non-Recourse Lender - offers an SOS if things do go south and you can't make payments. The lender will recover the collateral and not come after personal assets. Another perk with non-recourse is, that so long as your insurance and taxes are in an entity's name, you will NOT have to count that property towards DTI constraints on Conventional loans underwritten with Freddie Mac. These properties do NOT count towards your 10 slots either.

At the end of the day, these loans are not typically meant to be stayed in long term. They are meant to weather the market until conditions improve. Meanwhile, investors can benefit from the above perks and securities with mitigated risks. I suspect that once the market conditions improve, we will see a shift back to FRM and very few ARMs or I/O as before the market turned. If you are planning to hold long term, appreciation is a moot point in these times as you need rental income to be consistent enough to cover your loan and keep cash flows up. As history has shown us, the appreciation will bounce back just as it does in any down turn. If you plan to sell or refi in a few years, then appreciation may be a more concern, but as long as you have a tenant and rental income that covers your loan, it is not as important at all.

Also, these points are in reference to 1-4 units only.

Cheers!

 Well explained , thank you so much, I didn't know about " the non recourse lender", that's awesome , 50% of my portfolio is in 10 y arm, which by than , I will sell them or 1031 exchange, but my cash flow is greater, I do send money to the principal as well.

Thank you again for the great explanation