A great strategy for growing your residential (1 to 4 units) rental property portfolio over time is to regularly acquire new homes to live in and convert your old ones into rentals. Assuming you don’t mind moving every so often, this is a great way to supplement other acquisition efforts and leverage more favorable financing terms along the way.
The primary advantage of building your portfolio this way is that you can take advantage of more favorable owner-occupied financing terms. Interest rates on owner-occupied traditional bank mortgages tend to run an average of 1% to 1 ½% lower than comparable investment property loans, which can add up to a lot of cash flow over time.
You also have a lot more down payment flexibility when financing owner-occupied. These days you pretty much have to put down at least 25% for an investment property, but down payments on owner-occupied properties can be as little as 5% for a conventional loan and 3.5% for an FHA loan. I don’t recommend putting down less than 20% and/or financing with FHA if you can avoid it because of the required mortgage insurance, but you do have the option.
One of the most confounding traditional bank financing issues for many investors is the Fannie Mae limit on the number of financed properties you can own. Believe it or not, this acquisition strategy can help you avoid it in many cases. I’ll explain more later.
Financing Considerations to Keep in Mind
If you’re converting a primary residence to a rental and acquiring a new home, there are some considerations to keep in mind when qualifying for the new bank loan. The biggest issue for most people has to do with their debt-to-income ratios (DTI) because the lender will want to make sure you can handle the old loan and the new loan. You can use the new rental income to offset the ding of the new mortgage to your DTI, but with certain limitations:
- If you’re converting a one-unit property to a rental, you must have at least a 30% equity position in the existing property to use the new rental income.
- If you’re converting a 2 to 4 unit property, you must have at least a 30% equity position in the existing property to use the new rental income from the unit you previously occupied. You can use the income from the other units regardless of your equity position.
One way you can make sure you have always have this kind of equity position in each home you purchase is to avoid buying at a retail price point. Many investors already have a business buying fixer properties, rehabbing them, and reselling to an end buyer. Why not do the same for yourself? Buy a fixer, rehab it, then move in yourself. If you’re buying right in the first place, you should always have a healthy equity position in the property.
Lenders usually like to verify rental income via filed tax returns, but income for a newly converted property probably won’t show up on your returns quite yet. To document the new rental income, you’ll likely be asked to provide a fully executed lease agreement and a bank statement documenting the security deposit. To account for maintenance, repairs, and vacancies, the lender will use 75% of the gross rental income for qualifying purposes.
Another big advantage of expanding your portfolio by regularly converting your homes to rentals is that it gets you around the often sticky limits on financed properties. When you’re taking out a bank loan on an investment property, Fannie Mae guidelines only allow you to have up to 10 financed residential properties. Practically speaking, the limit is often more like 4 because it can be hard to find a bank that will finance properties 5 through 10 even though Fannie allows for it.
However, if you’re taking out a bank loan on an owner-occupied property, the limits don’t apply. If you’re financing a property to move into, the whole number of financed properties issue is completely moot. You can have as many financed properties as you like! Pretty cool, huh!
If you’re thinking that moving on a regular basis is a pain in the neck, I’m with you. I’m not a huge fan of moving, that’s for sure! However, would adding another cash flowing property to your portfolio help ease the pain of packing and unpacking all your stuff? If you have a family with a few kids, this might not be worth the trouble, but if you’re single or married without kids, this might be a great way to build your portfolio until you need to be more established and permanent.
Employing a strategy of acquiring new homes and renting the old ones allows you to take advantage of the best bank financing terms – which helps maximize cash flow and ROI – and you can avoid the annoying Fannie Mae limit on the number of financed properties you can own.
Note that guidelines can change at any time, so be sure to check with a qualified mortgage professional for current guidelines and qualifying information specific to your particular situation.
- How to Finance a Home: The Basics of Qualifying for a Home Loan - March 20, 2012
- FHA Mortgage Insurance Premiums Set to Increase in April - March 12, 2012
- What is a Debt-to-Income Ratio (DTI) and How is it Calculated? - December 30, 2011