How to Buy and Finance Investment Property
Quick Flip or Long Haul?
Investment property can yield income two ways--through regular rents and/or capital gains. Property "flippers" tend to buy distressed properties, rehabilitate them, and promptly resell them for a profit. Other types of real estate investors may do some initial repairs, but their goal is a long-term investment that yields monthly income and some tax advantages as well. Most experts advise novices to invest for the long term rather than try for quick flips.
A good investment should deliver healthy cash flow and growth potential. So first, analyze every deal as though you were Donald Trump. He reports looking at just three things -- how much you'd pay for the property, what it costs to rehabilitate it, and what you could then sell it for. If there isn't a 20% profit involved, he doesn't bother. So how do you minimize what you pay and maximize what you earn?
- Look for distressed or motivated sellers. Today, in many parts of the country it isn't hard to find people who need to get out from under their houses, or mortgage lenders with property on their books that they need to unload. But don't assume that short sales or foreclosure homes are bargains -- you should know what the property is truly worth before making an offer.
- Know local house values. Do a lot of homework. Check public records (available online in most counties) and see what properties in your area are selling for. Resources like Realtor.com can also give you a good idea of what a home should sell for given its features, location and condition. Don't overpay. Experienced investors know the adage, "You make your profit when you buy a property, not when you sell it."
- Make minor cosmetic improvements only. If the house needs an extensive renovation, pass on it. Don't over-improve a rental property. Potential renters are far more concerned with the neighborhood, schools and proximity to work than they are with floor plans.
- Prepare to look at a lot of properties. Some seasoned investors say they look at 100 houses for every one that they buy.
- Enlist the help of an agent specializing in investment property. Expert advice and knowledge of local market conditions is an invaluable resource.
Long-Term Cash Flow
Another source of income is your monthly rents. Analyze your potential cash flow like an underwriter or an appraiser. The investment property appraisal form lists gross rents, expenses -- including all utilities paid by you -- reserves for replacing appliances and fixtures and a vacancy factor (lenders usually assume 25%). Your monthly operating income equals rent less these expenses. Then, you'll have to subtract the mortgage payment to get your net cash flow. That number is either added to or subtracted from your income when your mortgage application is being evaluated.
Keep in mind that your actual after-tax income will be different. Your mortgage payment includes principal -- which isn't an expense (you recoup that when you sell the home) -- and you get to deduct your operating expenses as well as depreciation. You can have negative operating income but still have a positive cash flow. Running the figures through tax software can show you how the property will really affect your finances.
Investment Property Mortgages
There are several options for coming up with the funds to purchase an investment property.
Hard money. Financing investment property is a different ball game than buying an owner-occupied home. If you buy a foreclosure property at the courthouse (risky), you'll have to bring cash. Property flippers often use "hard money," or private lenders to get cash -- they pay several points upfront, a high interest rate and make a substantial down payment. However, they only borrow the money for a short period of time, just enough to rehabilitate the property and sell it. You can see why this is risky. If you end up holding onto the house for too long, this kind of financing can drain your resources very quickly.
Conforming mortgages. You won't get the best mortgage rates unless you pay the mortgage fees and surcharges upfront -- and there are lots of them. Fannie Mae and Freddie Mac will guarantee investment loans, but they don't guarantee them as much as they used to. Your application must be beyond reproach, specifically:
- No bankruptcy or foreclosure within the last seven years.
- No payments more than 30 days late on any mortgage in the last 12 months.
- Any other rental property income must be documented with two years of tax returns.
- You must have at least six month's reserves (mortgage payments) in the bank for each investment property you own.
- You can't have more than four financed properties unless you put down at least 25%, and your credit score is greater than 720.
- Plan on bringing in a hefty down payment. While Fannie Mae officially allows 90% investor property financing, as a practical matter, you can't get the necessary mortgage insurance to complete the deal. Even with 20% down, there is a 3-point surcharge added to the loan fees. You can cut that to 1.75% with 25% down.
Other mortgage options. Portfolio lenders, like your neighborhood bank, may finance your purchase with less onerous conditions. You may also need to go that route if your property requires a jumbo mortgage. Or, if you have enough home equity, you could finance an investment property with a loan against your primary residence. This strategy could get you better mortgage terms.
Some of the richest people in the country have made their fortunes in real estate. Successful real estate investment takes hard work, diligence and a good team, including you, your real estate agent and your mortgage lender.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.
By HSH Associates Financial Publishers