Vacation rental purchase

Occasionally, an inspired entrepreneur comes to me looking to buy a vacation home in Florida, or some other popular vacation spot. While they may use it, the main focus is to rent it out.

What can you do to prepare for a vacation rental purchase?

1) Prepare for sticker shock.  Many times you fixate on what a house cost where you are from, but a vacation rental is automatically going to cost more for its size because of the location and the earnings potential.  Prepare mentally and financially for that ahead of time.

2) prepare for a bigger downpayment.  A lot of people are shocked to hear of needing more than usual.  While you can call it a second home, and maybe get closer to a normal downpayment, the reality is that there is probably no $0 down program.  A true rental property is 15-25% down, and that gets a higher rate than your home as well.  So it costs more all the way around than your home.

3) Don’t forget prep costs.  There are towels, decorations, furniture, etc. That you need for a vacation rental.  It is basically a furnished home is the expectation of your renters so dishes, utensils, appliances, etc. Have to be up to the level of the rental.  If you are charging top dollar, they may not appreciate plastic silverware for example.  All of this adds up significantly.

4) prepare for ongoing maintenance costs.  From mowing the lawn to cleaning after each guest leaves, you have to have someone to monitor things and provide those services.  This is often forgotten or at least under budgeted in the equation of how

much you could make from a rental property.

5) Prepare for higher property taxes and insurance as a rental property.  This can affect the payment if escrowed and if not, should be budgeted as the yearly cost could easily add up to several months’ gross rents! So whether the lender or you budgets for it, it still must be paid.  The insurance is higher for a temporary rental as the guests are generally not that concerned about their temporary home and it sits empty at times as well.

If you count all the costs, and budget for them, it will help you see what the minimum rent should be set for as well as what it will take to truly make a profit…

Rental properties – Commercial loans or something even better?

I was amazed working for another employer how they did investment rental property loans, specifically 1-4 family household properties.   They used a 3-5 year ARM (adjustable rate mortgage), many times wanted to only go with a maximum 20 year total term, and added with it annual financial reporting!

When I mention annual financial reporting, I am talking about turning in personal and business tax forms again, each year, along with a personal financial statement and sometimes a full application’s information.

What are the consequences of not complying? 

First off, the customer is in default on the loan if they do not!  There is a loan covenant, one of those buried lines of potentially bad for you information in a loan agreement, that says that they have a right to annual financial statement reporting.

Secondly, although uncommon, I have seen banks downgrade commercial loan borrowers based on the analysis of what financials they received and then ask the customer who did not meet their criteria to leave the bank.  I am not talking about an application, I am literally talking about an existing loan, a loan already done and funded, and a property already rented.  Yes, that existing loan is re-analyzed in a giant waste of time and resources yearly on both the borrower and lender’s part!   The worst part about it is that re-underwriting can lead to your termination of that loan, although you had already received it, had “banked” on it continuing, and even if you made all your payments on time!

Is there an alternative to this insanity?

Yes, happily, there is.  Both conventional and alternative lenders can “set it and forget it” by simply financing you once for 30 years (or more).  You don’t have to always have an ARM, nor always have tiresome annual financial reporting, nor answer every year for the next 20 to 30 years for a loan that you had already received.   There are even interest only and 40 year term options!  All of this is made possible so that you can cash flow normally, without having the added burden of reporting back into your lender.   You can even refinance your investment rental property loan from one of those burdensome commercial lenders and get cash out!

For real investment rental property options,  look up your favorite mortgage lender.

DSCR – yet another acronym in mortgage?

Debt Service Coverage Ratio.  Now that we know exactly what that is, you get why it’s so great, right?  Me neither.   But D.S.C.R. is the greatest loan program for investment rental property.

Why is DSCR better than conventional lending?
Once a person gets past 4 rental properties, it’s really hard to then get another conventional loans.  As it approaches 7-10, it becomes even harder, and if you are into investment rental real estate, I don’t need to tell you that 10 properties is the limit.  Most people actually never get there, because of a variety of reasons, mostly they simply don’t meet the criteria, including the minimum credit score.

But DSCR lending eliminates most, not all, of the issues.   The reason is that it lends on cash flow of the rental property.  Yes, that is the key.  Other debts, other loans, all the other noise in a real estate investor’s life, is generally ignored.   Does the property positively cash flow?   If it cash flows well (1.15, 1.25, or 1.5), even better for rate and terms.

One of the problems with traditional conventional lending is the “double haircut” theory.  A rental property income is calculated from taxes by taking the net income (after all deductions), then adding back depreciation and interest expense (the small or large portion of your payment that is the interest).  One could argue that this is fair since this is the “cash flow” of the rental, all the other expenses are hard expenses.  But we all know that some of that is simply not true.  The interest and depreciation are higher in the beginning of a loan, but home improvements actually tend to be higher at any time.  Since that is a hard charge, as well as property taxes and insurance that could be escrowed in the payment, it’s a “double haircut” because the net amount and the additions typically are not enough to cover the real expense, the payment.  Since most conventional loans are at 50% maximum debt to income, it literally becomes harder and harder for a real estate investor to show $12,000 of income to pay $6,000 in payments (or 50% debt to income) when you don’t add everything back in.

DSCR takes a simple formula: PITIA (payments including principal, interest, property taxes, insurance, and any HOA fees, etc.) divided by gross rents.  This gives a true “cash flow” for that rental property, ignoring the many possible extra temporary expenses you may have.   Also, you can use this type of loan to get a cash out refinance on a rental property.

So what’s the catch?

A large down payment is required, no 100% financing here.  Also, they want to see that you have reserves in the bank to cover the unexpected.  And although credit score is not a primary factor, there are minimum scores, minimum derogatory credit events, etc.

I have also written on the difference between this and other commercial home mortgage options, be sure to check that out!  To get started on your scenario, look up your favorite home lender.

2019 Best home mortgage loan options


What is your best mortgage option? 

The one you get approved for.  All kidding aside, there is a lot of truth to this.  You can read online, apply at a lender with an option or two, or even go to your local bank.  But every single one of these could literally tell you no, or even worse, put you in the wrong type of loan!  And not because you are so bad, just because they don’t have any unique, out of the box options, or the right product for you.

1) FHA

Don’t count out an FHA loan.  They have a higher debt to income limit generally than does a conventional loan. They have a higher loan to value ratio for refinances than does conventional.  They have an option for citizens, non-citizens, even non-resident aliens, more options than conventional in general.  They allow lower credit scores than conventional and don’t penalize the mortgage insurance premium by the borrower’s credit score.  This can lead to real savings. Time to take another look at FHA!

2) Bank statements for self employed individuals

Bank statements can be used instead of traditional tax returns to prove income.  This program is available from a number of non-traditional lenders.  This allows a self employed borrower to show 1, 12, or 24 months of business (or in some cases personal) bank statements to prove deposit income.  This could help a heavy gross sales, but low net sales (after expenses), client to still qualify for a loan.  Expect a little higher rate, but it’s better than not getting a loan.  Stated income is back? It’s now bank statements

3) Debt Service Coverage Ratio

Commonly used in commercial lending, this is a simple formula for income producing properties (AKA rentals) where the customer’s other assets and liabilities are ignored and the income of the property is the primary consideration of the loan’s ability to be repaid.  The cash flow of that particular property is the main consideration, and that cash flow is based solely on the rental income versus the PITIA payment.  Rental properties – Commercial loans or something even better?

4) Home improvement all in one loan

Whether it’s FHA or Conventional, the home improvement loan market is booming.  Many customers don’t know why this is better than a simple cash out mortgage refinance, or financing home improvements with a second mortgage or even a separate type of loan.  First of all, all in one can save you money on a lower rate and one payment (instead of 2 or more).  A “cash out” refinance also costs more than a home improvement mortgage loan.  It also makes the equity position simple, I owe this much on my house, not give me a minute and let me add it all up.

But the biggest reason of all, even bigger than the convenience of one payment, is the fact that this type of mortgage uses “future value.”  What is future value?  With the quote for the repairs from a licensed contractor in hand, the appraiser goes out and literally says that after these repairs the home will be worth that amount.  This will allow you to take advantage of that increased equity from day one.  Last of all, the conventional option even allows you to do this with a rental property.  While not for fix and flip transactions, it’s more for fix and rent investment properties, this could literally be a game changer.   Stop paying higher rates, points, etc., and get a conventional home improvement mortgage loan.  Remodel or rehab loan?

Wrapping it all up

What does all of this mean to you?  You are looking for a mortgage.  Go where there’s more than a handful of options.  Go where your unique circumstances are taken into consideration and may have a niche loan product answer.   To get started