Buying Investment Properties and Second Homes

Your New Year’s resolution is to wade back into the real estate markets. You have some money in the bank at 1.5% interest and you are determined to put it to better use. Mortgage interest rates are still at historical lows and home prices have declined to their 2003 levels across the US. You would like to purchase one house as a vacation home and the other as investment property to rent out but have no idea what banks are requiring now days. The purpose of this HUB is to bring you up to date.

Defining Investment Property and Second Homes

Let’s start by getting a good handle on terms. When you say that you are interested in purchasing investment property, the bank classifies the home as Non-Owner Occupied. In other words, it is not your intention to live in it at any time during the year, but to rent it out twelve months out of the year. The main purpose aside from any tax benefit and equity growth is to produce income from the rent you collect. Rental properties can be hundreds of miles from your primary residence or they can be next door.

A vacation home is classified as a Second Home. It has nothing to do with whether you are currently a homeowner or not. In other words, you may be renting an apartment as your primary and only residence in NY, have never purchased a house in your life, and the home you purchase in Florida to vacation in, is from the bank’s perspective, a second home. Therefore, a second home is anything other than your primary residence that you plan to occupy sometime in the next twelve months, for some undetermined length of time. The critical issue is not how long you plan to occupy it, the key is that you do not plan to rent it out to other people for the sole purpose of producing income as in a non-owner occupied, rental property. You can still rent it out seasonally as in a beach home during the summer months, but again, long-term non-owner occupancy is not the intent.

Second homes are normally 50 miles or more from your primary residence. In other words, it has to make sense why you would want to get away to this property vs. your primary residence for a little rest and relaxation or fun. For example, if your primary residence is in Kissimmee, FL and you approach the bank that you want to purchase a second home 3 miles from Disney World, the bank is going to grin and tell you “no”. On the other hand, if you live in Kissimmee and want to purchase a home in Cocoa Beach, even though it may not be 50 miles away, it makes sense geographically and most banks would classify the purchase as a second home.

This distinction in terms is very important because it has everything to do with the types of properties you can purchase, the kinds of loan products that you can use and your cost of financing.

Not much here, it's pretty vanilla. I will start by telling you what type of loans and programs you cannot use. Below is the list:

• VA Loans
• FHA Loans
• USDA Loans
• First Time Homebuyer Assistance and Bond Loans

You are restricted in most market places to 80% maximum financing using conventional conforming loans. Conventional means that the loan is not insured or guaranteed by the federal government (i.e. FHA, VA, USDA) and conforming means that it complies with the underwriting standards set by the agencies known as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Yes, theoretically, there are lenders who on the books will go up to 90% conventional financing on second homes and investment property, the problem is that most if not all Private Mortgage Insurance (PMI) companies will not insure these loans, and the devil is in the detail. When you read the fine print, the multi-layered exceptions driven by credit score requirements, distressed property geographic exclusions and property type exclusions (i.e. 2-4 unit and detached/attached, etc.), not to mention the associated costs of these higher loan-to-value (LTV) loans, you realize you are much better of, or really have no choice but to put the 20% down payment.

You also may be able to find lenders that offer portfolio loan products that will allow higher financing than 80% without PMI, but again, be prepared to pay higher costs, have shorter loan amortization terms and higher rates of interest.

Also depending on the lender you may be able to use Fixed Term Adjustable Rate Mortgages (3/1, 5/1, 7/1 and 10/1) with or without interest only features along with standard fixed rate products.

Moreover, with respect to maximum loan amounts, they will vary based on property type and geographic location. You can find the maximum conventional conforming loan amount for the property type and your geographic location at:

http://www.fanniemae.com/aboutfm/loanlimits.jhtml

http://www.freddiemac.com/sell/selbultn/limit.htm

Property Type and Use Determines Interest Rates and Costs.

Here is a simple rule to follow, costs and interest rates move from lowest to highest as your property use changes from Primary Residence to Second Home and finally to Non-Owner Occupied. The same reasoning applies to property type so a Single Family Residence (SFR) will normally receive a better interest rate/closing cost scenario than a 2-4 unit property, regardless of the intended use. Also, keep in mind that pricing is done on a cumulative basis. Therefore, using the aforementioned rules, financing a non-owner occupied triplex will be more expensive that financing a non-owner occupied SFR.

With second homes, you will not notice that much of a difference in costs and interest rates. Of course, much of that depends on the lender and what type of overlays they may impose. However, with investment property, you will see a noticeable difference. Why you ask? Primarily because investment property has historically been associated with higher risk. From the collateral perspective, investment property may be more susceptible to deterioration and accelerated devaluation as renters may not properly maintain it. In addition, if cashflow gets tight for the property owner and it comes down to which property will go into foreclosure first, the primary or rental, the rental property usually goes first.

Finally, your lender is not the sole reason for higher costs of financing on investment property. Remember that conventional conforming loans must strictly adhere to the guidelines set by Fannie Mae and Freddie Mac in order for that loan to be sold in the secondary market and the lender recoup their loans funds to lend out again. Therefore, Fannie and Freddie are part of the consideration when banks price their mortgages.

In fact, both agencies charge your lender “pass-through” fees to purchase investment property loans. That is because Fannie Mae and Freddie Mac were primarily charted to facilitate primary residence ownership as evidenced by their property portfolio mix, not second homes, and especially not investment property. As of their 12-31-2009 10-K filings, both Fannie Mae and Freddie Mac reported a holdings mix of 93% Primary Residence, 5% Second Homes and 2% Investment Property. Therefore, it is evident that the extra cost associated with financing investment property is a function of the historical risk and because this is not a central part of the agency business model, so the market will pay a premium.

This premium, charged to banks as a “pass-through fee” is generally anywhere from 1.5 to 2 discount points (though it could be higher) depending on the geographic market, property type, credit scores and LTV. However, the bank itself may overlay additional charges. And guess who pays for all of that extra cost? You got it, you and me.

Some lenders may leave the extra agency fee and internal overlay as part of your closing costs or they may choose to “premium finance” it. When these fees (or any other fees for that matter) are premium financed, the lender quotes you a higher interest rate and reduces your cash to close. Skip to the next paragraph if you don’t give a hoot about the internal mechanics of premium financing. (Don’t worry your lender is not getting shorted. They make up the difference when the loan is sold. In essence, what is happening behind the scenes is that mortgages are priced, bought and sold like corporate and treasury bonds based on a present value formula for a given discount rate. If we assume that at rate X (or PAR rate), Fannie/Freddie is willing to pay 100 cents on the dollar to purchase a mortgage from your lender, then any rate below X demands a discount be paid to Fannie/Freddie by the lender and any rate above X demands that a premium be paid to the lender by Freddie/Fannie. By pricing and selling the mortgage at a rate that produces a premium equivalent to the pass-through fees and overlays, the lender is made whole by the sale of the loan, and instead of you paying the extra costs to the lender at once as part of your closing costs, you pay them over time to Fannie or Freddie as part of your payment).

This is also how “no closing cost” or reduced closing cost loans are done. Over the long term, the premium financing strategy may cost you more due to the interest rate differential and reduce your positive cashflow on the property, but it will lower your cash to close if your funds are limited.

 

Property Type and Use Determines Qualifying Guidelines

Just as closing costs and interest rates are driven by property type and use, so are the qualifying guidelines. Here are a few important highlights to consider but are in no way meant to cover a multiplicity of exceptions and exclusions which may be state and lender specific. In general:

• Max financing of 80% on investment property and up to 90% on 2^nd homes when you already own four financed properties.
• Max financing of 75% on 1 Unit Investment or 2^nd Homes with a min. score of 720 and if you own between five to ten financed properties.
• Forecasted Rental Income from the subject property as documented on a rent comparison analysis of the appraisal may be used to qualify.
• You must obtain rent loss insurance that covers rent losses that are incurred during the period that the property is being rehabilitated following a casualty. The coverage must be for at least six months rent loss.
• If you own one to four financed properties (including the subject property) the reserve requirements are: (1) Two months of reserves on the subject property if it is a second home. (2) Six months of reserves on the subject property if it is an investment property. (3) Two months of reserves on each other financed second home or investment property that you own.
• If you own five to ten financed properties (including the subject property) the reserve requirements are: (1) Two months of reserves on the subject property if it is a second home. (2) Six months of reserves on the subject property if it is an investment property. (3) Six months of reserves on each other financed second home or investment property that you own.
• Fannie Mae’s definition of reserves includes all components of the monthly housing expense (PITIA), including: (1)principal and interest, (2) hazard, flood, and mortgage insurance premiums (as applicable), (3) real estate taxes, (4) ground rent, (5) special assessments, (6) any owners’ association dues (excluding any utility charges that apply to the individual unit) (7) any monthly cooperative corporation fee (less the pro rata share of the master utility charges for servicing individual units that is attributable to the borrower’s unit) (8) any subordinate financing payments on mortgages secured by the subject property.