One of the biggest questions I get after clients have purchased their first home is, "How can I buy a rental property?".
There are so many different ways to put a rental property purchase together. I have literally come up with at least 10 different ways, of which 8 of them do NOT use a bank or mortgage broker! In this post, I will stick to the few ways using a mortgage broker or banker and getting the great wholesale interest rates. I am also talking about rental property financing for properties up to a four-plex.
Determine the Size of Down Payment
In order to begin assessing whether to buy a rental property and to qualify for the mortgage, you need to know just how much money you are going to put into the deal. As an investor, you may have been told to put as little as possible into a rental property so that you're not risking a lot of money and you can have more money to buy other rental properties. However, if you aren't risking the money, who is? Well, the bank is, so expect to pay for that risk.
The Role Of High Ratio Insurance on Rentals
CMHC has an Income Property program whereby you can put as little as 5% down payment, get bank financing at great rates, and start earning cash flow on your first rental, but they add an insurance premium to the mortgage that is equal to 6.5% of the mortgage amount. Consequently, your down payment of 5% gets eaten away by a premium of 6.5%, so your mortgage is worth more than the purchase price once it closes. Hardly worth trying to avoid risk by putting a small down payment.
As you increase your down payment in 5% increments, the CMHC premium will go down. With 10% down it is 4.75% of the mortgage amount; 15% down it is 3.5% and once you hit 20% it is 2.5%; at 25% down it drops to 1.75% and with 35% down it is 1.25%.
You may ask, "Once I put 20% down, there shouldn't be any CMHC premium". You are partially right, but banks like to have CMHC insure your mortgage whenever possible because the government is guaranteeing that if you default on your mortgage, they'll get paid! There are lenders that will only remove the CMHC financing on a rental once you put 35% down payment. The lower the risk for the bank, the better price you get as a consumer.
Rental Income and Cash Flow
I wish it was as easy as saying, "The rental property I want to buy makes $1200 per month, so when I pay the mortgage, property taxes and expenses, it leaves me with $200 extra, so I should qualify".
In order to mitigate risk, most bank lenders will use 80% or less of the actual rental income to help qualify your application, but use 100% of the expenses. In essence, the bank is saying that if this rental property can't carry itself with 20% less rent, then it doesn't qualify. Now 80% usage of the rent is a CMHC guidelines, but some lenders will go further and only use 50% of the rental income to help qualify the deal. Ultimately this means that they want you to be able to pay for the property should renters not pay, etc.
Once you get past 25% down payment, there are a few lenders who will take the rental income, subtract the expenses and use the surplus in addition to your income. Some will even look at the property and as long as the income meets a positive cash flow surplus ratio called DCR, they will approve the property based on the rental business model rather than your income and debts. NOTE: there are very few of these lenders so choice and service is not great, but they do exist.
Your mortgage broker will help assess the lender options in this case.
The Second Home
Numerous clients have taken advantage of the CMHC or Genworth Second Home program. This program allows an owner of a property to buy a second home for a family member. It is most typically used for parents who want to help their children go to post secondary school or for children to purchase a home for their aging parents, etc. This program is not considered a rental property program so the CMHC premiums are normal, but you are required to sign a declaration that a family member will be living in the unit.
Zoning and Student Housing
I am shocked when I see advertisements from realtor listings that promote student housing as an easy way to get into the rental market. In London, Student housing from landlords who simply buy a home and rent out several bedrooms has been negatively showcased in the news over the past few years. Countless parties, recklessness and violence are reported to be happening in various areas of the City of London, which doesn't give banks and mortgage lenders a warm and fuzzy feeling about student housing. Moreover, there are fire codes and insurance regulations that need to be explored before getting into this type of renting.
What I want to really stress in this paragraph though, is that banks don't like student rentals and will not provide financing for them if they know it is a student rental! When I have explained this to various clients in the past, they brush it off and say that their previous bank provided the financing before and knew it was a student rental. I can assure you that the rogue employee who may have pushed through your student housing approval in order to meet their quarterly sales goal DID NOT inform their head office approval centre that your rental was student housing! There was a time where an investment company such as AGF provided student housing financing, but I have not since heard of any banks providing student housing without lying! NOTE: I just went and tried to GOOGLE "student rental financing" & "rooming houses" at Canadianmortgagetrends.ca and I could not find any discussion about this topic. Our industry avoids this conversation so that we don't anger realtor referral sources and potential clients, but if the banks knew that this kind of financing was getting pushed through without disclosure, they could call the loan on you.
ZONING: Ensure that the property you plan to buy is zoned properly. Otherwise the rental income you think you can use to qualify could be reduced or eliminated completely, leaving you without financing. If you are using income from 2 units, ensure it is zoned as a duplex. A great place to start is by calling the City or municipality and your lawyer BEFORE you negotiate the offer to purchase.
Ultimately, there is more to the topic of rentals that I have covered here, but I wanted to give any new to the process some basic information on how banks will look at rental property financing.
A Small Action Plan
1) Determine your down payment amount.
2) Get pre-approved with a mortgage broker.
3) Interview realtors who specialize in rental properties, then select one.
4) Read about landlord rules, ACTs, etc.
5) Hire a good lawyer who specializes in rentals.
6) Design a comfort level of what type of renter you'd like.
7) Don't go outside of your comfort level!
8) Design an application process for potential renters and stick to it.
I welcome any investors, mortgage brokers, bankers, etc. to add to this blog post because it really just touches the tip of the iceberg for rental property financing.
Thanks for reading!
Your London, Ontario Mortgage Brokers at Dominion Lending Centres Forest City Funding FSCO# 10671
Update on 2010-02-17 20:16 by Mike De Sousa
.....and just when we thought rental properties were all figured out, the government changed the rules. 20% down payment is now required for all non-owner occupied properties for CMHC insurance.