If you’re considering buying rental property as an investment, you’re not alone. Demand for investment properties is strong and growing across the United States. According to the National Association of Realtors, investment home purchases in 2015 increased for the first time in five years – up 7%, translating to more than 1 million sales in 2015. The typical investment-home buyer in 2015 had a median household income of $95,800 and bought a home that was 22 miles from their primary home.
But there’s another angle to these types of purchases: owner-occupied rental multi-units as investments.
While being a landlord and living in the same building as your tenant may sound like a setup for an NBC sitcom (or horror story, depending on your outlook), there are some key benefits to living in your own rental property. The main benefits come from being able to take advantage of Federal Housing Administration (FHA) loans.
Remember, you should always consult with a financial or real estate professional before you invest in any property.
(For the purpose of this piece, we will focus on two-to-four unit properties, commonly known as “duplexes,” “triplexes,” or “fourplexes.”)
Pay Your Mortgage with Rent Money
Even though rents leveled off nationwide at the end of last year, the rental market has exploded over the previous years, with rents topping the list of fastest-rising prices in June 2016. A recent report by Apartment List found there are significant shortages of low- and middle-income housing in the nation’s most expensive markets, and some of the fastest rent growth is happening in the smaller cities around the priciest areas.
With this trend occurring, there is a real possibility that some – or even all – of your mortgage for a two-to-four-unit dwelling could be paid by the rent you collect, giving you a virtually free place to live.
Put Down a Smaller Down Payment with FHA Loans
Loans insured by the Federal Housing Administration, or FHA, may be the easiest route to buying duplexes or multi-family homes if you are planning use the property as your main residence for at least a year. FHA loans require only a 3.5% down payment for owner-occupants of multi-family dwellings, compared to 20-to 30% down for investors buying a duplex or more units (if they are buying as an investment and not as a residence). You can also use gifted money for all of a down payment on FHA loans.
Note that putting only 3.5% down and leveraging an asset can be risky business. You should crunch the numbers carefully for your market so you can estimate how much you are likely to receive in rents, and you have enough cash cushion to make this work through a downturn or a reduction of rental rates.
Take Advantage of Residential vs. Commercial Loans
The FHA has a few different loan programs for multi-unit properties. If you’re a new to investing in real estate, you may want to purchase a property with four or fewer units because FHA loans for such properties aren’t considered commercial property loans, which have more strict requirements and are often made through conventional loans. For instance, a loan for a residential property can be a fixed-rate loan with a consistent monthly payment, whereas most commercial loans are adjustable-rate mortgages with payments that can fluctuate.
There are a few things to consider, however. FHA borrowers for a property larger than a duplex — from three to four units — must have higher cash reserves to show they can handle the loan. Three months of mortgage payments are needed to qualify for a three- to four-unit property loan, which includes principal, interest, taxes and insurance. The cash reserves must be met whether the property is vacant or not; having a completely rented complex doesn’t necessarily mean that fewer reserves are needed. The reserves are to help show that you can meet the mortgage payments even if a unit is vacant for a while. One month’s reserves are needed for a one- to two-unit property.
One of the main criteria for a multi-unit FHA loan is that you (the owner) must live in one of the units. While this will make you a real estate investor in your own property, possibly allowing you to live mortgage-free, like any other home, rental property will have expenses. FHA loans require mortgage insurance, which protects the lender if you default on the loan. You’ll also have to pay for maintenance and property taxes.
Use Rental Income to Qualify for a Loan
One of the key benefits of buying a multifamily home and renting out the units while living in one of them is that some of the rental income can help you qualify for an FHA loan. Proof of rental income is needed for this to apply, but it can be projected rental income, based on a home appraisal and comparing to rental rates for similar homes in the area. The amount will be added to your income to help you qualify for a loan.
Only 75% of the rental income is added to an applicant’s income as a way to compensate for a 25% vacancy rate in rentals. Some lenders may require you to have experience as a landlord before approving a multifamily home loan — which is a Catch-22 if you’re trying to start as a landlord — while others may let you use projected rental income to qualify. Some lenders may require that renters have signed a lease to verify the rental payments.
FHA loans may differ by location. Some may have a vacancy rate lower than 25% that’s allowed, reducing the amount of rent that can be added to the borrower’s gross monthly income.
Owning rental property can be stressful. Be sure to study the area where you want to buy to see what the rental rate is, and if you’ll have enough cash flow and savings as a backup if rentals fall off for a few months. If it’s a risk worth taking, you could be on your way to becoming a real estate mogul.
Chris Carucci, CFP®
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