Demand for affordable housing remains high, which is good news for single-family real estate investors across America. As the single-family rental (SFR) industry continues to mature and become more institutional across the board, many investors are opting to keep their flips as rental properties.
The steps to fix-and-flip and fix-and-hold are similar, but there are important things to consider as you build a rental portfolio. You’ll want to answer some strategic questions on your journey to building long-term wealth.
After nine consecutive rate hikes by the Federal Reserve since March 2022 and a Fed Funds rate over 5%, every investor in America is acutely aware of interest rates and the impact they can have on their investment. For the SFR investor looking for the right financing solution for a rental property, there are two options: a mid-term or long-term approach.
The mid-term solution comes in the form of a 5, 7, or 10-year interest-only, adjustable-rate mortgage (ARM). The benefits of a mid-term solution are two-fold: 1.) You only pay interest on the principal balance of the loan, which means cashflow is higher than that of a fully amortizing loan, and 2.) You have a window of time to assess long-term interest rates and plan for the day when you ultimately lock in a long-term 15 or 30-year financing solution. The risk of an ARM is that long-term interest rates move higher than your existing interest rate during the 5, 7 or 10-year window and you get stuck in a negative leverage situation.
The long-term solution comes in the form of a 15 or 30-year fully amortizing, fixed rate mortgage. The benefits of the long-term solution are also two-fold: 1.) You have certainty of what your mortgage payment will be over the long-term, regardless of what happens in the interest rate market, and 2.) At the end of the financing period, the asset will be free and clear of all debt while still providing a steady stream of cashflow. The downside of a long-term solution is that these mortgages typically come with hefty pre-payment penalties over the first five years of the mortgage period, which makes it more costly if you want to refinance the asset as/if long-term interest rates move down during that five-year period.
Related: 5 Ways Rental Properties Make You Money
While shopping the capital markets for long-term financing solutions, you are sure to run across traditional banking institutions and private lenders eager to help you. Consider these points along your search:
Time is money. Traditional banks will usually have a lower interest rate than private lenders (by a whole or half percentage or so), but they are slow. In the words of Aaron Lester, SFR Rental Associate at Residential Capital Partners, “It’s not uncommon for a traditional bank to take 60 days to close. There’s a lot more documentation and red tape associated with conventional lenders, which can cost you time. We work very hard to close 30 days after receiving the borrower’s application.”
Will you get a quick no? Don’t get sucked into trying to over-engineer a financing transaction by an eager private lender that just wants to close the deal. Lester continues, “We strive to be the quickest yes and the quickest no in the industry. A lot of people [private lenders] are reluctant to say no and believe they can find a way to say yes. This only leads to the lender dragging their borrower through a stilted ‘approval process’ that ultimately leads to a no. There are deals that make sense and deals that don’t, and we’re prudent with our borrowers’ time.”
Related: What to Know About Your Private Lender
This year, about 25% of rental property loans dispersed by Residential Capital Partners were to investors that first purchased their property through us as a fix-and-flip. This is a smart move for several reasons:
Lester adds, “Whether we are structuring a rate and term rental loan or a cash out refi rental loan, we help our clients crunch the numbers to see what’s best for them.”
It’s always good advice to keep an eye on your debt service ratio, and today it’s especially key. Lester reports, “In a high interest rate environment, it’s important to have a good understanding of the financial cushion or the delta between your rent and your total monthly debt service payment. If something were to happen—if something breaks or rent falls through—would you be over leveraged? I’m more conservative by nature, so I caution investors not to put themselves into a position where one straw breaks and creates serious consequences for their investment property’s performance.”