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First Time Investor

Are You Ready To Be a First Time Investor?

June 22, 2004 - Dana Fitzsimmons

If you currently own your own home and are considering buying a new one, you may be in a position to move into the league of "Investor". This happens when you keep the old home and turn it into a rental property.

There are some things you need to ask yourself:

Am I prepared financially to go without rent if there is a tenant turn over or problems collecting rent from the tenant?
What is the going rent for a property like mine, and the costs of keeping the property?
Do I hire a property management company or can I property manage myself?
Do I provide lease agreements and collect rent or do I want someone else doing that?
How much does it cost to hire a property manager?
Can I qualify for the new home loan and keep this home?

This is where you need a good team of professionals to help you make the decision. Your lender should be the first person you call. If you do not have one, call your REALTOR. Your REALTOR knows who is knowledgeable and who is not. You lender will tell you how much you qualify for if you keep the property and how much you qualify for if you were to sell it. If you have equity in the property, (you owe less money than the property is worth), that difference can help you buy more house, but you would have to sell the house to get to it. But if you keep the property, the equity helps keep the mortgage payment low. You may need to demonstrate a positive cash flow for the property in order to qualify for the home loan on the next house you will buy. If that is the case, you will need to show the lender the rental agreement. In some cases you can get a tenant to commit to a future date, allowing for your home to close and for you to move the day escrow closes on the new home. In some cases, you may have significant equity in the property that you may be able to do a "cash out refi", that would allow you to pull cash out of the property. You would want to consult your CPA and tax attorney as to what you can spend that money on. If you want to keep it in savings for reserves or if you plan on using it to buy the next home. But do not do this without consulting a CPA and your tax attorney to make sure you do not find yourself with tax challenges as a result.

Turning your primary residence into a rental property allows you in most cases to keep the owner occupied loan you currently have without changing the rate. (Check with the lender to make sure.) When you buy a property with the intention to rent, then you have to disclose to the lender that you will not be living in it. This is called "non owner occupied". This is important when you are shopping for financing. You need to compare "non owner occupied" rates with "non owner occupied". Same is true with "owner occupied" rates. Your rate for a "owner occupied" (owner living in it) is lower than a "non owner occupied" (owner not living in it) interest rate. The lender believes they take less risk when an owner lives in the property. The cost of borrowing money is based on the degree of risk the lender believes they will have to take.

Turning a residence into a rental also means you need to change the type of insurance you have been carrying on the property. You will need to convert it to a "rental owner policy". Check with your insurance agent to see what you have to do. You will increase your liability, so you may want to consider a "Liability Policy". A few hundred dollars spent on a good policy, can save you thousands.

The next professional you need will be a REALTOR in the event you believe you are ready for your first investment property. Since you will be renting the existing home, you will need to find a new place to call home. You will be occupying the new residence so you will be able to get the "owner occupied" interest rate and LTV benefits. LTV, Loan to Value, is the term the lender will use to determine how much money you can borrow based on the value of the home. If you apply for a loan with 80% LTV, you are putting 20% down and borrowing 80%. You will qualify for the new home loan the same way you did when you bought the other home. The lender will look at your cash (down payment), credit (FICO scores), debt and income. Your job counts as income, but so does the rental income from the first property. The lender will calculate your rents and divide that by 75% (some lender may be higher or lower). The lender does this to take into consideration any future vacancies.

If you find you qualify for the new home loan based on keeping the first residence, you still need to re-consider if you have the endurance to manage the properties yourself. Hiring a property manager costs money, but it is usually worth it in the long haul. If you do not have a real estate license, you may have trouble accessing good lease agreements and having access to professionals if you need to evict a tenant or fix damages done by a tenant. There are Fair Housing rules that you have adhere to to avoid discrimination suits. And there is the increased liability exposure you gain by having tenants in your property.

Here are some fine books on this subject that you may want to read further: