Why it’s hard to buy – or sell – a big rental house

“What goes up must come down” can be painfully true when you’re talking about the prices of stocks, bonds, commodities and investment real estate.

And except for the tourist industry, nothing is more important to us than the health of the investment real estate market.

Driving to work each day, if you have a job, should tell you just how important it is.

How many cars and trucks do you see in driveways sporting the names of agents, general contractors, subcontractors and folks working for real estate support industries? Of those you know who have been laid off or lost their homes, did they earn their living in real estate or construction?

At the core of the problem is a gaping hole in the financial system. It revolves around what lenders refer to as “jumbo-priced” investment homes. Any loan for more than $417,000 is considered a jumbo mortgage.

These days, no investor in the global market who buys mortgages from banks and other lenders is willing to take on jumbo loans on rental homes. Without these investors, banks would quickly run out of money to lend. So the ability to offer these loans depends on the existence of this secondary market of investors.

The majority of the Outer Banks vacation rental homes sell for more than $417,000. So without a full cash sale or significant down payment, the odds are stacked against anyone getting a jumbo mortgage loan for a rental property.

When the investors return, the rules will change

Still, profit-seekers, similar to Mother Nature, abhor a vacuum, and we can expect investors to return to the jumbo market. It’s a matter of when, not if. But the rules will almost certainly be different next time, so buyers, sellers, and Realtors take heed.

When these players return, the catch-phrase will be “Old School” lending. The rules will be similar to those in force during the 1980s and 1990: no more limited down payment, interest only or “negative amortization” loans. Think 25 to 30 percent down payments. Income and assets will be verified and verified again.

Credit scores will need to be stellar, upwards of 700, even 750. Lenders will require more than one appraisal on properties over $1 million. Equity will be based on cash down payment, not the appraised value of the home as a percentage of the loan amount. Your debt-to-income ratio will need to be less than 40 percent. If you retain a CPA with a very sharp pencil, don’t expect to qualify for a loan.

Houses will need a solid rental history

Historical rental income will rule the day. Homes with a rental history will be in good shape under certain circumstances. A simple axiom will apply: what lenders used to call the “10 percent rule.” Simply stated, gross rents on an investment property must be at least 10 percent of the price of the home, in conjunction with a 30-year mortgage and the hefty down payment requirements.

Thus, a $1 million rental home will require a history of two or more years generating $100,000 or more in annual rental income coupled with a loan amount of no more than $800,000. The only way to get around this will be if the borrower has enough personal income outside of current rents to offset any shortfalls in the 10 percent rule.

Why this particular formula? You will find that a loan made under these conditions will generate enough rent to cover the monthly mortgage payments and absorb expenses. Many homes already meet these conditions, so when the lenders return, the news will be good. Any property not meeting this requirement will generate “negative cash flow,” anathema to lenders already knee deep in high-end foreclosure properties.

Sketchy rental history? Find a Powerball winner

The bad news? If the rental history of the home you are selling does not meet the 10 percent rule, be prepared to wait a long time for a qualified buyer to show up. And if you plan to “spec” a home, line up a Powerball winner as your buyer. No rental history equals no loan.

Sellers need to be realistic about their asking prices, and buyers need to do their homework on the past history of any investment homes. There is light at the end of the tunnel, but expect the new round of funding to embrace something lacking the last time — common sense and sound underwriting policies from lenders.

Russ Lay of The Outer Banks Voice is a former banker.