One common question that I get from real estate investors is — “How do I overcome the debt-to-income (DTI) ratio?” That, along with — “How do I buy more units and grow my business more quickly?”
For anyone who has accumulated a few units in a reasonably short period of time, I’m guessing that these are problems that you’ve had to deal with yourself…
Addressing the first question, in a nutshell, the debt-to-income ratio (monthly debt service divided by gross income each month) is a common barometer that a lender uses to gauge whether or not an investor is well positioned, or “qualified”, to take on more risk (debt). Just like a stock investor wouldn’t be too keen on loading up on shares of a company with an extremely bloated balance sheet, lenders (especially post-subprime) are especially hesitant to approve lending to a borrower who already has too much debt on the books…
With the debt-to-income ratio, it typically starts to rear its ugly head as soon as we exceed 40%.
But as anyone involved with cash flowing real estate can attest to, not all debt is created equally! Yes, debt will ALWAYS be something that inherently magnifies risk, but I would argue that a real estate investor who carries $1MM in debt that is 100% serviced by free cash flow is in a far better position to manage the burden than say a homeowner who has to rely on their day job to make the monthly loan payments.
And if you’re an investor who has high aspirations and wants to scale quickly, you’re gonna need to take on more loans to reach your goals!
So, how do we get around the 40%?
The easiest way is to be able to show that you have 2 years (or more) of landlord history and experience. Basically, what this means is that you must be able to show the lender evidence of a rental property appearing on two separate tax returns.
Although obtaining 2 full years of experience can sound pretty rough (for anyone trying to grow and scale quickly, this is an agonizingly long amount of time to wait for seasoning, especially in the depths of a brutal bear market), like is often the case of real estate, the rules are malleable…
I’ll give you an example:
My good buddy purchased his first rental property towards the end of 2013. He didn’t close escrow until December 30, 2013.
But because the transaction was completed and title had been transferred to his name, by the spring of 2014, he had to file his first rental property on his tax return…
In essence, my buddy was able to “work the system” (although unintentional), and gain credit for 1 full year of landlord history and experience, even though in reality, he was just getting started!
So, by the time he had completed filing his 2014 taxes in the spring of 2015, as far as underwriting was concerned, he was a landlord with sufficient 2 full years experience, so they were more than happy to waive any debt-to-income requirements (rental income could now be qualified and counted into the income statement to help offset debt service, which was not previously allowed) on any future rental property purchases.
Definitely, this is perhaps the quickest way to sidestep the debt-to-income barrier that many lenders force us to overcome.
However, the easiest way of getting around the debt-to-income issue is to just to keep shopping around, looking at different lenders…
Although debt-to-income is a common check for many lenders, not all will adhere to it so strictly. For instance, if you first approach the big banks (JP Morgan Chase, Wells Fargo, Citibank, etc.), you’ll quickly learn that they run tight ships, so getting your file cleared through underwriting may be challenging. But if you go with a smaller bank, or lender, you might just have some better luck…
In my own experience, I purchased Rental Property #3 in 2013 without first having cleared the 2 years of landlord history guideline… As I mentioned above, the big banks are tough, and they refused to lend to me… they claimed that I was “unqualified” because I carried too much debt and they refused to count my rental income. But I persisted, and ultimately chose to work with an out-of-state lender that was much more accommodating to investors. Without having really any landlord history, this particular lender was still willing to completely null out my debt because they understood full well that the cash flow I had coming in each month was more than sufficient to offset any “risks” to them.
You might have to get creative, but there are definitely ways to overcome the debt-to-income problem!
When it comes to residential real estate, Fannie/Freddie will let most qualified investors finance up to 10 loans. However, for some odd reason, they don’t put in any guidelines as it pertains to the nominal value of each property that you are buying…
In theory, you could take out 10 residential loans, and each property could be valued at $500,000/each… As far as underwriting is concerned, that’s no different, and the exact equivalent to another investor who chooses to invest in cheaper properties, and takes out 10 residential loans at $50,000/each…
You would think that the latter investor should be more qualified to take on even more loans because the total nominal value of all their loans combined is substantially less than the former investor?
As far as underwriting is concerned, both investors are on a level playing field and present the same amount of risk…
10 = 10
With that knowledge in place, then, it really makes no sense for an early stage real estate investor to jump in too hastily and start burning through loans on some very cheap properties…
Further, if your aspirations are to grow and own as many units as possible, you really want to maximize those 10 loans as much as possible. As far as the guidelines are concerned, a single family home (SFH) is equivalent to a fourplex (above 4 units is technically commercial property and does not qualify for a residential loan). In other words, you could tie up 10 loans on 10 units, or stretch it out much further and finance 10 loans on up to 40 units…
Depending on your location, it may or may not be worthwhile to focus more heavily on acquiring more units during the early stages of your real estate career. In my own case, homes in the Bay Area aren’t cheap (multi-family units don’t really cash flow either…), so my acquisition strategy has mostly been focused on snatching up affordable townhouses (1 unit per loan)… However, I do own some duplexes out-of-state, and if I was living in the Midwest, most definitely my strategy would be more predicated on accumulating as many units as possible with each loan.
Since the 10 loans is a fixed number, once you max out on that, you’ll most likely need to work with a portfolio lender to obtain financing on any additional properties. That, or you could migrate over to the commercial real estate space that only cares about the “income approach” and isn’t subjected to these same rules and regulations.
Another important point to keep in mind is that underwriting guidelines tend to change once you’ve accumulated more than 4 units.
Typically, for loans #1 to #4, a borrower will need to come up with between 10% to 25% on the downpayment and be able to show sufficient reserves (PITI) for 3 months on each rental property owned.
Once an investor gets to loan #5 and beyond, the rules change and lending becomes more difficult. Typically, the downpayment will need to be 30%, and reserves (PITI) need to cover 6 months on each rental property owned.
With this knowledge in place, as mentioned previously, an investor probably wants to strategize their purchases by focusing on more expensive properties on the front-end of things. In other words, it makes more sense to utilize loans #1 to #4 (10% to 25% downpayment) to buy the more expensive: duplexes, triplexes, and quadplexes.
Save the cheap stuff for later.
It’ll be a lot easier to save up 30% for a $100,000 SFH than it will be to save up 30% for a $500,000 quadplex…
Underwriting can be tough at times, but as is often the case with real estate, there are typically alternative methods and solutions an investor can utilize to make the most of any situation.
It is important to know the rules of game well in advance so that we can define a gameplan and strategy to help us meet our goals.
Although I never did quite make it to 10 loans, I utilized the above methods to help me amass 8 rental properties and 10 units total in a span of about 3 years (2012-2015).
When I was most aggressive in 2013, it was beneficial to work with a lender willing to overlook my debt-to-income, and to also purchase a duplex with loans #1 to #4.
Lastly, if all else fails, it may not be a bad idea to also consider teaming up with other investors and forming partnerships. I’m personally involved in three side hustle deals, and to date, those might arguably represent my best assets.
Real estate can be extremely lucrative… But to meet your goals, sometimes you’ve got to be fluid and adapt to the rules, regulations, and guidelines.