According to the Canadian Rental Housing Index, rental properties are in demand across Canada, where 32% of all households occupy rental properties. Growing demand is attributed to increased immigration, mortgage stress-tests that curb borrowing, tight rent control regulations, etc. Vacancy rates for rental properties have steadily decreased nationwide from 3% in 2017 to 2.4% in 2018.
What has been the effect of more demand and falling vacancy rates?
The Rental.ca recent Rent Report shows an increase of 1.9% in rental prices month-over-month from May to June 2019. The report predicts an increase of 6% year-over-year.
Investing in Rental Properties with Mortgage Loans
Investing in rental properties seems like a promising venture considering that demand seems to be outpacing supply; CBC reported that 37,000 new purpose-built rental apartments entered the market in 2018 while the demand was for 50,000 new units. The Rental Housing Index also cites the need for more affordable rental properties.
Getting a mortgage offers an easy way of entering the residential rental market. In this article, you’ll learn more about rental mortgage terms, factors lenders look for before granting rental investment loans, and more.
Differences between Home and Rental Property Mortgages
Since 2010, a 20% down payment is required for non-owner-occupied rental units. Home mortgages, on the hand, require a down payment of at least 5%
Borrowers with high ratio mortgages (where the down payment is less than 20%) have to pay mortgage insurance. It lowers the lender’s risk in case the borrower defaults.
For the rental mortgage loan, you don’t pay the default mortgage insurance.
Lenders view investment property mortgages as riskier than conventional property loans, so the interest rate might be slightly higher.
Six Tips on Getting a Rental Mortgage Loan
1. Have a clear investment strategy
You can invest in real estate to hedge against inflation, build equity, generate passive income, mitigate risks from other investments, etc. Before taking the plunge, have a clear reason why you’re buying the rental property. Formulate both short-term and long-term investment goals. For instance: are you planning to own 10 rental units within 10 years and generate an extra $10,000 in monthly passive income?
What type of residential property will you buy first? New rental buyers tend to favor single-family units or condos. A single-family home, for instance, may have long-term renters, be easier to manage, and appreciate steadily in value.
Two to four multi-unit residential properties cost more than single-unit homes but might generate more positive cash flow. What’s more, if you occupy one of the units and rent out the rest, you might only pay an initial down payment of 5 to 10% instead of 20%.
Buildings with more than 4 units are zoned as commercial properties. The lenders offer commercial mortgage loans that have more strict requirements and evaluation process.
2. Access your financial situation
Qualifying for a rental property mortgage depends on your credit and financial position. The lender will look at your credit standing; you need a minimum credit score of 600 to qualify for a mortgage below $1,000,000; experts recommend that you keep your score at 680 or higher.
If you part with a down payment of 20% from your pocket, can you still fulfill your financial obligations? Besides the down payment amount, there are closing costs (legal and administrative) comprising 1.5% of the purchase price. Do you also have money left over for any unforeseen expenses or emergencies?
3. Select the best rental property
You’re investing in real estate in the hope that your investment will yield a positive cash flow every month. The property you purchase must be able to attract quality tenants. It’s best to choose a location where properties are in high demand to reduce the vacancy rate.
Renters prefer neighborhoods that are near hospitals, schools, public transportation, mixed-use retail residential developments, etc. They might also factor in the local crime rate, walkability, and local amenities like parks.
Get your hands on demographic information that might tell you more about the area, for instance, the size and growth rate of the population, the median income per household, jobs held by the residents and more. You can also speak with local agents and learn about the rental market.
4. Is the investment worth it?
Does it really make sense to spend money on buying a particular rental property? It’s vital to ask this question. To get the best answer, you must evaluate the return you’ll get when you invest.
First, determine the rate of rental properties in the area. You can find listed vacancies in that area on MLS listing websites. It’s also vital to get information on the vacancy rates, so you can estimate the period that will pass before your property is occupied. Your real estate agent should provide this information, The Canada Mortgage and Housing Corporation conducts property censuses in metropolitan areas and publishes vacancy rates.
Next, estimate and calculate the costs of acquiring and maintaining the rental property. The costs include taxes and tax deductions, homeowner association fees for condos, property insurance, maintenance, vacancy allowances, advertising, tenant risk and utilities (gas and electricity bills are paid by the renter and the owner pays the garbage, sewer and water bills).
Calculating the price-to-rent rate can also paint a clearer picture of how the property market behaves in the area. To get this ratio, divide the median property price by the median year rental income. For instance, if the median home price in the area is $100,000 and its median yearly rent is $5,000, the ratio comes to 20.
If the price to rent ratio is between 1-15, this indicates that it’s better to buy than rent. Our ratio tells us it’s better to rent than buy.
You should also calculate the profit you will make every month after deducting all the costs, including the mortgage payments. Also, predict the time it will take you to recoup your money.
5. Approaching the lender
You can find the rental property then look for credit. Alternatively, before house-hunting, contact your mortgage lender to learn how much credit is available and the interest rate. If you have bad credit, then bad credit direct lenders can always help as these are specifically designed for poor credit borrowers.
Lenders require several documents when qualifying you, such as the rental appraisal letter or copies of the lease agreement if it’s a tenanted property. The lender may carry out their own evaluation and appraisal to see the rent amount the property will bring.
Some lenders will require you to show that you didn’t borrow the down payment amount. They might require bank account statements for the last three months. If you sold another property or used a home equity line of credit to generate the down payment, you’ll need to prove it.
Lenders also need to know if the property will generate enough profits to meet mortgage payments and other costs. The most common calculation done is the debt coverage ratio (DCR).
DCR = Annual net operating income divided by
Annual debt service (all the monthly mortgage payments)
For example, property A has a net operating income (NOI) of $10,000 and a debt service of $8,000. The DCR comes to 1.25. Most lenders require the DCR of at least 1.10%.
Other lenders use your Total Debt Service (TDS) ratio, calculated by factoring in your gross income, property taxes, credit card balances and other debt obligations like auto loans.
Seek professional help
Getting a rental mortgage might take you down new paths and set up you against new challenges. It’s advisable to seek professional help with investing and financial decisions, legal, tax, and real estate matters. You can seek guidance from investment advisors, insurance brokers, home inspectors, lawyers, accountants, property managers, and mortgage brokers.
You may also be interested in: Down Payment vs. Deposit – What’s the Difference?
Writer: Bruce Mullins
Disclaimer: All investing can potentially be risky. Investing or borrowing can lead into financial losses. All content on Bay Street Blog are solely for educational purposes. All other information are obtained from credible and authoritative references. Bay Street Blog is not responsible for any financial losses from the information provided. When investing or borrowing, always consult with an industry professional.