Million Dollar Journey

Melanie and Robert McLister, mortgage planners and editors of Canadian Mortgage Trends, have taken the time to write about obtaining financing for real estate investors.  This is a must read for Canadians considering getting into the rental market. 

Aspiring real estate investors seem to ask one question more than any other: “How much do I have to put down to buy an income property?”

Most are unaware that it’s now possible to buy a small rental property (2 units or less) with $0 down.

It wasn’t always that way. Until last fall, most borrowers wanting 100% financing on an income property had to resort to “alternative” (private or subprime) lenders, or negotiate vendor take-back mortgages (VTBs). The problem is that VTBs are often hard to arrange and 100% alternative financing is expensive–and has all but dried up thanks to the credit crunch.

In October, however, property investors got lucky. CMHC came to the rescue with its insured small rental program. It allows regular people to buy a small rental property with little or no money down, at fully discounted interest rates!

CMHC’s 100% financing program requires that the borrower (among other things) has a:

1. Credit score over 679
2. Credit report that is clean overall
3. Provable income
4. Tenant lease (or leases) in place

CMHC looks for a “strong history of managing credit.” If you’ve been recently or habitually late with your payments, don’t waste your time applying.

Regarding point #4, under CMHC’s program “market rents” (rent estimates) are usually not acceptable. That means you need to have a tenant lined up when you go to apply for the mortgage.

This is not necessarily a deal breaker. AIG, another insurer who competes with CMHC, has a rental program of its own. AIG will rely on an appraiser’s opinion of fair “market rents” to qualify the deal. That means you don’t necessarily need an existing renter to qualify with AIG. The downside is that AIG only allows a 95% loan-to-value, so you’ll have to put some cash down.

There’s one key point to remember about rent. Under CMHC’s and AIG’s programs, you can only use 80% of the rent you receive to qualify for the mortgage on a non-owner-occupied property. This is called an “80% rental offset.” CMHC and AIG use 80% instead of 100% to account for vacancies and other contingencies.

Eighty percent is still pretty good. It potentially lets you qualify for additional properties without depending solely on your own personal income. If you’re able to cover the rental mortgage, taxes, and heat with 80% of the rent you receive, you can theoretically keep buying rental properties without any increase in your own income. Restrictions do apply, however, and you’ll need to have cash for the closing costs.

That’s not to say that the borrower’s own income isn’t a factor. While there is no minimum income requirement per se, the borrower’s overall monthly debt obligations must be covered by 40-42% of his or her provable monthly income—including 80% of the rent received.

Here’s an example of how total debt service (TDS) is calculated:

Borrower’s Monthly Income
Salary	$6,500
Rent Received ($1,000 per month)	$ 800 ($1,000 x 80%)
Total Income	$7,300
Borrower’s Monthly Debt
Mortgage – Primary Residence	$1,100
Mortgage – Rental Property	$ 850
Property Tax – Primary Residence	$ 175
Property Tax – Rental Property	$ 150
Heat – Primary Residence	$ 75
Heat – Rental Property	$ 75
Credit Card Payments	$ 100
Car Loan	$ 350
Total Debt	$2,875

In the example above, the person’s TDS ratio is:

$2,875 / $7,300 = 39.38%

Therefore this person would meet CMHC’s and AIG’s TDS requirements.

Keep in mind, there are sometimes exceptions made to these ratios if the borrower is strong in other areas. However, exceptions are becoming less and less common these days thanks to subprime-related credit concerns.

So now that you know some of the qualification standards, let’s talk about what you need to prove you qualify. Here is a sampling of the documents you’ll need:

	CMHC Requirements	AIG Requirements
Borrower’s Income	Job letter & pay stub (Salaried) OR Notice of Assessment or two years of T1 Generals (Self-employed)	Job letter & pay stub (Salaried) OR Notice of Assessment or two years of T1 Generals (Self-employed)
Proof of Existing Renters	Signed leases; rent rolls; cancelled rent cheques; etc.	Not required. AIG will do an appraisal and use market rents.
Purchase & Sale Agreement	Required	Required
Appraisal	Not usually required	Required

Talk to a licensed mortgage planner for the specific documents required in your case.

Keep in mind that you must prove your income if you want high-ratio financing. I know of no “stated income” mortgage for real estate investors who want to buy with no down payment. However, if one has 25% down, stated income financing may be possible.

On a side note, it’s also possible to finance three or four unit buildings—but they’re a bit different. For one thing, a minimum of 10% down payment is required. This down payment can come from borrowed funds or be gifted (under the CMHC program). For the time being, AIG’s programs still require that the down payment and closing costs (1.5% of the purchase price) come from the borrower’s own resources. This can be proven with three months bank statements.

Note, Genworth also has a rental program but its standards are a bit tougher. Genworth doesn’t offer 80% rental offsets on non subject properties for example. In addition, Genworth is capped at 90% loan-to-value–even for 1-2 unit properties.

So how much do the above programs cost? Well, CMHC and AIG are mortgage insurers, and insurers charge insurance premiums. Here are some sample premiums (based on a percentage of the mortgage amount):

100% financing (CMHC):	7.25%
95% financing (AIG & CMHC):	6.50%
Gifted down payment (CMHC):	0.25% additional
40-year amortization:	0.60% additional

These premiums aren’t cheap. If you buy a $300,000 rental property with 100% financing and a 40-year amortization, you’ll pay CMHC $23,550. If you roll it into your mortgage (which most people do), you’ll also pay interest on top of that. So you need to carefully consider how this increases your total monthly payment.

On a positive note, insurance premiums are a cost of business that can usually be written off over five years. See this link and your accountant for more details: http://www.cra-arc.gc.ca/E/pub/tg/t4036/t4036-e.html#P387_37921

Apart from insurance premiums, there’s interest of course. For qualified applicants, interest rates under CMHC’s and AIG’s programs are currently pretty good. As of this writing, 5-year fixed rates are in the mid-5% range and variables are around prime – 0.60%.

Last but not least, there are closing costs to consider: legal fees, appraisal costs, home inspection fees, land transfer fees, etc. Roughly speaking, and notwithstanding the above, closing costs will run 1.5% to 2.5% of the property’s value.

Now for a few things to be wary of:

• Things are peaches and cream when real estate values are rising. But they’re not going to rise forever. When home prices fall, unwise investors get hurt. If you’re forced to liquidate in these circumstances, and you’re 107% financed, you could end up owing more than you can sell for. The same goes for buying in a depreciated area. You must have a long-term time horizon.
• You can’t assume the interest rate you have now will last forever. At the end of your term, rates could, and often do, go up. That means your cash flow projections must be able to withstand potentially higher mortgage payments.
• Be wary of using the 100% program to do fix and flips. Insurance premiums of 7.25% to 7.85%, and lender interest penalties, are a lot of expense to overcome in a short period of time.
• Don’t settle for questionable tenants. Always get a credit check on each renter and get statements from the vendor on each tenants’ payment history, if applicable. A few months of vacancy, or a non-paying renter, can crush your cash flow projections and put you under water.
• Make sure to analyze the property with a magnifying glass. Are there ANY improvements or major fixes that might need to be done? Unexpected expenses will also kill your monthly net income. Capital reserves are crucial in this business. I’ve seen borrowers get into serious trouble because they didn’t budget for contingencies.

Today’s small rental programs are excellent tools for prudent investors that do their due diligence and have capital reserves. Low interest rates and long amortizations help with cash flow, while reduced down payments help investors build property portfolios faster than they otherwise could.

But prudence is the key. Build your rental empire slowly and methodically, and make sure each property cash flows well before buying the next one.

If you’d like more information, contact us or any other qualified mortgage planner specializing in rental properties.

Links for more information:

• CMHC Program
• AIG Program
• Genworth Program

Please note: The above information is for general educational purposes. Information, rates, and costs are subject to change. Always consult a professional licensed mortgage planner before acting on such information. Financing is not guaranteed and is based on many factors, including approved credit.

photo credit: lumaxart

If you enjoyed this article and would like to be notified when new money related articles are posted, you can have them delivered right to your e-mail inbox or to your blog reader absolutely free.