Financing Strategies to Scale Your Single-Family Rental Portfolio
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- Amanda Farrell
- March 18, 2023
- 10:30 am
- No Comments
Owning real estate is a great way to build wealth and find financial freedom. However, purchasing and managing a real estate investment portfolio can be more complex and time-consuming than an investor initially anticipates. That might explain why most landlords are likely to own fewer than ten units, resulting in an average annual income of $69,085, a comfortable sum, as the average American makes around $54,132.
For investors who want to push beyond that comfort zone and scale their real estate portfolios, reaching a loftier goal will likely require tapping into equity, following repeatable systems, leveraging tax deferments, and exploring loan options designed for portfolio growth.
In this article:
Investor expertise, market conditions, and portfolio size all play a role in successfully executing these methods to scale a real estate investment portfolio. Risk often accompanies growth, and each investor should carefully examine the pros and cons of each of these methods.
One of the most common wealth-building strategies with real estate is to leverage the equity in one property to purchase more investment properties. Home equity is the difference between the outstanding amount on a mortgage and the value of a property. If a mortgage balance exceeds the home’s current value, the borrower is said to be “underwater” on the loan. For those with a mortgage paid off or positive equity, there are a few ways to convert the positive equity into cash.
- Home Equity Loan. A second mortgage is a home equity loan that can be used to purchase another property. A second mortgage lien is filed against the property, and owners receive a lump sum from the lender that is paid back in monthly installments like a first mortgage. Fortunately, securing the loan with the first property usually means lower fees, closing costs, and potentially a lower interest rate than a personal or unsecured loan. However, it can still be expensive compared to a first mortgage since the new lender’s lien on the property won’t have priority. If a borrower defaults on either loan, the second lender must wait for the first lender to be paid before collecting any debt from a foreclosure proceeding.
- HELOC. A HELOC or Home Equity Line of Credit is another type of home equity loan, but it functions more like a credit card. Instead of receiving a lump sum, the owner has access to a draw period where they can take as much or as little out of the approved credit line. Terms of the HELOC may require an initial withdrawal, a minimum withdrawal amount, transaction fees or inactivity fees. When the draw period ends, the borrower must pay back the principal plus interest. HELOCs typically have an adjustable rate, which means the cost of accessing this cash can fluctuate greatly due to market conditions. For instance, when an owner initiates a HELOC, rates may be rock bottom, but by the time the repayment period starts, those could be double, tripled, or more.
- Cash-out refinance. Like a home equity loan, a cash-out refinance is a great way for homeowners to get cash based on their equity. Unlike a home equity loan, a cash-out refinance will eliminate the first mortgage and replace it with one new mortgage payment at a different interest rate. Cash-out refinances are known to have higher interest rates and origination fees compared to a home equity loan or HELOC. The underwriting standards for a cash-out refi are also more stringent. A borrower with a high credit score and lower loan-to-value value ratio will likely see more favorable terms.
Ideally, it’s best to use these options when interest rates are low so that the cost of borrowing against equity is reduced. Closing costs, lender fees, and loan underwriting requirements like an appraisal to determine market value will typically apply to all these options.
Investors should be cautious about borrowing capital using other assets as collateral, as one bad investment can trigger a domino effect. Should the property decline in value, vacancy rates rise, or rents decrease, the cash flow from the property will likely not cover the mortgage. One bad loan could put the entire portfolio in jeopardy.
Use the BRRRR Method
Another common way to scale a real estate investment portfolio is the BRRRR method, which stands for buy, rehab, rent, refinance, and repeat. This strategy is best suited for long-term buy-and-hold investors looking to acquire properties that maximize appreciation and cash flow while minimizing the acquisition costs.
Here are the general steps involved in the BRRRR method:
- Buy: Investors identify a property that is undervalued or needs renovation. Usually, investors target distressed properties in markets with strong and growing rental demand. The goal is to calculate potential cash flow from rental income and the after-repair value (ARV). Ensure the numbers align with comparable homes recently rented and sold in the area. The more tappable equity after renovation, the better.
- Rehab: Before purchasing, have a clear idea of the scope of work and how repairs will be completed. Walking through the property with a contractor during the inspection period can help you lay out a plan to complete the work promptly and efficiently. Going DIY on more minor repairs may help your bottom line, but ultimately, investors should focus on the renovations that offer a higher return on investment – like updating the kitchen and bathroom. Other improvements like adding energy-efficient appliances, windows, and doors, landscaping to increase curb appeal, and luxury vinyl plank flooring are great ways to increase rental applications and potential income.
- Rent: Investors use several formulas to determine a fair rental cost. One popular method is to charge 1% of the total cost to purchase and rehab the property. The sooner the property is rented, the quicker you’ll build equity and generate cash flow. Finding a great tenant requires screening candidates to ensure they have a stable job, no significant criminal record, and a good credit score, indicating a reliable payment history.
- Refinance: Typically, investors seek out a cash-out refinance loan with a bank for this step, but some may use a hard money lender or other loan products. While a hard money loan may have higher borrowing costs, the requirements and closing process may better suit some investors’ credit history and timeline. Different lenders will have different requirements on how equity must be accrued, and how long you must own the property before refinancing (usually called a “seasoning requirement”).
- Repeat: With cash in hand from the refinance, investors purchase another undervalued property and start the process over again.
Successfully executing the BRRRR method requires solid local real estate knowledge. If you’re targeting new markets, it’s worth building relationships with local professionals to streamline the process and avoid miscalculating your returns. Local real estate agents can help evaluate local renter demand and market the property once it’s ready. Include local and reliable contractors in your business plan and build relationships with banks in the area to secure a loan. Avoid delays and constraints on your ability to complete due diligence by communicating the timeline to the lender, contractor, seller, and other parties involved in the transaction.
This method is a great way to accelerate REI growth relatively quickly, but it’s not for novice investors. It’s best suited for those with high tolerance toward market uncertainties and risks, like a lower-than-expected after-repair value, vacancies, managing tenants, and challenges of finding additional properties. Recently, the BRRRR method has become more challenging as higher mortgage rates and building costs rise. Strict budgeting and finding the right renters will help fuel the BRRRR cycle. If the properties aren’t appreciating in value and cash-flowing, banks will be unwilling to refinance a failing asset.
Sell Lower-Performing Assets with a 1031 Exchange
Instead of leveraging the equity in one asset, a 1031 exchange allows you to sell one property, defer the capital gains, and purchase a new property with the proceeds. If used correctly, there’s no cap on how often you trade up with this tax deferment program. This tax break is particularly useful for investors looking to dispose of their lower-performing assets to purchase a new property with a better-projected appreciation and cash flow.
Also known as a “like-kind” exchange, there is no restriction on the property type. You can trade in a single-family residence for a duplex, raw land, or an office building.
Here’s how the 1031 exchange process typically works for investors:
- Find a Qualified Intermediary. You must use a third party known as a Qualified Intermediary (QI) to facilitate a 1031 exchange. The QI’s role is to hold the funds in escrow until the exchange is complete and prevent receipt of the cash prematurely. This professional can’t be a known business associate, so you’ll want to find a reputable person by interviewing potential candidates, checking references, and looking for referrals from other investors. An attentive and trustworthy QI will ensure you meet the required deadlines and help navigate the nuances of the 1031 exchange process.
- Evaluate which asset you want to sell. Determine which property you’d like to sell. The property must be held for business purposes or as an investment and not for personal use. A vacation home or primary residence doesn’t qualify.
- Identify the property you want to buy within 45 days of selling the first property. There are strict timelines associated with executing a 1031 exchange. The first is to designate the replacement property you wish to purchase within 45 days of selling your first asset. The IRS allows you to choose up to three potential properties as long as you close on one. It’s possible to designate more than three if the criteria for specific valuation tests are met.
- Close on the new property within 180 days of the sale of the first property. The new property must be of equal or greater value than the exchanged property. When going under contract, specify that the purchase is part of a 1031 exchange. Any additional cash received after the transaction, known as a boot, will be taxed as partial sales proceeds and possibly as a capital gain.
- Report the exchange on your tax return with a Form 8824. Come tax time, the 1031 exchange must be filed with the IRS using a Form 8824. It’s a good idea to consult a tax professional to ensure you complete the form correctly.
Like most of the United States Tax Code, there are additional tax implications to consider before starting the process. Debt reduction and depreciation recapture associated with an asset will be treated as income and taxed as a boot. For example, if you trade in a property with an outstanding loan balance of $500,000 for a new property mortgaged at $400,000, the $100,000 in debt reduction will be taxed as cash. Similarly, if you swap improved land with a building for unimproved land with no structures, the depreciation that you’ve previously claimed on the building will be classified as a type of profit called depreciation recapture and taxed as ordinary income. Hiring the right professionals to guide you through the process can help avoid making an unexpected tax mistake.
Explore Loan Options Designed for Investors
If an investor lacks the cash to close a specific deal or finds the conventional loan process inconvenient, there are loan options designed to cater to investors’ strategies. Unbound by the strict eligibility guidelines of a federal loan and the underwriting requirements for a conventional loan, these financing options give investors looking to scale their portfolios more flexibility in how they reach their goals.
We’ve already touched on a few of the options available to real estate investors, but here’s a more comprehensive list of loan programs:
- Home Equity Loans
- Cash-Out Refinances
- Hard Money Loans
- Private Loans
- Non-Qualified Mortgage (QM) Loans
- Owner Financing
- Portfolio Loans
- Owner Financing
- Debt Service Coverage Ratio (DSCR) Loans
- Blanket Mortgage Loans
As property values and rents steadily increase, DSCR attracts more attention from investors. Meanwhile, a blanket mortgage is an effective tool to quickly push an investor’s portfolio past the average benchmark of ten units.
Let’s take a closer look at these two loans.
Debt Service Coverage Ratio (DSCR) Loans
Underwriting approval for a conventional loan requires extensive income verification. Conversely, a Debt Service Coverage Ratio (DSCR) loan, a type of non-QM loan designed for real estate investors, examines the cash flow of an applicant’s rental property. With no tax returns, pay stubs, or other proof of income needed, approving a borrower for a DSCR loan is much quicker.
However, there are other eligibility requirements before a hard money lender approves you for this type of loan.
- Debt-Service-Coverage Ratio: the ratio of operating income from a rental property to debt obligations. This metric is a benchmark to project whether a borrower can produce enough cash to cover debts.
- Loan-to-Value (LTV) Ratio: a ratio measuring the loan amount to the appraised property value. Typically, a lower LTV will result in a lower interest rate.
- Credit score: a number representing a borrower’s credit behavior and predicting whether the loan will be repaid. A better credit score will improve the interest rate terms, but there usually aren’t any strict FICO scores to qualify.
- Property type: the type of rental property may disqualify you from this loan. Only single-family rentals, small multi-family rentals (2-4 units), and planned urban developments are typically eligible. The lender may also view a short-term rental as riskier than a long-term rental and refuse to lend against that property. Alternatively, the lender may qualify those properties based on how they would perform as long-term rentals or charge a higher rate for short-term rentals.
Strategic investors can also leverage their LLCs to maximize credit and minimize risks to personal assets with a DSCR loan. If there are multiple owners of an LLC, the credit score calculation may vary depending on what formula the lender uses. For example, for an LLC owned by two people with equal shares, one lender may use the highest score, another may use the lower score, and others may use a median score.
These hard money loans are excellent mechanisms to increase accessibility to cash quickly, but they might not be the best option for you. Before applying for this kind of loan, investors should dive deeper to understand the loan structures, fees, and eligibility requirements. Not all lenders will have the same terms, so it’s crucial to vet each potential hard money lender carefully, just like a conventional loan.
Blanket Mortgage Loans
A blanket mortgage finances two or more real estate investment properties under a single mortgage, with the assets serving as collateral. These types of loans are frequently used in a commercial context, but single-family residential landlords and house flippers can also utilize these loans to drive business growth.
Here are a few of the pros of a blanket mortgage loan:
- Blanket mortgages can finance the purchase of various property types, including vacant land, single-family residential properties, commercial properties, and others.
- A lender may provide the option to use a balloon structure on a blanket mortgage. This means that earlier payments are lessened, creating opportunities for investors to make improvements with more cash on hand and increase the properties’ value.
- A release clause allows one of the covered properties to be sold or refinanced without affecting the other properties or paying back the full loan amount. However, the remaining assets under the loan must retain a high enough value to cover the remaining balance of the loan.
- Making mortgage payments is easier under one consolidated loan by reducing the number of loan servicers, payment methods, and balance sheet reconciliations.
A few cons are also associated with a blanket mortgage loan:
- A borrower must already have a sizable portfolio with a healthy valuation.
- Lenders usually require a higher down payment, anywhere between 25% to 60%, a much higher portion than a conventional loan. The fees for originating and underwriting the loan may also be more than other types of single-family investment loans.
- Defaulting on one property may trigger foreclosure proceedings on all properties covered under the mortgage.
- A lender offering this type of loan may have geographic restrictions and require all properties to be located in one area or state. Buying in a new real estate market can help diversify and strengthen a portfolio, so limiting where you purchase can have negative implications for its long-term health.
While an investor can benefit from the flexibility of these loans, the terms and qualification process for each can be complicated. Structuring these loans to your advantage requires a deeper understanding of which is best suited for your investment needs, long-term portfolio goals, and risk tolerance.
Scaling Your Single-Family Rental Portfolio with Blueprint
Optimizing your property acquisitions with more innovative financing is only one part of the scaling process. Completing the transaction in your timeframe requires a smooth and transparent title and closing experience. At Blueprint, sophisticated real estate investors and entrepreneurs work with experts specializing in creative deal structures. Our team is experienced with contract assignments, novations, transactional funding, double closings, and other methods to fund and close transactions.
Whether you’re doing one or 100 transactions, placing and tracking your title orders is easy with the Blueprint platform. Get insights on what’s happening with the Status Tracker, find support, and upload, download, and electronically sign documents in one place. Closings are convenient with eSignings, mobile signings, and remote online notarization for eligible transactions.
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