Have you ever considered how the United States government can help jumpstart your real estate investment business? A loan backed by the Federal Housing Administration (FHA) just might be the perfect option for investors looking to acquire residential multifamily property (2-4 units).
Today, I want to offer an overview of FHA loans, along with the pros and cons, and a closing recommendation about whether and how multifamily investors should use them.
What’s an FHA loan?
Established by the National Housing Act of 1934, the FHA has been a useful tool in promoting home ownership. Strictly speaking, the loan doesn’t come from the FHA, but from your lender. The government’s role is to insure those funds, which allows the banks to widen its lending parameters to give you a better deal.
Who can get an FHA loan?
From a financial standpoint, FHA loans are among the easiest to secure. As long as you have a credible work history, a credit score above 580, sufficient monthly income to meet FHA’s debt-to-income requirements, and at least 3.5% of the purchase price to put towards a down payment, you can qualify.
Who can’t get an FHA loan?
The FHA loan program was designed primarily to motivate residential home ownership. For that reason, FHA won’t back a loan for commercial property investments, which would include any multifamily property with 5 or more units.
Moreover, FHA requires purchasers to establish occupancy within 60 days of closing and maintain primary occupancy of the property for at least one year. While it is possible to open up a second FHA loan on a future property, you’ll have to give your lender a convincing reason (family growth, job relocation, etc.) to approve it.
So, where does that leave a multifamily real estate investor?
I wouldn’t rule out FHA just because of its occupancy restriction and ban on commercial property. I’ve known plenty of multifamily investors to build a firm foundation by using FHA to purchase their first small multiplex, live in one of the units for the first year, and grow their business from there.
Deciding If an FHA Loan is Right For Your Investment Business
Why would you want to consider an FHA loan? Here are several good reasons:
- More Affordable Down Payment – With FHA, you can get away with a minimum down payment of 3.5% of the purchase price. That’s far lower than the 10-20% you’d pay on a conventional loan. Additionally, there are down payment grant programs available that could lower your down payment to 0%.
- Lower Rates – Because of their government backing, the base rate on FHA loans is typically lower than what you’d find on a conventional loan. Needless to say, lower rates make for cheaper mortgage payments and better cash flow.
- Looser Credit Requirements – This is one of the main benefits of an FHA loan. Just be warned, lower credit scores tend to fetch higher interest rates.
- Seller Concessions – In most cases, FHA allows sellers to contribute up to 6% of the purchase price towards your closing costs, prepaid expenses, discount points, and title expenses. This is especially valuable for investors who want (or need) to minimize out-of-pocket costs as much as possible.
- Assumability – This valuable benefit often goes overlooked. Let’s say you take out an FHA loan today at 4%. Now imagine, 10 years down the road, we find interest rates at around 7 or 8%. If you decide to sell at that time, you can offer buyers the option to assume your loan at 4% rather than the current market rate. That’ll give you a huge competitive advantage against other sellers.
These advantages add up to a fairly compelling case for FHA. But, that’s not the whole story. Let’s look at a few of FHA’s disadvantages:
- Upfront Mortgage Insurance Premium (MIP) – If you put down less than 20% on an FHA loan, you’re going to have to pay an additional 1.5% of your purchase price to help insure the lender’s interests against default. This fee will be added to your total loan amount at closing.
- Monthly Private Mortgage Insurance (PMI) – In addition to MIP, you’ll have to pay monthly PMI on any FHA loan originated with a loan-to-value ratio (LTV) lower than 80%. Depending on the purchase price and the amount you put down, annual PMI can range from .45% up to 1.05% of the loan amount. FHA used to knock out the PMI once you hit 78%. But now, if you put down less than 10%, it will stick with you until you either pay off the loan or refinance.
- Property Condition Requirements – To insure your loan, FHA requires that the property meet their minimum standards for safety, security, and soundness. In the event of a foreclosure, the government doesn’t want to be stuck with a dump. This requires a FHA-approved appraiser to evaluate the property and, if necessary, require additional repairs before closing. That process in itself can lead to forced renegotiations on repairs, closing delays, and headaches all around.
My Closing Recommendation
I want to commend the FHA loan as a strong option for investors just starting out in the multifamily investment business. If your family situation allows it, I wouldn’t be put off by the occupancy requirement. Purchasing a plex and living in one of the units is a fantastic way to learn how to own and manage a multifamily.
My biggest piece of advice would be this: purchase a property that’s going to give you stable, reliable cash flow even with the additional monthly PMI expense. When you do, move in and start adding value right away. As soon as you can get your LTV up to 80%, make sure to refinance and get rid of that monthly PMI so that you can increase cash flow.