Multiplying Your Rental Income Through Equity, Leases, and the DTI Ratio: Part 3

Written on September 19, 2016 by , updated on December 2, 2016

Multiply the RentCollecting rent is nice, but it can be even sweeter than you thought. In this final installment of the Breakthrough Multifamily Investing trilogy, we will focus on growth.

While it may appear that a large initial investment will inhibit your borrowing power, this assumption is only partially true. In some ways, owning rental property begets more rental property. Because your multifamily property will be generating income and has also eliminated your ongoing housing expense (rent), your debt-to-income (DTI) ratio as discussed in part 1 of this series should remain largely intact.

This metric is the key to your long-term borrowing power.

A Typical Bank’s Formula

As far as the bank is concerned, they will credit you with a meaningful portion of this income. The banking industry’s standard for true rental income is two years of Schedule E income from your tax returns. If you have not owned the property for two whole tax-filing cycles, some banks will allow you to count 75% of your incoming, lease-verified rent as personal income from your first property. Additionally, they will also allow you to count a similar portion of your future rental income as long as the property you are trying to purchase has a well-documented rental history.

The borrowing capacity of your current and future rental income, at your maximum 43% debt-to-income ratio, is factored down to (.75*.43)= .3225, or about 1/3. This illustrates how your (gross scheduled rental income / 3) is the additional monthly debt service that the bank will allow your new rental income to support.

Here is an example that shows my own debt-to-income ratio over time. When I began investing, I had eliminated much of my outstanding debt that was unrelated to real estate (Starting Point). After I purchased my first property, which was highly leveraged as we discussed in part 1 of this series, my debt-to-income ratio shot up dramatically (Property 1). This was partially offset, however, by the new income that it was generating. I got a great deal on my second property, and after using some of my initial equity in the first property to fund the materials behind some significant sweat equity, the rent that it brought in offset nearly all impact to my debt-to-income ratio (Property 2). And so this pattern continues:

part3-pic

Getting the Down Payment for Future Properties

This is great news for your DTI, but when it comes to the required down payment for a second property, you may have to get more creative. In my case, I had just spent all of my available funds purchasing the first property and adding value to it as discussed in part 2 of the series. The beauty of this strategy I’m about to reveal is that the equity you have built up in the first investment can be borrowed against and recycled back into your new investments. Here’s the plan: If you take out a home equity loan, Home Equity Line of Credit (HELOC), or a cash-out refinance on the first property, you can use that money as a down payment for a second property.

This is a wonderful technique if used properly. All that is required is that these recycled funds are shown on your two prior months of bank statements at the time of your next mortgage application. The process of parking your money is known as seasoning and allows you to make the most of your initial investment capital. A word of caution is warranted here to ensure that you do not become over-leveraged. By using this approach, you expose yourself to some additional foreclosure risk at both properties. A strong financial analysis is required to know that all of your properties can support all of your outstanding debt. If they can, you’re in great shape.

If you are willing to put in the hard work, you can use your growing asset collection to begin compounding your financial progress.

Adding to Your Portfolio Indefinitely

You can continue adding to your portfolio over time by piggybacking off of your first investment property. These subsequent purchases can be small multifamily investment properties, the single family home that you so diligently bypassed the first time around, or really anything else that you’ve got your eye on. Just remember that financing personal expenses instead of rental properties will severely limit your borrowing power.

This cycle can be easily continued until you own 10 properties, which is well within reach. The game changes a little bit afterwards, but this cycle or some variation of it can be repeated, more-or-less, indefinitely. The more that you intelligently pour into your real estate investing strategy, the more waves you will be able to make.

In my own life, I will continue to use the equity that I have built up in my portfolio to continue to expand and improve it over time. The strategy of buying with low barriers to entry, improving over time as you raise the rents, and then moving on to repeat the cycle is a time-tested progression toward great wealth. If you are willing to put in the hard work, you can use your growing asset collection to begin compounding your financial progress.

How have you leveraged your real estate equity and income into additional rental properties? I would love to hear your thoughts in the comments below!

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2 CommentsLeave a Comment

  • Keith

    Banks in my area are telling me I cannot get a HELOC on rental property. I guess my only option is a cash out refi.

    • Usen

      Likewise. Local lenders will not do HELOC or refi of investment properties in my area. Only single family owner occupied.

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