What’s the Reason for a Vacancy Factor?
If you’re new to the world of investing in real estate, one term you may run into is the vacancy factor. As part of the approval process to buy a rental property, one of the early qualifying factors will be income. Rental income from the property might be able to be used to qualify for the new mortgage. In general, lenders will only let you use rental income to qualify on second properties, but not the first rental property. After owning a rental property for a minimum two years, lenders will allow rental income to be used when determining affordability. Lenders want to see that new investors can properly manage and maintain the unit over a a two-year period.
How Lenders Calculate Rental Income
Let’s first see how lenders will calculate rental income. One of the primary factors when investors evaluate a potential purchase is whether or not the property generates a positive cash flow or not. The money coming in must be more than the cost of ownership, including principal and interest, property taxes and insurance. There should also be cash reserves equivalent to two or three months’ worth of house payments. But not all of that income can be counted, even after owning and managing investment real estate for two years. Instead, the lender will calculate a vacancy factor. The most common vacancy factor is 25% and here is how that’s calculated.
How the Vacancy Factor Works
Let’s say the monthly rent on a property is $2,000 per month. The tenants have been paying that for nearly a year, but their lease is up in just two months. Investors can attempt to find new tenants right before the purchase but in all likelihood the unit will need to be emptied first. The new owners will want to update the unit and make needed repairs. Perhaps a new coat of paint throughout the house or new wood flooring will be installed. It’s obvious that the property can’t be occupied by renters while this work is being done.
It’s also easy to assume it might take a month or two to list the home searching for new tenants. This also means there won’t be any rental income during the listing period. Buyers might also place the rent on the high side of the market to try and get as much rent as possible. This can also slow the selling cycle down as other renters decide on less expensive units in the area.
Real World Lending Examples
Using this example, the lender will use $1,500 as additional income as it represents 25% of $2,000. When the vacancy factor is applied, it might very well be the case that the $1,500 is just short of the costs of ownership and when calculating debt to income ratios, the shortage would be listed as an expense, even though it’s known to all involved in reality the income is $2,000.
Lenders also use the Comparative Market Analysis, or CMA, performed by a licensed appraiser. This is something that can be requested by the buyers or the individual lender may require it. When the market rent is analyzed and calculated by the appraiser, this final amount is what lenders will use when qualifying. The actual lease agreement is secondary and is used to support the rent analysis.
The vacancy factor needs to be taken into consideration when deciding whether or not to buy a rental property. Lenders will certainly take it into consideration so if the total mortgage payment is very near what the rental income for the market area will be, it’s possible buyers could end up ‘upside down’ at least in the eyes of the lender. If you’re not sure about such a scenario, let’s talk and we’ll run the numbers together. You want to know in advance how your loan application will be evaluated.