Rental Property

What Does It Mean to Back Into Your First Rental Property?

Real estate investment gurus can’t resist the temptation to offer advice to would-be investors. They want to help those new to the industry leverage real estate as successfully as they have. It’s an admirable trait. However, it sometimes leads to unwise advice that could get inexperienced investors in over their heads. Consider the practice of ‘backing into’ a first rental property.

This particular strategy relies on already owning a primary residence you are willing to rent out. It’s not an easy strategy to pull off, especially where financing is concerned. It is also a risky strategy inasmuch as you are sacrificing your primary residence in hopes of reaping future returns that are never guaranteed.

How the Strategy Works

Backing into a first rental property is a strategy reserved mainly for acquiring residential rentals. It requires that the new investor own a primary residence of significant value. Here’s how it works:

  1. The seller converts his primary residence into a rental.
  2. They then buy another home to live in.
  3. The new home is purchased with a traditional mortgage; equity from the existing home can be leveraged to come up with a downpayment.
  4. Rental income from the first home covers its mortgage. There may be enough left over to cover the second mortgage as well.

Why would someone employ this strategy? To get a lower interest rate on the second mortgage. Normally, loans offered for obtaining investment properties come with shorter terms and higher interest rates. Simply put, they are more expensive. Backing in allows for financing a new primary residence at a more traditional rate and with longer terms.

You’ve Got Some Explaining to Do

Not only is backing into a new rental property risky, but it is also difficult to pull off. Any traditional lender is going to require an explanation of why you want to do what you are proposing. At the end of the day, lenders may determine that your investment strategy is riskier than you think. Even if you do get a loan, you still may be left with higher rates and shorter terms.

There is also the risk of being left to pay two mortgages without sufficient rental income to support them. For instance, what if your renter ends up being a deadbeat who doesn’t pay his bills? What if your renter does not renew the lease for another year and you’re left without tenants for 6-12 months?

There Are Other Ways to Do It

There are other ways to fund investment properties without risking your primary residence. Hard money is just one option. Actium Partners, a Salt Lake City hard money firm specializing in commercial real estate, explains that not all hard money lenders will write loans for residential properties. Still, many do.

Actium recommends shopping around the same way you would for a traditional mortgage. Just be prepared to offer that first rental property as collateral on the loan. That’s how hard money works. Loan decisions are made based primarily on the collateral offered. And in real estate investing, the property being obtained is almost always the collateral.

It is theoretically possible to back into a first residential rental. People have done it before. Others will do it in the future. But it is a risky strategy that requires careful consideration and a willingness to push the envelope. Based on my limited knowledge of real estate investing and hard money lending, I wouldn’t do it. There are other ways to obtain rental properties that are not nearly as risky. But then again, I tend to be risk averse with my investments.