Where Do You Find the Money to Finance Short-Term Rentals

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At some point across the last couple of years, I’m sure most of you have seen the returns other investors are making on short-term rentals (STRs) and asked yourself, “how do I get in on this action?” If you have taken this a step further and looked for a loan on an STR, I would also bet that most of you have also asked, “how the heck does anyone finance one of these?” 

As an active short-term rental investor and Partner & COO of a nationwide, non-qualified mortgage lender focused on investment property loans, I want to share insights on how to set yourself up for success as you execute on your goal to build a portfolio of STRs. My phone is constantly inundated with calls from investors left days before closing without financing because their lender either didn’t understand the investment approach or didn’t fully understand the intricacies of their loan program. 

Therefore, I felt a duty to provide fellow BiggerPockets readers with the knowledge to operate confidently in this space.  By understanding the loan products available and knowing the right questions to ask a lender, you will be able to add a veritable Swiss Army knife to your investing toolbelt.

Will Short-Term Rentals Continue to Be Cash Cows?

The stats available now make me feel bullish and make me whisper Yee-Haw! With demand for short-term rentals in the U.S. reaching record levels this summer, STRs continue their trend of strong growth with indicators pointing towards outperforming demand in prior years, even during this period of high inflation. Although inflation has begun to weigh on consumer spending, there has not been any discernable slowdown in the number of bookings based on AirDNA’s outlook report.

A great sign for investors that currently own and are seeking to acquire additional STRs that generate significant cash flow compared to long-term rental income on the same property. 

Everything You Need to Know About Financing Short-Term Rentals

Can I get a conventional loan?

The answer is yes, but with many caveats. Investor friendly? Not even close! 

Conventional loans backed by Fannie Mae and Freddie Mac are highly restrictive and focus on personal income vs. short-term rental income of the property. The debt-to-income (DTI) ratio calculation is punitive towards STRs as it would only consider 75% of the long-term rent of the property being added to the income portion of the calculation. 

If you have very high W-2 income and taxable income (i.e. you are not writing off your income with depreciation) and are willing to jump through lots of hoops, then you might qualify for a conventional loan on your STR.    

Want to buy the property in an LLC or own more than 10 STRs or acquire luxury properties? Not allowed! Here’s the 1,243-page loan guidelines that conventional lenders need to follow. That’s a lot of rules!

Are there other ways to finance?

Yes! Debt Service Coverage Ratio (DSCR) based loans for investment properties tend to be the easiest way to finance an STR. This type of loan is a significant advantage to an investor because borrowing power is not constrained by your personal income, but rather the STR income of the property. This allows investors to scale an STR portfolio without worrying about their DTI ratio.  

Another option worth exploring right now is a short-term, interest-only bridge loan. These loans will typically finance 75-80% of the purchase price and provide 18-24 months before needing to be refinanced. A bridge loan provides extreme flexibility and ease to purchase a short-term rental since they do not have DTI or DSCR requirements and have no pre-payment penalty.

This provides the flexibility to refinance at any time if rates drop. A bridge loan will allow you to close quickly, allows time for long-term tenant leases to end, provides resources to rehab and furnish the property to maximize potential income, and build STR rental history. This bridge to long-term financing is used by many sophisticated investors to remove barriers to expanding their STR portfolio.     

How is the debt service coverage ratio calculated?

DSCR equals the property income divided by the sum of principal, interest, taxes, insurance, and HOA fees (if applicable). The income portion of the calculation uses the property’s STR income (i.e., 12-month trailing rental income). 

To qualify for the loan, the DSCR typically needs to be above 1.10, meaning the property will be cash-flow positive. Since the loan considers short-term rental income instead of long-term rental income, you are far more likely to be able to qualify for the maximum leverage that these loans allow—80% for a purchase or rate/term refinance and 75% for a cash-out refinance.  

What if the property does not have a 12-month history of short-term rent?

Not a problem! Find a lender that works with short-term rental investors and this will not be the first time they have come across this scenario. Most of the time, a property is converted upon purchase from a long-term rental or primary residence to a short-term rental. In this case, some lenders allow the potential short-term rental income (80-90% of the AirDNA STR Rent Estimate – “Rentalizer”) to be used to calculate DSCR instead of the long-term rent an appraiser puts in their report.

In this case, the lender will likely prefer that the borrower(s) have experience managing short-term rentals (ideally in the subject market) or have a contract with an experienced STR property management company like Evolve, AvantStay, Vacasa, and many others. 

Here is an example of how this works: 

• Let’s assume you’re buying a vacant property that would generate $3,000 monthly with long-term tenants but average $7,000 monthly with short-term rent. 
• Let’s assume you want a $500,000 loan (80% LTC) on a $625,000 purchase price, and the interest rate is 6.75%. This is approximately $3,200 monthly for principal and interest, and after adding taxes, insurance, and HOA expenses, the monthly PITIA is $4,000 per month.  
• You would not qualify for the 80% loan with $3,000 of rental income as this would only be a .75 DSCR (3K/4K). You would need to reduce the loan to approximately $375,000 (60% LTC) to get to a 1.0 DSCR. You would be required to bring an additional $125,000 to closing…ouch! 
• If your lender allows for 90% of estimated short-term rental income to qualify DSCR, you would have no problem qualifying for the 80% LTC loan. The 90% of $7,000 gets you to $6,300 monthly income, and when divided by the $4,000 monthly expense, you end up at 1.575 DSCR. You are golden! 

What if the property needs to be remodeled before it’s listed as a short-term rental? 

You have a couple of options, but the easiest would be getting a private or hard-money bridge loan that covers some or all of the purchase price and rehab costs. Ideally, this loan ends up being 75-80% of the after-repair value so that you can set up a rate/term refinance rather than a cash-out refinance (which tends to have higher interest rates and lower maximum loan-to-value). 

Other Questions About STR Financing

Can I finance more than 10 STR properties? Yes, DSCR loans typically allow for an unlimited number of loans on individual properties and can also be set up as a blanket loan on multiple properties. 

Can I acquire them as an LLC with multiple members? Yes, DSCR loans are provided by lenders who work with real estate investors and are providing non-owner-occupied investment property loans. They typically prefer that the borrower be an LLC or another type of entity. This also allows investors to bring in various partners to expand and scale their investment activity.

Can I have gap funding or seller financing cover my down payment? The answer is maybe. If your lender allows for it and is made aware of this plan in advance they may allow for an exception but typically prefer that the borrowers have equity in the transaction. Another option to bring in other-peoples-money (OPM) into a short-term rental investment would be to have the seller financing or gap funding be a loan to the LLC you are buying the property with or adding them as a member with profit share that aligns with the agreed upon economics. In this setup, an investor-friendly lender should not have any issues with OPM in the transaction.     

How are DSCR loan rates calculated? There are a variety of factors, including LTV, FICO score, and fixed vs. adjustable rate that impacts the interest rate available. Rates tend to be slightly higher than conventional rates, but the ease and ability to qualify and get properties financed typically allow investors to scale their real estate portfolio. This blog article provides additional information on factors that impact interest rates.

Conclusion

We all are painfully aware of how important it is to have the right people on your real estate team. Whether or not you end up with your new favorite cash-flowing assets often hinges on your lender’s understanding of your real estate goals and being able to execute. It’s worth your time and energy to make sure that you have the right person in the right seat on your team so that you can end up with another cash cow rather than wishing you were able to get that last deal done!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.