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Q: Hi Kyle, I have recently run into issues with my bank qualifying my next rental purchase. They told me last year when I bought my most recent rental not to worry about it, but now they are telling me that their guidelines have changed and I don’t qualify anymore. I have great credit (my credit score is over 800), and all of my properties cashflow. Can you explain how I have hit a wall and what I can do to fix it?

A: Yes, unfortunately your relationship with your banker would often mean that they would be able to put together each deal for you no problem, but now with decrees coming from VP’s in Toronto, your branch manager likely has no control over what they can and can’t do. With their new guidelines, you don’t “fit the box” anymore, despite your excellent credit and cashflow.

I’ll give you an indication of how the banks are now evaluating rental property income, which may help clear up some of the uncertainty.

50% Add to Income method

Almost all major lenders now use this method, espcially since CMHC reverted back to using this instead of “80% offsets” in April of 2010.

This is the math behind it:

If the rental income is $1,000 / month, they will take 50% of this income ($500) and add that to your income.

Once this has been added to your income, your monthly debt load (including 100% of the rental property mortgage, credit cards, personal residence mortgage, etc) is typically not allowed to exceed ~40% of your total gross income. This means that if we break it down even further, this $500 that has been added to your income really only gives you $200 ($500 x 40%) of borrowing leverage.

So, if you have a property that is $1000 in revenue and expenses per month (neutral cashflow), onl the books the banks will be looking at this as an $800/mo loss. If you have 4 properties like this, it is a $3,200 loss that your income has to make up for. You need to make $8,000/mo just to carry the 4 rental properties, let alone your home mortgage and Line of Credit, car loans, credit cards, taxes, etc.

Luckily for us, many of the major banks have a few other methods of qualifying. However, for any insured mortgages (borrowing more than 80% of the value of the property), you must follow these guidelines.

80% offset

This method was used by CMHC and some lenders prior to April 19, 2010 to qualify rental income.

Now, only a select few (mostly credit unions) use an offset. It might not always be 80% (sometimes 75%, sometimes even 90%). Because the lenders know they are the only ones offering this product, it may limit you to higher rates or limit access to special programs you may have had access to before.

This is how the math works, using the same example as above ($1,000/mo in revenue and expenses):

– 80% of $1,000 in income is $800

– The $800 is used to write down the expenses of $1,000, so there is a $200 shortfall

– $200/month is used as a liability (not $800/mo!)

The really cool thing about the offsets is that if the rental income x (whatever % offset) covers all of the expenses, there is no net effect on debt servicing. In theory, you could qualify for mortgage after mortgage as long as 80% of the rental income covered the expenses.

In essence, an offset uses 4x more rental income to qualify you than 50% add to income will.

“DCR” method

Teaching my clients this method has been important as this is one of the easiest methods to follow.

DCR stands for Debt Coverage Ratio. If the income is $1,100/mo, and expenses (as calculated on their spreadsheet, which may vary a bit from your actual numbers) are $1,000/mo, your DCR ratio is 1.1 : 1. This in many lenders eyes is favourable, although they all vary a bit. Some lenders are more lenient and are ok with 1.0 (or lower in certain circumstances), others require 1.2 or greater. As well, some require each property in the portfolio to follow these guidelines whereas others can bend the rules if the subject property (property you are purchasing or refinancing) meets their criteria as well as the average of the portfolio as a whole.

Because the DCR method is much easier to follow, it is usually the easiest way to know if you will be financable on your next deal. I always get my clients to learn how it works and to fill it in themselves, so they can almost pre-qualify themselves and really have a good handle on where they stand.

I usually recommend a DCR of 1.1 : 1 as this will fit with most lenders.

Analysing your T1 Generals

This has been more common as again, CMHC will take a look at your T1 Generals (tax return forms) for the past two years in lieu of the 50% add to income method of qualifying. The rules here really vary from lender to lender, but typically the banks will take the average income/loss for the past year or two and add/subtract this on your debt servicing.

The main problems with using this method is that many clients have one or two properties that they haven’t owned long enough to have a 2 year history of in their T1’s, and so typically a 50% add to income method is used for these properties.

Also, if you have done renovations, had large vacancies, or other issues that are not likely to be recurring, this can easily put the net rental income to a negative figure which will again hurt your chances. That said, on larger portfolio’s this loss is usually still better than using 50% add to income.

Liquid Assets Requirements

Many lenders are now requiring more in liquid assets, with some lenders requiring $100,000 once you hit 3 properties, and $10k more for each property over 4. Most don’t have a strict guideline but this is one the the “grey area” rules thatmany lenders are now evaluating much more than before.

If you are having problems qualifying with your bank, it is often because you don’t fit their box. This doesn’t mean you can’t fit with one of the 40 lenders that are on the market that brokers have access to.

If you would like to learn more about how banks qualify clients for rental properties, contact me at 778-373-5441 or kgreen@mortgagealliance.com.

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