Interest only loans are the new black for investing in STR vacation rentals

[AJ Wong]

From 2003-2009 I was 20 years old and had my first real job and taste of Real Estate for a mortgage company at HomeBridge Mortgage Bankers in south Florida.

It was a crazy market and a crazier place to work, but I learned from a great salesman, who 'learned' under the tutelage of Jordan Belfort how to sell and 'do' mortgages. 

For those of you too young to remember (I was 21) this is pre housing 'boom' when creative financing solutions reigned supreme and ANYONE could qualify. We won't get into the nuances of mortgage banking here, but I wanted to highlight an option that is slowly creeping onto the real estate lending and investor radar, interest only ARM's and payment options.

Let's call a spade a spade, and accept that rates are 'high.' At the time of writing a 30 year fixed mortgage for a prime borrower, primary home with 20%+ down is in the high 6%'s-7%. Investment properties with less capital commitments are trending in the low to mid 7%'s in a best case scenario. I just had two local Oregon credit unions price several investment loans for AAA borrower's with 25%++ down and the terms were prohibitive to say the least. How's 8% on a $1M loan...on an ARM?

In twenty years of mortgage madness and relevant real estate experience, I'm actually in the camp that in historical terms, mortgage rates are not that bad..I certainly would not lend you my money, for one much less 30 years at less than 10%. Is that not the golden ratio for cash on cash returns? 

However, when you factor in recent price appreciation and inflation, at current interest rate levels, there is good financial reason (that particularly on the higher end of the market) sales demand and competition has dropped precipitously. 

The cost of borrowing is simply too high and the numbers, or return on investment do not crunch. 

Clearly there is still very strong demand, many prime properties that are appropriately priced on the Oregon Coast still have several offers to consider within hours of listing. However, often high valuation buyers are 'bye' passing lenders as it is estimated that nearly a third of all sales are still cash transactions.* 

If purchasing a primary, long term residence, at some point one has to buy, but at some point you can refinance. Primary home buyer(s) might not have the the same luxury as investors of 'waiting' until interest rates drop to make an investment, because investors don't want to make a losing investment. 

When payments go up, and prices stay the same (or go up) cash flow is reduced. The options are to counter balance the sales price or amount borrowed or committed OR improve the lending conditions in order to enhance invest-ability. I have written repeatedly about rising rates being a double edged sword. On the one side, it is harder to pinpoint properties which positively project (say that ten times fast!) because the rents are too low and protected by housing laws OR the payments are too darn high. 

What investors miss is that opportunity costs are also at play. On paper the number might not work BUT if the client intends to utilize the property as a second home..uh..vacation rental..and plan personal usage on the Oregon Coast, that savings needs to be factored. For example an ocean front Oregon Coast Vacation Rental north of Florence to Lincoln City or Cannon Beach will run you anywhere from $500-1500 per night depending on caliber, availability accommodations. If a family spends, or intends to spend two months per year utilizing the property personally, that's in a best case scenario $30k per YEAR in rental payments, that will be better utilized (and likely cover) the entire down payment or investment over an extended forecast. 

The reason to invest, is not to rent, and in the case of short term vacation rentals, invest where it is difficult to rent. I have a client in town this July 4th weekend staying at an STR on the Oregon Coast and they have a large family, and a large bill, $1400/night for four nights.

They visit annually, for years and would do so more frequently if they could avoid the cost and inconvenience of booking an AirBnB each time, and arrive to their own HOME without packing on short notice. 

When analyzing potential performance of any real estate investment it's important to consider the external costs of ownership, perhaps most notably, at least in a more remote area, particularly as a absentee or out of state investor is Property Management Costs. On the Oregon Coast, quality service is going to cost you, around 25-30% depending on the size of the home and specific geographical location. We can discuss what optimal qualities and unorthodox things and perspectives to consider when searching for an STR later, but one thing is for sure. You will need a reliable team to keep the business operating.

Make no mistake. Owning a successful AirBnB is a business. It IS a hotel. Hence the barrier to entry in finding a local jurisdiction and area that will allow you to have a high transitory volume of guests and services. 

If investors think they can buy a house, without making it a home, they are very mistaken. To provide comparable hospitality services as a high quality hotel, takes a high quality hospitality team. The cost of this is apparently a 1/3 of the income produced. My question is, are hotels paying 25-30-35% on hospitality services? No they are not. I have analyzed many hotels and have one of the most successful coming up as a listing before year's end. 

Their secret sauce is long term insight and attention to details and customer satisfaction. When the original owner and builder of thirty years was showing me around the property their was a blade of grass on the floor of one of the units that he picked up off the floor. 

That is what makes his hospitality business successful. The owner, and extraordinarily successful businessman of three decades, who bought and built his ten room hotel in downtown Florence, noticed a flake of dirt and removed it. Nobody will care for your business like you, and I'm sorry but no management company deserves a third of your business. Maybe if they put down 33% of the deposit and absorb 33% of the risk and costs, they still don't get to use it 33% of the time, but they can have a third of the profits then!

Anyhow, the point is most STR's generate roughly, roughly, 10% of the sales price. So a $1.3M oceanfront (permittable) STR on the Oregon Coast will generate $10k per month in gross annual average income. $120-130k.

This is absurd. Truly. 10% cash on cash. Minus operating expenses. Well most taxes, insurance, utilities and maintenance average slightly over 1-1.25% of the valuation per annum or put another way in our $1.3M example...$13-16k...$1333 TOTAL monthly. Let's keep in mind that one night in a comparable property runs that...

$10k per month in gross revenue minus $1300 should leave us plenty of room to breathe, but many investors are leveraging or utilizing financing (as they often should) to make 'things work.'

Full circle back to financing, and even with 25% down ($325k) plus closing costs (2%+/-) a purchaser would require a jumbo loan of $975k at a floor rate of +/- 6.99% (before potential seller concessions or interest rate buy downs) with P&I (principal and interest) payments of $6480.15 and a full income documentation qualifying income of $15kish monthly. 

$10k-$12k minus $8k is $2k-4k per month net. Well not if 25-35% goes to silent partner.. but $24k on $325k for oceanfront property ain't bad, considering the projected rise in demand, population and popularity on the Oregon Coast, as well as the comparable UNDERvaluation (more on that later) but also one could finance such property with as little as 10-20% down but also that there is an enjoyment and personal usage opportunity cost of OWNING a HOME. 

Life comes fast. We had a client earlier this year that purchased a turnkey vacant TRIPLEX with 10% net down ($50k) and projected to return as a mixed use of LTR and a single STR unit at $15-17k PER year. Yes you read that correctly. A cash on cash return in three years. More importantly within one month of closing the buyers received notice that their current rental (primary) was sold and they had two weeks to move. Low and behold they owned a property with one vacant one and moved to their own property and saved their new mortgage payment in rent payments. Side note they were introduced to me on via DM here on Bigger Pockets and will now be ready to purchase their next investment/primary nearly a year before schedule**

Point is that things happen outside of our control and owning property can often solve those unexpected 'life events.' Real Estate investors have the best of both worlds! They get REAL assets, using fiat money, at (cheaper than auto loan rates) and it typically cots more to physically duplicate a replicate asset. You can't sleep in, on or with your money. Well you could, but it would get weird..There is intangible real value to real estate, and if location really does mean anything, I'm unfamiliar with something more precious and valuable for the foreseeable future than oceanfront real estate that one can use, as they wish, with 10% down. If you can afford a million dollar rental, you can afford a million dollar mortgage. Making it a deal depends on your due diligence, insight, goals, resources and options. 

One of the most useful and valuable an investor can have is a professional team. Organizations are as good as their weakest link. Great ones are certainly captained by valuable leaders, but like all great leaders, value investors have the advantage of good data and information from their crew. The properties don't really change, it's what, when, how, why or who you know, more so than anything else that separates real estate investors. It's a free market. At least here in 'Merica. 

In this market, nothing really matters more than the cost of property management  borrowing. Jordan Belfort didn't sell stocks. He sold greed. 

We didn't sell 0% down No Doc Loans in pre 2008. We sold payments. 

Buy today. Equity tomorrow. Refi and take cash out. Why? Total up all the credit card and even auto payments. The bank will give pay off your $50k in CC debt and $50k cash to buy your next home and go on vacation...in two weeks for the same housing payment and save you $2500 per total!

How? Interest only payments. 

I already know what you're thinking...I don't want to do that. Well I have news for you, you're already doing it. 

I'm not talking about short term adjustable rate loans, I typed interest only mortgage payments, and you're already doing it. 

Let me explain: 

In Oregon, or all of America for that matter, 15-20-30 year fixed rate full amortized mortgages are paid over 180-240-360 payments. Each payment includes Principal & Interest Portions. On our example loan of $975k @ 6.99% the cost of interest (assuming a borrower were to stay in THAT SAME LOAN) for 30 years is $1,357,847.12 And the total amount of 360 payments equals $6480/mo or $2,332,857. Keep in mind, today's borrowers (assuming rates reduce) will not be in the same loans, even if they are in the same homes, for greater than the next 1-2-5 years. I believe the average for ALL borrowers is 6-7 years, I'm not familiar with the data on investors, but please feel free to fact check me or active reputable lenders, please comment below...

On the same amortization schedule one will notice that of the initial $6480 P&I payment, the Interest portion of the payment is $5679.38 and the principal portion of the payment is $800.77 CENTS. In case you are wondering (I WAS) $975k at 3.375% (the rate I purchase my last STR for in late 2020) equals $4310/mo and $2742 INTEREST and $1568 principal. So don't sell me these garbage bank bailouts were necessary and struggling BECAUSE rates were 0%?? THEY WERE MAKING BETTER LOANS FOR THEM! Safer loans. Bigger margins. Now who pays the price? Consumers?? Also absurd. lol

Anyway. In one year of ($77,760) P&I payments borrowers would have paid down..(drumroll please...............) $9,924.79 in principal...OR 12% of the total (less than two actual monthly payments) towards principal?? The math is right but that doesn't make it any less dumbfounding. 

At 3 years it certainly doesn't get any better....$233,280 in hard payments...Roughly $32k towards principal. 

We really should not apply for another loan until these lenders restructure to simple interest terms, like most other nations, but I already have 3 other posts to write..j/k

Where were we, interest only options..

Just recently one of my Florida lenders (no relation) brought to my attention the reemergence of interest only payment options. It is truly just that. The option to pay interest. Typically (or back in the day at least) interest only loans were roughly .25-375% higher than the principal and interest options. In our example an interest only option would cost 7.25-7.375% depending on specifics. And the qualifying rate and payment for income purposes might be based on the (Fully amortized) proposed principal and interest payments..

So they are harder to qualify but on higher loan amounts, when available, worth consideration. Here's why:

The payment on $975k at 7.25% is $5,890. OR $70,687.50 in interest per year OR a difference of $7072 ($589 per month). Note- this is at a higher proposed note rate, (if it was apples to apple total amount of interest paid would be identical.)

Thus, borrowers payments are reduced by the exact amount they would pay towards principal anyway. Amortization tables don't really take off (start paying towards principal until year 8-9-10) and most likely, even if you own the same home, you won't be in the same loan. 

Remember, way back when, I said interest only is the option to pay interest? There's no more penalty for borrowers paying towards the principal than there is on a 'conventional' principal and interest amortization schedule. Pre payment Penalties aside, (now uncommon or incentivizing) borrowers simply have the option to pay principal. Clearly there is money to be made for banks and lenders, why not take one of the only options they're beginning to give? 

Rates are high enough, but borrowers will not pay anything meaningful towards principal on a fully amortized loan anyway..especially with current rates, these loans won't last forever. More importantly you know what happens when you make 13 mortgage payments per year (on a 30 year loan) the loan is paid off many years sooner**

How? Well do the math. Even at 7% $6500x23 years is $150k. The initial balance was $975k. There's more than that in INTEREST. $150k of $975k is 15% of the loan balance, that you don't have to pay 7% interest on for 30 years. It's a whole other investment, and less than the down payment but saves $500k+ in payments. You're welcome :) 

Going back..to the future..$600-700 (at these levels) is significant (not as significant as the $2500-3000 per month that could be reduced by hiring a FULL time cleaner and ambitious entrepreneurial teenager looking for work) but nonetheless is sufficient to cover ALL of the electricity, water, sewer, trash and internet that vacation rentals require. At least they're not asking to be a silent partner..

The bank isn't exactly losing out here..they still get almost $6k per month in interest, or $70k for lending $975k..per YEAR. Borrowers are taking most of the risk. Oceanfront property for $975k if an investor defaults on their $70k in interest per year, am I missing something? 

As business owners, with all the supposed risk and responsibility, you won't net that! BUT for $250-325k down..you will own an oceanfront vacation rental that now NETS $40k per year..less management fees..Or $40k per year if you can hire a reliable cleaner and reinvest in your asset regularly. 

Call it $25k per year. That's ten years to essentially get your investment back. 10% Cash on Cash return. I forget.. isn't that the golden investing rule? Long term. Safe. Hard. Oceanfront. Undervalued today..

Where can investors earn that type of protection and potential for appreciation, with something that they ALSO can actually create memories and a legacy with, within 30 days or less? 

Oceanfront vacation rentals, or any rental income producing property for that matter. 

Interest only investment mortgages are an option. Investing in real estate is an option for capital, leaving your assets in a bank are an option. What, where and when is an option. But the returns the bank offers are not an option. 

At last glance, most checking accounts were offers a few basis points and even the most attractive CD's do not cover the loss of purchasing power to inflation.  

Investors have the choice to use it or lose it. If their investment portfolio is significant enough to qualify for a $1M+ property they have more incentive than ever to take advantage of seller (and apparently lender leverage) concessions. Or give their hard earned assets and capital some options. 

Or somewhere to sleep for the night.. Maybe find a safe space to bury it buy the beach for the next thirty years... 

Cheers.