Next Frontiers in DSCR Loans - 2024 and Beyond (original) (raw)
This article was originally published September 27, 2023 on BiggerPockets.
Throughout the past year, this series of articles has comprehensively covered the DSCR Loan product. We have covered an how to get the best rate and terms, how to use advanced strategies to maximize return and a long list of FAQs. Also published was a guide on the full list of Documents needed for a DSCR Loan and a helpful Glossary of Terms for navigating the private lending process. We explored specific real estate investing strategies and how DSCR Loans stack up when investing in Short Term Rentals, using the BRRRR Method or diving into Small Multifamily investing. In the finale of this series, we will go over “what’s next” in DSCR Loans – an overview of what innovations or additions to the DSCR Loan product lineup may come in 2024 and the future in the next evolution of this revolutionary loan product!
Medium Term Rentals
One of the biggest developments in real estate investing in 2023 has been the rise of Medium Term Rentals. The “medium term rental” (sometimes referred to as “mid term rentals”) is an investing strategy that combines elements of short term rentals and long-term rentals. Typically, defined as tenants renting properties for greater than 30 days but less than a year, its become a preferred strategy of many investors. The seminal book on the strategy, “30-Day Stay,” published on BiggerPockets and written by MTR pioneering investors Sarah Weaver and Zeona McIntyre, has helped popularize the method. Real estate investors are attracted to medium term rentals to gain the benefits of extra cash flow versus long-term rentals, but also avoiding the regulatory risks, high turnover and intensive management of short term rentals.
While many investors are now turning to medium term rentals to build their portfolios, the lending world has unfortunately been a little slow to keep up. While over the last couple of years many DSCR Lenders have embraced and adapted to financing short term rentals, including using data-driven tools like AirDNA to qualify rents on short term rental properties, there is yet to be a similar tool for medium term rentals. Many investors use a general rule of thumb for mid term rentals that they should earn about 50% more in rents than an equivalent long-term rental (whereas short term rentals should earn double or 100% more than if the property was utilized as a long-term rental).
However, for DSCR Lenders, change can be slow and challenging, and many lenders prefer and require more precise qualification measures than “rules of thumb.” Thus, the next challenge and frontier for many DSCR Lenders seeking to serve the growing number of real estate investors pursuing this strategy is to cement a qualification and underwriting methodology to properly qualify MTRs and accurately project their revenues. Potential next steps would for a data provider to emerge similar to AirDNA for Medium Term Rentals to take on this growing opportunity. Until then, DSCR Lenders will have to be creative and flexible to tap this growing market.
Single Room Occupancy (SRO) Properties
With the relentless rise of interest rates the past couple of years, investors searching for cash flow have struggled to find workable deals without being forced to commit to cash purchases or ultra-low leverage (which severely crimps ability to scale). With the dearth of SFR (single family rentals) available to provide cash flow as home values have stubbornly stayed elevated even in the face of rising rates, investors have been pushed in alternative directions. For many, this has meant moving towards short term vacation rentals, multi-unit properties or other “creative” forms of deal making.
One alternative option that is increasingly popular for investors seeking cash flow is the rise of “single room occupancy” or homes rented by the room. While not a new concept, technology-enabled management companies such as PadSplit have helped investors take on this option, allowing single family residences to multiple tenants on a room-by-room basis, with specialized property management and technology (for leases, rent collections, etc.) that has made this an accessible strategy for real estate investors.
The problem? Many (if not all) of current DSCR Lenders and their capital partners are hesitant to lend on these properties, even if the investment is solid. Why? Many are tarred with the connotation of “boarding houses” or belief that the tenant mix may be low-quality and risk (many “halfway houses” operate in this way) or the type of tenant that can only afford a room in a group home may have greater risks of missing rent or having other issues.
In addition, the primary risk mitigation technique for DSCR Lenders is to foreclose on the property to protect against losses. Many lenders are not in the business of real estate investing themselves, so they will typically want to immediately sell the foreclosed property to recover capital, rather than trying to operate it as an investment. Due to these reasons, many lenders are hesitant to lend on SRO properties, because there is a limited buyer pool for properties that may have been altered for single-room living (door locks, split rooms, etc.) or for properties that are out of character in a market or not usable for most buyers (for example, an eight-bedroom home in a neighborhood full of three-bedroom homes is likely touch to sell, as not many families have a use or interest in a house with so many bedrooms).
Despite these issues, these investments still tend to make sense for real estate investors, and it is likely some DSCR Lenders will be willing to take the risk in the future. Don’t be surprised if financing options finally appear for SRO properties, particularly those with minimal alterations (functional obsolescence) and properties that fit in generally with the surrounding neighborhoods. Simply, if the property that is used as an SRO but could easily be converted into a normal SFR (one lease, one family), DSCR Loans should be available!
Manufactured Housing
Manufactured housing – or mobile homes are a significant piece of the real estate landscape in 2023, especially as relentlessly rising rates and housing prices continue to create a shortage of affordable options. While some DSCR Lenders have waded into the Manufactured Housing waters – most have not, despite the continued demand for loans for this asset class (if you peruse the BiggerPockets lending forum, you are probably familiar with a steady stream of investors searching for financing options for manufactured housing properties.
The main issue is with the collateral – as mentioned above, the main way DSCR Lenders mitigate risk is through the ability to foreclose on the real estate property in case of default. The issue with manufactured housing is that there is heightened risk the property could be moved. While they are typically fixed to the land with a foundation and other permanent aspects, the properties were initially “manufactured” and moved to the site, so there would be a possibility in many cases to move them again. A borrower in default that could move the collateral is a problem for lenders because they could get around foreclosure and the lender would take a large loss.
How can DSCR Lenders solve this problem? Some options would to include leverage limits (lower LTVs available) to protect against risk and to require features and aspects that tie the home to the land such as foundation requirements. Additionally, in some jurisdictions, the lender can require an affidavit filed with the county legally restricting ability to move the collateral and to classify the property as real estate. It is likely more DSCR Lenders continue to consider adding DSCR Loan options for manufactured housing and continue to develop these risk mitigants.
Mixed Use
DSCR Loans for properties that are “mixed use” or have elements of both commercial and residential features are another area for expansion. Typically these are properties in large cities, and are the familiar office or storefront with apartments located on the second story. While there have been Mixed Use DSCR Loans offered currently and in the past by some DSCR Lenders, this product has been rarer in recent years due primarily to overall market volatility.
These smaller mixed use properties can be lucrative investments, especially as financing options for commercial real estate continues to contract. Even with a recovery in commercial real estate lending, there has always and will likely continue to be a dearth of “small balance” commercial lenders that would consider properties with values in the six figure range. For this reason, DSCR Loans can be a good option for these properties as the investments share a lot of characteristics with the primary properties financed with DSCR Loans that are traditionally all residential.
What will Mixed Use DSCR Loans look like? These loans generally will have to be primarily residential in nature, typically required to be majority residential by units, by square footage and by rental income. Interestingly, while DSCR Loans strictly prohibit the owner of the property living in the property, they generally will allow the owner to occupy and operate a commercial unit in the space (think office or shop). So a Mixed Use DSCR Loan could be used for an owner operating a shop on the ground floor and renting to tenants in apartments above, but not the reverse, as the owner couldn’t live in one of the units but rent the commercial space to a third party.
Treehouses / Yurts / Orchards / Ranches / Pods
While some of these creative and “out there” properties will not likely be included in any DSCR Loan product expansion anytime soon, these wacky property types come up as requests from time to time with a lot of DSCR Lenders. While these may be good real estate investments, they are likely never to be a fit for DSCR Loans. Why? At the end of the day, DSCR Lenders must be able to know they can either sell or operate the properties if they need to foreclose, and there just isn’t enough potential buyers or managers out there for that to make sense. Maybe in the future though!
Conclusion
We hope you enjoyed this article and series on DSCR Loans and we look forward to seeing the many investors utilize these loans to scale rental portfolios and achieve financial freedom!
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About the Author
Mr. Simon is a Partner of Easy Street Capital, overseeing the EasyRent division, which provides long-term financing on business-purpose 1-10 unit residential mortgage loans. He is responsible for managing all aspects of the EasyRent line, including the marketing, business development, operations and secondary/capital markets.