In seven days the world of small-rental financing will change drastically.
As we wrote in February, the nation’s biggest mortgage default insurer (CMHC), is modifying its rental property qualification criteria.
The changes will affect anyone who needs a CMHC-insured mortgage to buy or refinance a 1-4 unit rental property.
Effective April 19, CMHC will:
Require 20% down on non-owner occupied rental properties (instead of 5% today)
Change its rental qualification formula from an “80% offset” to a “50% add-back.” (More on this below)
The changes are being imposed, in Finance Minister Jim Flaherty’s words, to stomp out “speculative mortgages.” To the extent they weed out weak rental borrowers, the Minister’s intentions are good.
Unfortunately, Mr. Flaherty’s rules also lump in untold numbers of non-speculators. According to TD, rentals account for 5-15% of new mortgage originations (probably closer to 5-10%). This number is largely composed of regular well-qualified folks who buy one or two properties to generate income. These people create much-needed rental stock and are not your typical “speculators.”
On top of that are families with rental suites in their homes (aka, “mortgage helpers”). These homeowners number in the thousands.
The Finance Department has carved out no exceptions for either of the above.
The Changes In Depth
“Demand growth will probably be tempered by…these new rules,” says Craig Alexander, deputy chief economist at TD. “If there were people looking to buy a couple of extra condo properties as an investment…instead of buying four properties with the same amount of money, maybe you end up buying one.”
The bigger down payment requirement eliminates the option of using 20:1 leverage to buy insured income properties—even for well-deserving borrowers with significant liquid assets and outstanding credit. You’ll soon be capped out at 5:1 leverage for insured financing. This “could be a significant deterrent to making the investment,” says TD.
When compared to the 20% down payment requirement, the new qualification formula brings about a more subtle effect. But it’s nonetheless far-reaching. For example:
Your Gross Monthly Household Income + (50% of Rent)
At first glance, the difference seems innocent enough…until you do the math.
Pretend for example, that you want to buy a $400,000 personal residence with a separate rental suite. Suppose it generates $800 a month in rental income. Today you need to make at least $40,900 a year to qualify for that mortgage.
Starting April 19 that number will rise to $53,600 a year (31% more income!) to be approved for the exact same mortgage!*
These new rules have multiple implications:
Other things being equal, debt service ratios (the things lenders look at when deciding to lend to you) will increase considerably for people with high-ratio rental properties
Some borrowers will be forced to simply renew with their existing lender at maturity, since they no longer qualify with a new lender.
Debt service ratios for rental investors will deteriorate rapidly as they add more properties to their portfolios. That means, the more properties you buy with insured financing, the harder it becomes to qualify. Don Campbell, president of the Real Estate Investing Network, told the Financial Post: “Even if you’re cash-flowing like crazy on paper, in [CMHC’s] formula you won’t be.”
“It will be next to impossible to get approval using these new rules on your fourth rental property,” says Campbell. “If they’re only taking in 50% of the rent in their math, you’re going to hit a brick wall where they say your debt-service ratio is above their threshold.”
Rental Financing Tips
For those affected, alternatives to CMHC do exist. People can, for example:
Put down 20% and sidestep the rules changes
You’ll need to use a lender that doesn’t insure their conventional rental mortgages.
Joint venture when buying non-owner occupied properties
Borrow your down payment
Thus far we haven’t seen any CMHC communications saying borrowed down payments won’t be allowed on rentals after April 18. (If we hear otherwise we’ll post about it.)
You’d need to debt service with the extra monthly payment, of course.
Apply for an uninsured mortgage
You’d pay a higher interest rate and be capped at 85-90% LTV maximum, OAC.
Use Genworth instead of CMHC if the borrower lives in a 1-2 unit property in Vancouver or Victoria.
Genworth permits a much more reasonable 100% add-back calculation for properties in these cities. Although, as of now, Genworth doesn’t extend the same benefit to those in other high-priced markets, like Toronto.
Campbell says investors should also consider switching their home mortgage to a “less investor-friendly bank.” Doing so frees up “cap space” at investor-friendly lenders. (“Cap Space” is the total amount a bank is willing to lend to an investor).
Once rental borrowers run out of cap space at non-insured lenders, they’ll be forced to use lenders with tougher CMHC guidelines.
These rules, by the way, will make mortgage planners invaluable for securing rental financing. Planners experienced in rental financing know which lenders offer the most beneficial rental income treatment, and (more importantly) which lenders to apply to first when the borrower wants to build an income property portfolio.
What’s Behind These Changes
When you get down to it, these rental rules are the Federal government saying: “We no longer want to insure rental properties.” The government knows that at 80% loan-to-value, knowledgeable borrowers (given the opportunity) will opt for a non-insured lender to minimize the hassle.
These are radical and sudden changes, no matter how you slice it. The government could have instead gone to 10% down, imposed tighter credit guidelines, net worth requirements, etc. Instead, they carpet bombed the entire rental financing market with the same extreme guidelines for all borrowers.
The president of one well-known lender told us he was “surprised” at the degree of policy change. He said CMHC has been insuring high-ratio rental mortgages for over 15 years. He felt the changes won’t have much effect on lenders’ profitability, however, since rentals are a small segment of deal volume.
While some may call the changes “responsible,” others believe they’re politically driven and statistically unwarranted from a risk perspective. So far, the Finance Department has provided no empirical data to support its case. Nor have we seen a single story or talked to a single lender who says rental property defaults were, or are in danger of becoming, abnormally high.
When we asked the Finance Department, “What statistical evidence is there to support that the rental real estate market is in need of these new guidelines?”, the Finance Department responded:
“The Government actively monitors developments in the housing market, mortgage market and the economy. As the Minister responsible for financial sector, the Minister of Finance is advised by the Governor of the Bank of Canada, the Superintendent of Financial Institutions, the President of CMHC, as well as Department officials. In its analysis, the Government uses a range of indicators and a variety of techniques. (This) action is part of the Government’s ongoing responsibility to monitor developments and to act as necessary.”
In the days prior to this statement the Finance Minister was quoted as saying:
“The percentage of mortgages in arrears for three months or more has remained at low levels, levels not seen since the early 1990s.”
Yet, the government, without substantiating the purported “speculative risk,” quantifying the actual “problem,” or exempting highly qualified borrowers, felt it warranted to apply drastic rule changes across the board. People are left with a just few pages of unspecific press releases to help them guess at the government’s motives and justifications.
We’re 101% in agreement that rental guidelines had to be tightened. It’s just a matter of how much and who the new guidelines should apply to. It would also be nice if the government were a bit more transparent with the data it uses to alter the financial establishment and affect so many people.
* Assumes a 4.25% 5-year fixed rate, 5% down, a 35-year amortization, 1% of property value for property taxes, $75 a month for heat, insurance premiums excluded, no condo fees, no other monthly debt obligations, and a 680 credit score.
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