What Are the Options and How Do DSCR Loans Stack Up?
This article is presented by Easy Street Capital. Read our editorial guidelines for more information.
Short-term rentals continue to be one of the hottest areas of real estate investing in 2023. Despite some market volatility, slow down, and saturation in some areas, smart, professional short-term rental investors continue to thrive, expand, and scale.
What separates the successful STR investors from those facing a personal portfolio “Airbnbust”? It’s simple: Investors who succeed with short-term rentals are those who approach the business professionally—lining up all the moving pieces for success in STR real estate.
Typically, this means approaching it like a business—utilizing a pricing engine; hiring top-notch management or implementing cutting-edge automated systems; developing relationships with the right agents, cleaners, handymen, and accountants; and often, the most important piece: mastering the financing. Getting each of these dialed is often the key to success and scale, freeing investors up to focus on the highest-value activity: finding and closing deals.
Short-Term Rental Loan Options
Figuring out the financing side of short-term rental investing can be the difference between a quick path to wealth and financial freedom and a huge headache, financial stress, and failure. When running the numbers, even minor differences in loan terms can lead to dramatically different returns on capital, pace of portfolio expansion, and even positive cash flow versus losing money each month.
If you are like most people looking to build a portfolio of short-term rentals, you will likely need to use leverage (and use it effectively), as many investors don’t have enough cash lying around to purchase without financing.
It’s hard to remember sometimes, but Airbnb is only 15 years old, founded in August 2008 at the height of the real estate mortgage crisis. Thus, this nascent industry of short-term rentals has grown and developed at the same time the mortgage lending business has undergone radical change. These changes included the passage of the Dodd-Frank Act in 2010, which created “qualified mortgage” rules that tightened up mortgage standards across the industry.
Changes also included the growth of nonbank “non-QM” lenders in recent years, pioneering DSCR loans, which are created specifically for investment properties but with healthy underwriting and documentation standards that were absent from the investors’ so-called NINJA loans (poorly underwritten loans to often unqualified borrowers) that were used in the early 2000s and are blamed as a big factor in the 2008 mortgage crisis.
Summer 2023 Short-Term Rental Landscape
Here, in the middle of 2023, short-term rental investors have multiple options for financing their portfolio. With many banks pulling back from lending in the face of high interest rates, regulatory uncertainty, and fears of a regional bank credit crunch, investors looking for STR loans generally find themselves with three main options:
- Conventional loans: Standard investment property loans underwritten to agency (Fannie Mae/Freddie Mac) guidelines and primarily underwritten based on individual borrower income and total debt-to-income ratio (DTI).
- Second home loans: Also sometimes referred to as vacation home loans, a subset of conventional loans that are best known and popular due to minimum down payments of just 10%.
- DSCR loans: These are often originated by private lenders for investment properties and underwritten primarily based on the property and its cash flow potential.
While generally a bit higher in rates and fees than the preceding two options, DSCR loans are typically the most popular and utilized by professional short-term rental investors. Why? Primarily because of the flexibility they offer—short-term rentals are a still-growing, rapidly changing class of real estate—and it’s far quicker and easier for private lenders to adapt than the government-sponsored agencies conventional lenders rely on for decisions and guidelines.
How DSCR Loans Stack Up Versus Other Common Options
When looking for financing options, it’s important to consider all the options. Here’s a look at how DSCR loans compare to other loan options.
Short-term rental loans: Conventional vs. DSCR
Conventional loans are often the lowest-rate option, typically coming in about 0.75% to 1% lower than an equivalent DSCR loan. These loans also are standardized—either they fit the rules or they don’t—and come with the certainty, if not flexibility, of what numbers and qualifications work and what do not. Finally, conventional loans do not have prepayment penalties, meaning that if you decide to prepay the loan early, either through a sale or refinance, there are no fees for doing so.
Sounds great. But of course, these pros also come with a list of cons when compared to DSCR loans—many of which are restricting enough to make the DSCR loan option worth it, even with higher rates.
Typical drawbacks to using conventional loans when financing short-term rentals include:
- DTI ratio requirement: Qualification for purchasing a short-term rental property financed with a conventional loan is based on the borrower’s global income and debt-to-income ratio. Thus, even if you’ve spotted a great STR purchase, crunched the numbers, and know you’ll earn comfortable cash flow, you may not qualify for a conventional loan if your personal income levels (W2 income) or expenses (all your expenses) don’t have the right ratio.
- Further, conventional lenders will “haircut” the income expected to earn on short-term rentals, so on paper, the property won’t be projected or enough revenue—even if you’re a professional who can easily beat the numbers. DSCR loans look primarily at the property and its cash flow potential and, importantly, do not factor in DTI or personal income, making many scenarios workable for DSCR but not conventional financing.
- Tax returns and documentation: Conventional loans are notorious for what some would call excessive paperwork and documentation requests, including digging up tax returns and all sorts of financial statements. Real estate investors know speed is the name of the game when seizing opportunities, so time spent gathering the extra documents required for conventional loans could be more than just a hassle—it could cost them deals.
- No ability to borrow in an LLC: Many real estate investors in the short-term rental space prefer to invest through an LLC (limited liability company) for many reasons. These include both the added legal protection (often valued in the STR space, with the frequency of guests and potential issues arising from hospitality) as well as the ability to borrow with partners (50/50 entity structure, for example). In addition, a major drawback of conventional loans is that you have to borrow as an individual, with your name on the loan documents. This also requires the mortgage debt to be reported on the borrower’s personal credit report, whereas borrowing through an LLC keeps the loan off your credit.
- Concentration and loan size limits: Conventional loans have limits on how many an individual borrower can carry individually, which causes problems with scaling. Individuals can have no more than 10 conventional loans. Conventional loans also have loan amount limits, namely $726,200 in 2023, which can be challenging for larger, luxury short-term rental properties.
- No flexibility or exceptions in qualification and underwriting: While the certainty of uniform standards can be a positive, the flip side is that there is much less flexibility, forward-thinking underwriting, and exceptions available.
Short-term rental loans: Second home loans vs. DSCR
Second home loans are another popular option to finance short-term rentals. People are particularly drawn to this loan product due to the 10% down requirement with a maximum LTV of 90% (higher than the typical 20% minimum down payment required for DSCR loans).
However, there is one large drawback—and it is a big one. Rules for this loan product require that the property is rented no more than 180 days per year, or generally half the time. This makes generating enough cash flow and return on investment as a short-term rental practically impossible (unless you are breaking the law, which is not advisable). Thus, these loans are really not geared toward short-term rental investors but rather people who want a vacation home that can be rented out from time to time.
Drawbacks of second home loans, when compared to DSCR loans, include:
- The same DTI, tax return and documentation requirements, and LLC restrictions as conventional loans, as previously mentioned.
- Restrictions on days rented per year: The property can only be rented a maximum of 180 days per year (versus year-round if financed with a DSCR loan).
- No property management company: If utilizing a second home loan, no property management company may be used.
- Restricted to single-family residences only: Borrowers cannot use these loans to finance short-term rentals on multiunit properties, key for maximizing cash flow for many investors.
- Restrictions on out-of-state investing: Second home loans require that the borrower “live a reasonable distance from the buyer’s primary residence,” removing the crucial flexibility to invest in the best markets from coast to coast.
Short-Term Rental DSCR Loans: Differences Among Lenders
In sum, DSCR loans, while a little more expensive than conventional or second home loan alternatives, are often the best bet to finance short-term rentals due to the relative lack of restrictions and investor-friendly flexibility. However, not all DSCR lenders are the same when it comes to short-term rentals. In fact, many DSCR lenders don’t even lend on STRs at all, restricting their offerings to properties utilized as long-term rentals only.
Thus, if scaling a short-term rental portfolio with DSCR loans, it’s crucial to know your DSCR lender’s guidelines when it comes to STRs. Generally, DSCR lenders fall into three buckets:
- Traditional DSCR lenders that do not lend on properties utilized as short-term rentals.
- DSCR lenders that lend on STR properties but do so conservatively, either requiring the property to qualify as if it were utilized as a long-term rental or require 12 full months of documented operating history on an STR platform.
- DSCR lenders that fully embrace short-term rentals and underwrite utilizing cutting-edge technology tools such as revenue projections from leading data sources such as AirDNA, financing multiunit STR properties (even five-plus units), and embracing seasonal vacation markets that don’t have traditional long-term rental markets.
Investing in short-term rentals is not for the faint of heart, but it’s an exciting space in real estate investing, as the industry is still in the middle innings of a growth pattern toward an institutional real estate asset class. Innovation, change, and growth continues to happen daily—it’s no wonder the BiggerPockets Short Term Rentals subforum typically has the most active discussions every day.
There is no doubt that the lending options available to short-term rentals will continue to evolve and expand—and staying on top of the loan options available will be key to success as the industry expands.
This article is presented by Easy Street Capital
Easy Street Capital is a private real estate lender headquartered in Austin, Texas, serving real estate investors around the country. Defined by an experienced team and innovative loan programs, Easy Street Capital is the ideal financing partner for real estate investors of all experience levels and specialties. Whether an investor is fixing and flipping, financing a cash-flowing rental, or building ground-up, we have a solution to fit those needs.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.