Real Estate 022: Using a Home Equity Line of Credit (HELOC) or Refinancing your Property

During the upswing of a market cycle, homeowners may be wondering if it is a good idea to tap into their home equity, or the difference between the market value of the property and remaining balance of the loan. There are three popular ways (other than selling) a homeowner extracts the equity portion of their property: refinance, home equity loan, and home equity line of credit. 

1. Refinancing your Home

We often hear it on the news, radio, or online advertisements, "take advantage of low rates, refinance and lower your monthly payment!" I know I have received dozens of mail from mortgage lenders offering me to take their deals. In short, refinancing means taking a new loan to replace your existing loan. This is usually done to either take advantage of lower interest rates, remove private mortgage insurance (PMI), or better terms (5, 15 vs 30 year amortization), to take cash-out, or both. People may benefit from taking the equity in their home which fluctuates with the market and putting that money to other use: consolidate debt, make necessary purchases, or even invest in real estate. In addition, without taking cash out of the property, you can use the lower interest rate to lower your monthly payments (assuming the gain is higher than the closing costs involved in the transaction). 

2. Home Equity Loan (HELOAN)

A home equity loan is another type of equity stripping used by homeowners to take advantage of a lower LTV (loan to value) which is experienced during times of appreciation. Equity loans are available in both fixed or adjustable rate mortgages where a financial institution (typically a bank or credit union) has 2nd lien position on the home. This means that in addition to your original mortgage which is in 1st lien position, or first in line to be paid out when there is a sale, refinance, or other action on the home, there is another mortgage that is on top of the 1st lien note. As 2nd lien position requires the 1st lien position holder to be paid in full before the 2nd lien holder sees a dime, this is seen as higher risk, as such there is more scrutiny during underwriting and may be more difficult to qualify. 

3. Home Equity Line of Credit (HELOC)

A HELOC, or home equity line of credit, is similar to the home equity loan in that it is a 2nd mortgage (home serves as collateral), but a HELOC is a form of revolving debt, like a credit card with simple interest (not amortized). This means that you are able to withdraw money up to an approved limit, using a bank transfer, card or check, repay it and draw it down again within the predefined terms of the loan. As a HELOC is a secured loan, you are able to obtain a lower interest rate than the average credit card (around 22-25%) or personal bank line of credit (typically 8-12%). 

A limitation to the HELOC is the draw schedule, typically 5-10 years, variable interest rate, and the loan to value requirements (e.g. 80-100% LTV). For example, if your house is worth $500,000 and you currently have a $300,000 mortgage balance, you are at a 60% LTV. If a lender decides to limit the LTV to 90%, that means the maximum amount your HELOC can be is $150,000 ( = $500,000 * 90% - $300,000). 

Depending on the usage of the HELOC it may be beneficial to consolidate debt or use the funds to purchase necessary items that otherwise may have carried a higher interest rate (e.g. 20% consumer credit rate vs 5.5% home equity line of credit rate). However, as this line of credit is secured by your home, you want to ensure you have a plan to pay off the debt so that you do not put your primary residence at risk of foreclosure.

In addition to purchases and debt consolidation, savvy investors use a HELOC to purchase a rental property all cash and refinance out their money to pay back the HELOC, or take enough funds for a 20% downpayment on a turnkey property. If the rental property is achieving double digit returns (i.e. 12% conservatively), against a HELOC rate of 5.5%, then you have created a 6.5% spread on the borrowing cost and increased passive income without using any of your own money (read: leverage/other people's money).

In conclusion, before you go out and apply for one of the three aforementioned products, please remember each bank and credit union have different rates and terms as well as conditions (draw schedule, etc.). Further, they will also have different programs that will incentivize a new customer such as paying for closing costs, appraisal, and introductory rates at 1.99% for 6 months. Make sure you watch out for any hidden fees such as annual maintenance fees and draw fees that may build up quickly. There are always risks involved when using other people's money and using debt to create income producing assets, however, if you know your numbers and have a solid plan of repayment, you will be able to scale up your property safely and quickly than other methods.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 021: Due Dilligence - Buy and Hold Rental Property Deal Breakers

Some of my readers have asked me, "what are some deal breakers when it comes to underwriting a real estate investment?" This is a great question and something we all should think about before starting to invest. The reality is, if we do not set standards, we can easily be blinded by the cash flow and satisfying feeling of the hunt, where we start to purchase mediocre deals that produce mediocre results and delay your path to financial freedom.

Real estate is generally inefficient, meaning every property has a price depending on the condition, timing of the market, location, asset class, etc. that could potentially make it a good deal. Sometimes, that number is a negative, meaning the seller would have to take a loss to let go of the property to stop the bleeding. Some people may argue that large CapEx items such as an entire HVAC system, or foundation issues are deal breakers, however, a savvy investor may understand the problem at hand and be able to significantly reduce the acquisition price and the risk involved in the transaction. Other factors, such as increased crime rate and high vacancy are things that are less tangible and will have to be reviewed case by case.

Lets take a look at my top 5 list of real estate deal breakers:

1. Large houses and lots

This was a painful lesson that I learned and relates to my first rental property purchase. This home sat on a huge lot the size of half a football field which I thought was an advantage at the time. I believed that the large lot would attract tenants who wanted privacy as well as room in the backyard for family gatherings. In my situation this resulted in multiple break-ins during vacancies as the house was well-covered by trees and vandals were able to get in undetected by surrounding neighbors. 

Large houses pose a similar dilemma as in my markets, a 3,000 sq foot home does not necessarily command 2x rents compared to a 1,500 sq foot home. However, a larger home means increased reserves as it costs more to replace a larger roof, paint more walls, and replace flooring. On the contrary, I also avoid homes that only have 1 bedroom 1 bath as they typically become rented by transient tenants who often do not renew their lease. As tenant turnover is one of the single biggest cash flow killers to a landlord, I avoid purchasing tiny homes altogether. I have realized that in the Midwest, a conforming 3 bedroom 2 bath home around 1,200-1,600 sq ft is ideal in attracting the type of tenants that stay long term and take care of my property. 

2. High crime/War Zones

As discussed previously, a real estate investor must first decide where they would like to invest - A class, B class, or C/D class neighborhoods. Although each investor may have their own definition of these classes, I incorporate multiple factors such as school ratings, crime rates, median income, and purchase point of the homes. While A class homes are generally in more expensive neighborhoods, have better schooling, and higher median income, it does not necessarily result in a perfect tenant. I have had B class tenants who leave after one year and leave a mess, but I have also had Section 8 tenants in rougher parts of town that renew and take great care of my property. I personally avoid high crime areas as they result in externally driven situations out of my control - such as gang violence, drug related thefts/break-ins, as well as high vacancy/lower comps.

3. Awkward layouts

This is a common deal breaker when speaking with real estate investors. If you have done hundreds of walkthroughs during your real estate careers, you will notice that some homes in one neighborhood all have the same layout and materials, and one street may have 10 different layouts from 10 different developers. This presents an interesting situation as if you come across a house with an awkward layout (e.g. limited access to the kitchen or bathroom, tiny bedrooms, no access to the garage from the inside), this can result in your property staying vacant as tenants will also realize this as a problem.

4. HOA fees & high taxes

I want to start by saying that there are hundreds of investors who have found success investing in condos, townhomes, and even single family residence with HOA fees. Without getting into details of the pros and cons of having HOA fees, I avoid homes with HOA fees as they are typically variable costs that is difficult to account for while calculating your cash flow. As an investor I see this variable as an increased risk that I do not need to take as there are many other types of investments available.  Further I avoid homes with significantly high taxes / tax assessed value as they may be very difficult to contend depending on the local government. Tax assessors may see the value of your home much higher than what you paid for market value, resulting in a negative impact on your cash flow. Do not assume you will be able to lower your taxes with an appraisal as each market is different and may take more time and money that is worth.

5. Shady sellers

As you continue throughout your real estate journey, you will encounter people who are less transparent than others, and people who try to take you for a ride. This last deal breaker is subtle than the others, and you will have to rely on red flags and your gut in determining whether this deal is worth the risk. Through simple google searches, you will find countless stories on real estate deals gone bad and the shady acts of the sellers. These sellers may attempt to pass off a property with a cloudy title in hopes you take the risk, may fail to disclose repairs that were not done to code, and other issues. This is a key reason why due diligence, not falling in love with a deal, is so important. Investors must trust, but verify the responses made by the sellers through an independent inspection, searching of title, and having multiple eyes on the deal. If you catch the seller trying to give you false information, it may be a huge red flag that there is an issue with the property that they are trying to pass onto you. Like the old age saying goes, where there is smoke, there is fire.

Remember that each deal may have its merit and you can potentially find a diamond in the rough. With a little bit of work and negotiation, the potential issue may result in massive equity and gains. However, other factors such as those mentioned above are not easily fixed, and need to be carefully considered before taking the dive and making the purchase.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.

Good luck!

Real Estate 008: BRRRR method of investing

In my previous posts, I have discussed different strategies to meet your real estate investing goals. I have recently come across a method that has been popularized by Brandon Turner at BiggerPockets.com but has existed and been used by savvy real estate investors who want to start investing using little to no money down. So what is it? The BRRRR method - stands for Buy, Rehab, Rent, Refinance, and Repeat. Lets take a closer look at each step below:

1. Buy

They say you make money in real estate in three ways: 1) buy 2) sell 3) cash flow. Knowing your numbers used in your BRRRR strategy is just as important as wholesaling, flipping, or buy and hold rentals. The main focus of the BRRRR strategy is to pull out all your money (in some cases, you may be able to pull out more than what you've put in) and end up with a cash flowing property with some equity. A general rule of thumb is to look for a purchase price that is 75% of the after repair value of the property.

For example: A home that has an after repair value of $150,000 * 75% (cash out refinance) - $25,000 est. rehab costs = $87,500 maximum purchase price.

If you are able to purchase below $87,500 or perform a quality rehab for under $25,000, then you will end up with more equity/less cash out of pocket. Note that the above calculation is a simple illustration and there are usually refinancing costs involved with the lender.

2. Rehab

The rehab budget is always an area of discussion among investors for many reasons. Here are my thoughts on the dollar amount on spent rehab and value add upgrades:

• There is a key distinction between primary residence (Owner Occupied) and rental properties (Leased). Simply put, renters may not need, nor would they pay the extra $25-50/month in rent to have all the bells and whistles that you would want for yourself. Granted, if there are two homes in a neighborhood with all things being equal and 1 has granite countertops/backsplash and the other has none, it may be more appealing and rent out faster. However, you have to decide for yourself, at what cost? For me, I am mostly focused on replacing key CapEx items with little useful life to reduce deferred maintenance as well as making the house livable and suitable for the market/neighborhood (an A class neighborhood will definitely have different upgrades than a C class neighborhood).

• You also have to decide what value add upgrades - new kitchen/new bath/new flooring will being the most return on investment. This is a great conversation with your property manager and rehab crew as they will have the most insight into the neighborhood and experience dealing with tenants.

3. Rent

The next key step is renting out the property after it has been properly rehabbed. Whether you decide to buy and hold or sell the property as "turn-key" alternative, renting the property will help you obtain refinancing with the lender. You can advertise and rent out the property by yourself, or I would personally recommend using a property manager who typically charge 8-12% of the rental income. Their marketing efforts, tenant screening, and maintenance handling should be well worth their fees. Make sure to received referrals from active investors in the market and interview multiple property managers. Remember, a good PM can make a good deal into a solid deal, whereas a bad PM can turn a solid deal into a horrible deal.

4. Refinance

You have crunched the numbers, bought/rehabbed/rented the property, so now you are ready to refinance and pull out your cash (downpayment + rehab costs). Depending on the lender, there will be different seasoning requirements. A traditional refinance may require a 12 month period for which you will have to maintain the property then request a refinance. However, there are many portfolio lenders who have 6 month seasoning requirements or some who can start the refinance process the day after closing (zero seasoning). The lender will order their own appraiser to go to the property and draft an appraisal. 

In the example mentioned earlier, lets look at two scenarios with the same expected ARV of $150,000.

Example 1: Purchase price of $50,000 (bought distressed/foreclosed/divorce/REO) and put in $25,000 amount of repairs for an all in cost of $75,000. The bank appraises it for $140,000. You request a cash out refinance and the bank gives you $105,000 (75% of the appraised value). Now you can fully pay off the $50,000 loan and $25,000 rehab costs (if you used private financing or hard money lender) and have $30,000 in excess cash + 25% in equity.

Example 2: Purchase price of $75,000 (normal sale) and put in $20,000 worth of repairs for an all in cost of $95,000. The bank appraises it for $135,000. The bank does not allow for refinances greater than your all in cost. In this case, you will get back $95,000 to pay off the $75,000 purchase and $20,000 in rehab, and the remaining amount will be left in equity ($135-95K = $40K/135K = 30%).

5. Repeat

The above examples are cases of success stories in which you were able to cash out your initial investment and maintain equity of 25% or greater in the home. Now you will rinse and repeat the process and scale your rental portfolio!

Few thoughts on BRRRR vs. TurnKey/buying off MLS

Although I have bought my first rental property from a turnkey company, I eventually want to try the BRRRR method for a couple reasons: 

• Ability to cash out refinance and retain equity in the home

• Control over the type/quality/amount of rehab

• Ability to retain your "seed" capital for other investments (typical buy will lock up 20-25% cash each time you by, thereby significantly lowering your buying power)

• Allows for faster scaling of your rental portfolio

• Higher return on investment (more of other people's money = higher ROI)

However, there are also a couple reasons why I do not want to jump on the BRRRR bandwagon just yet:

• More risk is placed on the project owner overall (you are buying/rehabbing/renting/refinancing)

• Risk of appraisal coming in lower than expected (not being able to break even)

• Risk of rehab delays (A turnkey is already rehabbed and tenanted)

• Longer process than buying turnkey/MLS

• Risk of being unable to cash out refinance

  • Seasoning requirements

The BRRRR method has been a very popular method for investors to increase their return on investment as well as overall net worth due to the fact that they are leveraging other people's money and if done correctly, able to repeat the process over and over. However, if it was so easy, why doesn't everyone do it? As mentioned in the reasons above, the BRRRR takes careful planning, finding the right deals, using the right team, and comes with its own set of headaches as things can go wrong during the process. What is your strategy? I would love to hear your thoughts on BRRRR vs buying turnkey/MLS.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!