Equity Stripping: Recycling Your Cash to Maximize Capital
A few months ago I was speaking to a co-worker about the advantages of owning rental real estate. What started off as a few causal questions turned into an hour-long discussion. He had considered investing in real estate for some time, but was hesitant to pull the trigger. So I went over the various metrics he should consider when purchasing a property as well as the basics of cash flow, obtaining financing, etc.
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However, there was one issue he couldn’t seem to wrap his mind around – how to continue acquiring property after all of his investment capital was depleted. I tried to explain the concept of equity stripping, the means by which you pull cash out of your investment’s equity to fund the purchase of a follow-up investment. It wasn’t until I shared the following example that “the lights turned on”.
Since sharing this information seemed to be so helpful to my co-worker, I thought I would pass it along fellow BP-ers. Here is how I used the same 35K to acquire three rental properties over a period of two years:
Locust Avenue (single-family): The purchase price for the property was $75K. The property was acquired as a distressed sale (short sale); as such, we were able to negotiate with the bank and agreed upon the initial purchase price of $85K. However, after wrapping up formal inspections, we argued for a $10K price reduction due to the amount of rehab required.
Note: A detailed inspection report was forwarded to the asset manager along with multiple contractor
bids to complete the work required. All contractors were encouraged to quote the going “retail” price point for the work needed. Two months and two asset managers later, the price reduction was granted. At the time of closing, the market value of the property was worth around $98-103K. Upon closing we had roughly $18-23K in equity.
My total acquisition price (out-of-pocket costs) was $23K (down payment, closing costs and $3K in repairs). The mortgage payment was set at $545 and the property was rented for $1125. I carried the property for a period of 8 months, during which the property appreciated to $113K. I refinanced the property at its current market value and pulled out $19K from the property (cash-out refinance). This increased my mortgage from a debt amount of $60K to $84K; my mortgage payment (compound) increased from $545 to $673, lowering my monthly cash flow by $128.
With the $19K I now had available plus the remaining $12K in our acquisitions fund, I was able to purchase the next rental property.
Auburn Court (duplex): The purchase price for this property was $110K. This rental was also acquired as a short sale. The market was flooded with REOs so the comparable sales used to determine the price allowed us to obtain a significant discount. The property would have likely sold for $130-140K in a conventional sale. With this information in hand, I agreed to purchase the property with the intention of refinancing it in a few months.
My total acquisition price was $32K (out-of-pocket costs). Both units were rented for a combined monthly income of $1,735. Both tenants were content to stay in the property and no additional rehab work was needed (atypical). The mortgage payment was $733. I held this property for a period of 12 months, then refinanced and pulled out $24K. The new mortgage payment was $887.
We waited several months until we had $28K of cash back in our acquisitions fund (separate from our cash reserves). We acquired the additional $4K from 7 months of cash flow generated from our two rentals.
Shortly thereafter, we purchased our next property.
Jeffery Street (single-family): We acquired this property as an REO. It was a great deal from the start â we won the highest-and-best bid by offering $3,500 over asking. Our purchase price was $65,500. At the time of closing the property was worth $85-90K. We invested $7K into the rehab and acquired a private loan for $45K (interest-only). Our total acquisition cost was $27K. We've held this property for 9 months, during which time the property has appreciated to over $95K. Our monthly payment is $585 (compound) and we are renting the property for $1,100 a month. After calling all the local banks in market, I finally met one who was willing to extend me a home equity line of credit (HELOC) at 75% of the market value. I am still in the process of refinancing this property; however, we just received the appraisal back a few days ago and the bank will be using today's market price of $97,500 to determine the value of the home.
If all goes according to plan, I will be able to secure a line of credit in the amount of $72K. This will provide me with $24K of working capital to continue funding future investments. The new mortgage will be about the same or slightly less than my previous mortgage.
I share these three examples to demonstrate how to recycle your capital, or strip equity, while still maintaining control of your investments without speculating too heavily.
Here are a few additional side notes to consider:
- Add value: If your market doesn’t have much in the way of “undervalued” property, try to think outside the box: purchase a 2/1 and enclose a formal dining room or den. Convert an attached garage (permitted) to increase the property’s square footage.
- Network within your community: Call community banks, credit unions and hard money lenders to see where you can find additional ways to access working capital: home equity lines of credit (HELOC), portfolio loans, private notes, hard money products, etc.
- Be strategic: Make sure each property you acquire has multiple exit strategies – rental, cash-out refinancing, flip, wholesale, etc.
Readers, I shared a few ways I keep my capital in play – what are a few of your strategies?