Rental Property Paid Off - HEL to Buy Another?
San Diego, CA · Member since 2013 · 55 posts · 12 votes
All,
I am in San Diego and currently in a refi with the home I live in that will include paying off one of my rental properties. It would probably appraise at $240k to $250k and I am currently renting it out at $1500/mo.
I have a buy-and-hold strategy and would love to have as many homes bought and paid for (by tenants) as possible by the time I retire. I am now 37 years old.
My question is this: What is the best way to achieve this goal? I was thinking about pulling out a home equity loan to put down 25% on another investment property...which would be ~$75k for a ~$300k property. Still not sure how realistic that is with everyone paying in cash for homes in this range here in SD.
I also would like to increase that $1500/mo positive cash flow if possible.
Anyone familiar with a) the San Diego market and/or b) long-term buy-and-hold strategies that may be able to pass along some advice?
Thank you in advance!
Interesting explanation on the 50% rule. I guess thats why my numbers come out a lot less than 50%. My taxes and vacancy are about half of that rule of thumb on my properties. And I don't pay any utilities at all. Even for the ones the village requires me to pay (i.e. water/sewer bills), I re-bill that back to the tenant Plus I PM my own properties.
As far as leveraging your properties, I would definitely say to do it. Obivously, you are refinancing your primary residence and paying off the rental for other reasons (i.e. its the only way you can refi and remove PMI because of the DTI ratio guidelines).
But now that you'll have a paid off rental property, the question is does it make sense to get a loan on it to use the money in some other way.
1) I definitely wouldn't use it to pay down your primary residence. Thats the cheapest money you're ever going to get. Your rate on the investment property will be greater.
2) Use it to buy more rental properties. To me this is an absolute no brainer. Buy every one you can - as long as they have some cash flow.
This is clearly the cheapest money we're ever going to get over the next decade or two. And, while I'm not at all familiar with California, my understanding is prices are still lower there than they have been in some time - if you cherry pick the deals of course.
What kind of return are you getting on your money if you have 300k sitting in a house that is making 1,500 a month? You're better off selling. Now what kind of a return are you getting if you borrow 75% of that (225k) and use that as down payments for 3 more houses?
Lets say you can have 1 house at 1,500 a month in cash flow that is completely paid off. Your profit is 1,500 a month plus appreciation on a 300k house. Rents will go up over time so maybe in 10 years, you'll be getting $500 a more in rent but your taxes and insurance will go up as well so maybe you'll be making 1,750 in profits. Plus your appreciation. Thats your return.
Now, if you refi that 225k and get 3 more houses just like it. Your profit will drop to, say 400 a month. But that would be on 4 houses. So now you're at 1,600 a month in profit. And here's where it gets good.
Your principal paydown will be about 800 month on those 4 loans. Your appreciation will be on 1.2 million in homes instead of 300k. 2 or 3% of 1.2 million looks a lot better to me than 2 or 3% on 300k.
And, lastly, in another 10 years, your principal paydown will be 300 month per house (1,200) and now your cash flow will be 650 a month per house times 4 houses.
Here's how it looks when I guesstimate numbers for my stuff. And why I'm a firm believer in buy and hold. And, again, this only works for buy and hold. If you're counting on appreciation of 10% over the next 3 years to make the deal work, then its not a good fit. I figure in true buy and hold, you're looking more at the historical averages to make the numbers work.
Keeping 300k paid off and doing nothing:
1) 1,500 in income Year 1.
2) Houses double every 20 years. In 20 years, house is worth 600k
3) Rental income 10 years = 1,750/mo
4) No principal paydown.
5) No mortg interest deduction so higher taxes.
OR
Taking out a loan on that investment property and buying 3 more just like it.
1) 1,600 month in income Year 1
2) In 20 years, 4 homes are worth 2.4 million and owned free and clear.
3) Rental income 10 years = 2,600/mo
4) Principal paydown starts around $800 a month and in 10 years, at about 1,200 a month
5) Mortg interest deduction so pay less in taxes.
Whats your risk? High vacancy? If the vacancy rates shoot up that means one thing. People are buying houses again. If that ever returns, then your risk is that you get stuck selling the house and lose all the real benefits of buy and hold.
One last thing I left off. I put the numbers above as if you were paying 300k for a 300k house. The reality is you should be paying about 250k or less for houses worth 300k or else you aren't buying right. So don't forget to add in the appreciation you'll gain as well.
To me, its not a debate. Bottom line for the people who want to hold the property free and clear - you're not in real estate for the right reasons if thats the only risk you can tolerate. The returns aren't great enough if you ask me.
The true value gain in investing in real estate is the ability to use OPM to add properties and cash flow. Thats just the only way I see real estate being the home run it is. Flipping and wholesaling is great. But its a job. You can build tremendous wealth with it. But its still a job. Buy and hold using leverage - in a smart way (i.e. with solid cash flow) - is the way to build wealth slowly but SURELY. IMHO of course. :-)
I would never recommend using your personal residence to pay off a rental property. IMO it would be better to do it the other way around. Maximize the loan on your rentals without sacrificing profitability with the goal of paying off your personal home. Then if anything unforeseen happens (and it will somewhere down the road), your home is safe.
Additionally, pulling a HEL or HELOC on a rental property is very difficult. Lenders hate that. I would instead look at a HELOC on your paid off primary to fund a down payment on an investment property. Then take ALL surplus income and pay off the HELOC as soon as possible. Once that is paid off, the credit is there again for another purchase without having to go through the loan process all over again.
On that 300k property you are looking at in SD will it cashflow? how much are you neting monthly on your current rental?
Al,
I'm currently netting +$710/mo. on the current rental. ($1500 Rent - $790 Mtg.)
And yes, I'm hoping it'll cash flow. Obviously that would depend on what I can rent it out for minus the mortgage.
I've heard of people doing thios though...and honestly, I'm more interested in having multiple paid off homes in a few decades rather than monthly cash flow at this point, so as long as they break even after factoring in maintenance costs, I'd be fine with that.
Simon,
That's really good advice, and I honestly never thought of it from that perspective.
We actually had no choice but to refinance this way because I am using a VA loan, and due to some debt to income issues, it was the only way we could do it. We bought the primary with the plan to refi in 6 months to get rid of PMI, which is where we're at now.
Perhaps in the future we can reverse our mortgages to put the equity back in the primary.
However, our primary loan will be ~700k, and will appraise around $750k, so paying it off isn't an option right now.
Since rates are still so low right now, wouldn't the best idea be to acquire as many rentals as possible rather than pay off the primary first - ensuring 100% cash flow as the mortgages are paid off?
I'm thinking that as housing prices rise, if SHTF, I can always dump one of the rentals and use the profit from appreciation to mitigate any crises.
Is this a risky/unwise way of thinking?
...and even if there is another housing crisis rents always seem to rise and never seem to go down, so as long as I acquire fixed-rate loans, I should always be able to at least break even.
Great thing about San Diego is everyone will always want to live here...unless the unthinkable happens...but then we have worse things to worry about it.
Hi Nathaniel,
I have been purchasing using a buy and hold strategy in Santee and Lakeside since 2011. It has been an incredible ride. Right now I have over $60,000.00 cash flow and between $1,200,000-$1,300,000 equity sitting in these properties. I have invested $680,000.00 in total down payments and rehab expenses. Two of our ten properties are paid off and 8 have mortgages totaling approximately $700,000. My lowest cash flowing property cash flows $400.00 before taxes every month. Not to mention the equity in my primary residence. That equity is around $150,000.00. We amassed all of this based on a simple goal. That was Cash Flow. Our goal in the next 5-10 years is to replace all our W2 earned income with cash flow. I don't think I could risk on speculating that prices will continue to increase. I have lived in San Diego since the 1970's and have seen the dramatic changes up and down and up and down in price values. With your strategy, what is your fallback? Do you have a significant emergency fund or reserves. I'm not into speculation. If the deal doesn't cash flow, Murphy will inevitably rear his head. Water heater busts, AC goes out, unit has an expensive plumbing problem. I didn't see anything in your posts about reserves. That worries me. This $240,000-$260,000 paid off rental property, where is it located? You may want to call me for advice. 858 722-7377.
Swanny
Swanny,
I will definitely be calling you! I appreciate the advice, and it looks like you've been wildly successful, and you've been in the game only about as long as I have.
Let me complete this refi and figure out exactly where I stand financially and I'll give you a call.
Much appreciated!
Lenders in my area will do a HELOC on your primary, but not on an investment property. They require a complete refi with cash out equity on investments.
I would just save for a down payment on another investment. I like to minimize risk personally. Plus, if you let the renters payoff the mortgage that will be nice cash flow in the future. You can keep refinancing as they do it, but you will always owe somebody and never realize the real cash flow. Essentially, your alarm clock will go off every morning so you can go to work for a bank...
My strategy is to leverage several properties than snowball all of them as fast as I can. Why? I can sit back and relax without worrying a mortgage to pay.
Simon,
Since rates are still so low right now, wouldn't the best idea be to acquire as many rentals as possible rather than pay off the primary first - ensuring 100% cash flow as the mortgages are paid off?
Yes, if your goal is to acquire buy and hold properties then now is a great time to build up the inventory. But, real estate investment does have inherit financial risks. Especially if we move as quick as possible to snatch up investment properties while prices are low and financing is favorable. That is why I do not recommend completely leveraging a personal residence.
If a financial crisis hits, yes you can sell your investment properties to pay off the house. But lets say you find yourself in an extreme financial bind (for example, vacancy rates increase dramatically). Now you are lacking the income to pay your personal mortgage. You list several rentals but it takes 6 months to sell. By this time you are so far behind on your mortgage that you cannot get out of foreclosure on your primary and your credit rating is so affected that refinancing is out of the question. Do you see the potential for a downward spiral that could effectively ruin the investor?
Only you are in a position to weigh your personal risk. Make sure that you are prepared for a worse case scenario and then invest accordingly.
Interesting, I had ZERO problems getting a HELOC on my rental property in East TN. It was through a local bank where I have a great relationship, so maybe that's the difference. But they loaned me up to 85% of the appraised value...
Good point, Michael, about the reserves. But I have to ask both of you how you are defining "cash flow.' Nathanial mentions only a mortgage (which may or may not have impounds for taxes and insurance) as the only outflow. But as many an experienced investor will tell you on BP, there are other costs that must be built into defining "cash flow," especially for a long-term hold. Vacancy (including potential eviction costs,) repairs & maintenance, CAPEX, management, and then of course taxes and insurance. Although your bank account may say you are cash flowing $710 / month, these other eventual expenses should be considered as reserves against the current income.
Just a thought...
All,
I really appreciate the advice from all of you. And yes, I actually do factor in maintenance costs when I analyze my rental cash flows, and I should've mentioned as much.
I know there's a formula that BP recommends to account for maintenence and vacancy allowances when doing a property analysis.
John, as far as CAPEX goes, will a new roof count as a CAPEX? How about new appliances? I'm not sure where the line is, but I understand it's for "large" expenditures. I'm actually throwing a new roof on my rental in City Heights next month.
When I divide up the 50% rule it is broken down as follows (percentage of gross monthly income):
10% Vacancy
10% Taxes
10% Insurance
10% Maintenance
5% Owner Utilities
5% Capital Replacement
The 50% rule does not include property management (7-10%) or any mortgages.
Thanks Simon! Very useful.
When I divide up the 50% rule it is broken down as follows (percentage of gross monthly income):
10% Vacancy
10% Taxes
10% Insurance
10% Maintenance
5% Owner Utilities
5% Capital Replacement
The 50% rule does not include property management (7-10%) or any mortgages.
I think you are missing room for the property manager due to the 5% owner utilities. That is a highly variable cost that isn't a factor in the 50% equation based on my understanding.
It's all just a guideline.
John, as far as CAPEX goes, will a new roof count as a CAPEX? How about new appliances? I'm not sure where the line is, but I understand it's for "large" expenditures. I'm actually throwing a new roof on my rental in City Heights next month.
@Nathaniel Donnelly, yes, a new roof will definitely count as a capital expenditure. Generally, an expense is considered to be CAPEX when it either increases the value or extends the useful life of an existing capital asset (the house, in this case.) For residential rentals this typically includes larger items like a roof, a new fence, larger systems like HVAC replacement (not just repair), significant plumbing or electrical work, etc.
Interesting explanation on the 50% rule. I guess thats why my numbers come out a lot less than 50%. My taxes and vacancy are about half of that rule of thumb on my properties. And I don't pay any utilities at all. Even for the ones the village requires me to pay (i.e. water/sewer bills), I re-bill that back to the tenant Plus I PM my own properties.
As far as leveraging your properties, I would definitely say to do it. Obivously, you are refinancing your primary residence and paying off the rental for other reasons (i.e. its the only way you can refi and remove PMI because of the DTI ratio guidelines).
But now that you'll have a paid off rental property, the question is does it make sense to get a loan on it to use the money in some other way.
1) I definitely wouldn't use it to pay down your primary residence. Thats the cheapest money you're ever going to get. Your rate on the investment property will be greater.
2) Use it to buy more rental properties. To me this is an absolute no brainer. Buy every one you can - as long as they have some cash flow.
This is clearly the cheapest money we're ever going to get over the next decade or two. And, while I'm not at all familiar with California, my understanding is prices are still lower there than they have been in some time - if you cherry pick the deals of course.
What kind of return are you getting on your money if you have 300k sitting in a house that is making 1,500 a month? You're better off selling. Now what kind of a return are you getting if you borrow 75% of that (225k) and use that as down payments for 3 more houses?
Lets say you can have 1 house at 1,500 a month in cash flow that is completely paid off. Your profit is 1,500 a month plus appreciation on a 300k house. Rents will go up over time so maybe in 10 years, you'll be getting $500 a more in rent but your taxes and insurance will go up as well so maybe you'll be making 1,750 in profits. Plus your appreciation. Thats your return.
Now, if you refi that 225k and get 3 more houses just like it. Your profit will drop to, say 400 a month. But that would be on 4 houses. So now you're at 1,600 a month in profit. And here's where it gets good.
Your principal paydown will be about 800 month on those 4 loans. Your appreciation will be on 1.2 million in homes instead of 300k. 2 or 3% of 1.2 million looks a lot better to me than 2 or 3% on 300k.
And, lastly, in another 10 years, your principal paydown will be 300 month per house (1,200) and now your cash flow will be 650 a month per house times 4 houses.
Here's how it looks when I guesstimate numbers for my stuff. And why I'm a firm believer in buy and hold. And, again, this only works for buy and hold. If you're counting on appreciation of 10% over the next 3 years to make the deal work, then its not a good fit. I figure in true buy and hold, you're looking more at the historical averages to make the numbers work.
Keeping 300k paid off and doing nothing:
1) 1,500 in income Year 1.
2) Houses double every 20 years. In 20 years, house is worth 600k
3) Rental income 10 years = 1,750/mo
4) No principal paydown.
5) No mortg interest deduction so higher taxes.
OR
Taking out a loan on that investment property and buying 3 more just like it.
1) 1,600 month in income Year 1
2) In 20 years, 4 homes are worth 2.4 million and owned free and clear.
3) Rental income 10 years = 2,600/mo
4) Principal paydown starts around $800 a month and in 10 years, at about 1,200 a month
5) Mortg interest deduction so pay less in taxes.
Whats your risk? High vacancy? If the vacancy rates shoot up that means one thing. People are buying houses again. If that ever returns, then your risk is that you get stuck selling the house and lose all the real benefits of buy and hold.
One last thing I left off. I put the numbers above as if you were paying 300k for a 300k house. The reality is you should be paying about 250k or less for houses worth 300k or else you aren't buying right. So don't forget to add in the appreciation you'll gain as well.
To me, its not a debate. Bottom line for the people who want to hold the property free and clear - you're not in real estate for the right reasons if thats the only risk you can tolerate. The returns aren't great enough if you ask me.
The true value gain in investing in real estate is the ability to use OPM to add properties and cash flow. Thats just the only way I see real estate being the home run it is. Flipping and wholesaling is great. But its a job. You can build tremendous wealth with it. But its still a job. Buy and hold using leverage - in a smart way (i.e. with solid cash flow) - is the way to build wealth slowly but SURELY. IMHO of course. :-)
@Mike H.,
This is just simply inspiring. Not because I see dollar signs (which I do, of course), but that you just validated my gut feeling plan and vision.
You also hit the nail on the head regarding my reasons for refinancing my primary and paying off the rental..it is because of debt to income at this point.
Other advantages I believe I have here in San Diego is that there will always be a high number of potential renters due to the Navy and Marine Corps bases nearby, and to say I'm networked into that community would be an understatement. The other is that yes, our home prices are still lower than they have been traditionally, so I had the exact same idea as you mentioned - snag up as many as possible while I still can.
Thanks again for this explanation. I hope I can ping you again sometime for some advice.
The 50% rule does not include property management costs since this is not a required expense to property ownership. Many property owners self-manage. This would be added on top of the 50%.
I agree that you would be in a better position to leverage the properties you already own and use that money to purchase other investment properties. In this way, you will greatly increase your cash on cash return. For example:
You have a property worth $100,000 which you paid cash for it and it rents for $1,500 per month. We will set aside 50% for vacancy and all expenses. This gives you a net profit of $9,000 a year or 9% cash on cash ($9,000 / $100,000).
Now, take that property and refinance it at 20% equity. You now have a $100K property which you paid $20k (not including loan fees which for the sake of simplicity we will leave out). Let us create a 30 year mortgage at 4.5%. Your monthly payment is $405. Your cash in pocket at the end of the year is $4,140. You now have a cash on cash return of 20.7% ($4,140/ $20,000).
Take the $80,000 you pulled out of Property #1 and invest it in 4 more $100,000 homes under the same cash flow scenario. Now you own 5 properties with the same $100,000 investment. Your annual cash before tax now totals $20,700 ($4,140 x 5 properties) and you are getting a 20.7% cash on cash AND now have 5 properties appreciating.
You have to love leverage!
Simon,
I'd be happy to find a vacant lot here in San Diego for $100k, let alone a SFR that would rent for $1500/mo.
Realistically, I'm looking at properties between $250k-$350k that would rent for that much. My 2/1 within SD city limits is only 684 sqft.
It's a fine balance here, and as long as I can find a property that can increase my cash flow, even minimally, and is not a wreck, I'll seriously consider it.
The example was not to set target purchase prices but to see how using bank financing instead of cash purchases can dramatically increase your cash on cash return and income stream. SD real estate is a whole different animal and you have to work with what you can find. I wonder if you could get a better return on mixed use investments such as a first floor storefront with rental units upstairs.