Understanding Return on Equity and when to Cash Out Refi?

22 Replies

Hi All,

My goal is to grow my portfolio to generate cashflow to live off of passive income. Mainly interested in BRRRR deals.
I have a couple SFH rental properties here in the midwest that are fully paid off. Having this equity sit around feels wasted and I could be using it more effectively to reach my goal.

Both properties' market value is about $220,000 and both cashflow $14,000/annually. ROE=6%

What is considered a good ROE? Can having too much equity be considered a bad thing? In this case I should do a cash out refi to invest in other properties, right?



Originally posted by @Waylan Liu :

Hi All,

My goal is to grow my portfolio to generate cashflow to live off of passive income. Mainly interested in BRRRR deals.
I have a couple SFH rental properties here in the midwest that are fully paid off. Having this equity sit around feels wasted and I could be using it more effectively to reach my goal.

Both properties' market value is about $220,000 and both cashflow $14,000/annually. ROE=6%

What is considered a good ROE? Can having too much equity be considered a bad thing? In this case I should do a cash out refi to invest in other properties, right?






I'm happy with an ROE of 7%, but I am in the preservation stage. 

If still in accumulation stage, I would want a higher return and would be willing to make a higher effort.  

Yes, I would think putting equity lines (nothing to refi) on these if you have opportunities to invest at a higher rate makes sense.  

My min return for the pain and costs of obtaining financing is my ROE + inflation + fees + indigestion factor + time comp for sourcing another deal. 

 

The ones at 12% float to the top and they’re out there.  You’re sitting on $1.1 million in buying power.  With rates in the mid-3’s you’d be crazy not to maximize your buying power and get as much leverage as possible.

@Waylan Liu

Employing the BRRRR strategy your goal should be infinite return, although in reality that's not very achievable. I've used private lending to purchase my BRRRR projects. When I refinance, my return should be a minimum 35%. My first BRRRR was a private loan for the purchase and I funded the rehab $17,000. Upon the refinance I paid the private lender with their interest and I had $5000 stuck in. At the end of year one, I had no money stuck in. Return was infinite after year one. Even if it took two years to get my money back that's a 50% cash on cash return. If you want to improve your ROE you can refinance those properties for some cash on hand. It's cheap money even at 4%. You'll want to make good buy choices to get the returns you need.

@Waylan Liu you said your goal is cash flow. With $24k/ yr in gross income on paid off Homes and personal income can you still expand your portfolio at a reasonable pace without refi? If 2020 thought us anything it would be that having a strong financial base is very important. How many months could you go vacant or without rent on the paid for houses vs if they were leveraged? That being said it is really hard to sit on significant equity like that if you see good deals that you are missing out on. I pulled all the equity out of my personal home this year and bought 2 more investment properties that cash flow enough to cover the Mortage on themselves and my primary residence. And I still have cash but deals are getting scarce.

@Mark H. Porter

Mark I disagree. The amount of cash you put out on a given investment is your cash investment. How it gets returned through the BRRRR is completed multiple ways. First by forcing the appreciation when you refinance returns some or part of your cash on cash return. The cash flow also works to return your cash funds. Both of these concepts at the end of the day provide your cash on cash return. ROE is another matter and really cannot be calculated until it's sold to have a truly accurate number, especially if you want to get into the metrics of your time spent on a given investment.

@Kenneth Garrett Ken, you’re using formal finance terms to mean something else.  I know it sounds correct, but it’s not.

ROE is an equation Net Income / Shareholders Equity.  And shareholders equity is Assets-Liabilities.

Cash in Cash is an equation of Before Tax Cash Flow / how much you initially invested.




@Waylan Liu , your first sentence says you're looking to grow your portfolio, so grow it.  You're sitting on $308k of tappable equity (70% of 440k, which is conservatively the estimate if you did a cash-out refi on both properties.) 

ROE is tough, because it is a changing calculation.  When you have a mortgage on a property, you're constantly building up your equity position.  That being said, your 6% ROE is low, which is why most RE investors love leverage.

Let's look at an example of equity in action. You buy a rental home for $100,000 with $20,000 down. The year of the purchase, you see that it is worth $100,000, but you only owe $80,000, as you have that $20,000 down payment as equity. Let's say that your annual positive cash flow is $3,600, or $300 per month over mortgage and expenses. Your ROE is $3,600 / $20,000, or 0.18 = 18% Return on Equity.

So while in the future, having all your properties paid off, and have a ROE of 6% on $5MM in RE may be amazing($300K income), right now, this untapped equity can really help you reach your goal of expanding your portfolio.

@Mark H. Porter I’ve been focusing on getting a solid education over the last 6 months. I’ve been blessed & have a line of credit of 250k at my disposal. Also have to older lower value rentals 70k each in Okc that are paid for. Your comment about how the original posted was sitting on 1,000,000.00 in buying power is the concept that has eluded me the most stubbornly. Can you please elaborate? How is this multiplied to maximum effect? Thanks in advance.

Originally posted by @Mike Crouse :

@Mark H. Porter I’ve been focusing on getting a solid education over the last 6 months. I’ve been blessed & have a line of credit of 250k at my disposal. Also have to older lower value rentals 70k each in Okc that are paid for. Your comment about how the original posted was sitting on 1,000,000.00 in buying power is the concept that has eluded me the most stubbornly. Can you please elaborate? How is this multiplied to maximum effect? Thanks in advance.

Mike, I won't pretend to answer for Mark but wanted to share my view generically about purchasing power.

Not counting pain, time or costs, RE leverage is generally about 4:1.  Put 25% down conservatively (some houses will only require 20% down, but there are also reserve requirements and closing costs) on 4 houses and your $250k buys $1M of RE.

But the real world is different.  Finding good value takes effort and risk and borrowing costs aren't accounted for.  But in theory, magnify your capital by 4 for RE purchasing power.

 

Originally posted by @Mark H. Porter :

@Kenneth Garrett Ken, you’re using formal finance terms to mean something else.  I know it sounds correct, but it’s not.

ROE is an equation Net Income / Shareholders Equity.  And shareholders equity is Assets-Liabilities.

Cash in Cash is an equation of Before Tax Cash Flow / how much you initially invested.

Thank you, Mark.  I learned something here.

I have just been broad-stroking my ROE estimate of 7%.  I do that with my no loan RE. 

For instance, I just bought a little 11-unit apt community for $1M basically.  No debt. It nets me a little north of $6k/mo  so I figured my ROE at 7.2%.   

It gets more complicated that I only have $860 in it, but it's worth $1.1M all day.  To keep it simple, I round to 7%, knowing it meets my 6% rule of 'perpetual withdrawal without touching principal'.  Like the 4% rule in stock retirement, but for RE.   Whether the value goes up or down, I should be able to maintain my 6% so it doesn't 'matter'. 

But I need to be using after tax net. Got it.  

 

@Steve Vaughan thanks. The part that confuses me the most from a brrrr standpoint is, how/why do you put 25% down on a house your intend to refi ASAP. Is that possible? How is it done? Hard money? LOC. My line of credit is through my bank. They've handle my personal & biz stuff for years. It's secured against stocks so none of my property is mortgaged. My personal residence is also paid for. I thought you had to buy the house outright or with money borrowed from someone other than who was going to refi it. Again, thank you for your time & Happy Thanksgiving.

@Steve Vaughan . It gets interesting when you start digging into the expenses stated on a property as it often excludes management fees. I always add management to the tune of 5% of revenue to the Operational Expenses so I get a clean NOI. From that I'll subtract CAPEX (2% on new builds, 5% on older) and leverage costs so I can get down to a pre-tax cash flow. It's this number I divide by my invested capital to get to ROE.

It’s conservative, realistic, and a much safer play.  I didn’t always do this correctly, but I’ve learned that banks like it.

Originally posted by @Mike Crouse :

@Steve Vaughan thanks. The part that confuses me the most from a brrrr standpoint is, how/why do you put 25% down on a house your intend to refi ASAP. Is that possible? How is it done? Hard money? LOC. My line of credit is through my bank. They've handle my personal & biz stuff for years. It's secured against stocks so none of my property is mortgaged. My personal residence is also paid for. I thought you had to buy the house outright or with money borrowed from someone other than who was going to refi it. Again, thank you for your time & Happy Thanksgiving.

The parts I think you're hung up on are the parts that matter most to the new and broke, not you.  We will also have access to the lucrative houses or odd properties that aren't bankable.  Talk about removing competition. 

For instance, like you, I will just buy the house with cash. Forget all that hard money stuff.  Forget all the fees and deadlines, too. My last purchase had closing costs of $471.  With a loan it would have been 10x that. 

I have a heloc on my primary, but haven't really used it.  You might get one as well for reserves if you need it.  

You and I don't have a need to refi ASAP.  Matter of fact, by the time I season the purchase 6 months to avoid my low purchase price being included in the appraisal comps, my dry powder is usually re-stocked so I don't bother putting financing on it at all.  

Take purchasing power and BRRRR as separate matters. I just BRR and you can as well if you choose to. Congrats on having a great line of credit and a paid-for house BTW!

 

Originally posted by @Mark H. Porter :

@Steve Vaughan. It gets interesting when you start digging into the expenses stated on a property as it often excludes management fees. I always add management to the tune of 5% of revenue to the Operational Expenses so I get a clean NOI. From that I'll subtract CAPEX (2% on new builds, 5% on older) and leverage costs so I can get down to a pre-tax cash flow. It's this number I divide by my invested capital to get to ROE.

It’s conservative, realistic, and a much safer play.  I didn’t always do this correctly, but I’ve learned that banks like it.

Gotcha. My NOI on the community I mentioned is after a PM, but probably needs tweaking on cap ex and misc. Thank you!

 

@Waylan Liu

Its all about objectives. A higher return means higher risk.

If you want to grow portfolio, and can face a higher risk, you could refinance your house and get proceeds to invest in another one. Your return will grow as well your risk. The other house will demand mortgage payments and might face vacancy. If something happens, you will have to pay mortgage and your cash flow will be challenged. Can you afford it? Will you sleep well?

If you can afford the risk, Go for it!

Leverage will give you power to quickly build your empire.

If you are more conservative ( i am conservative, for example), you can leverage cautiously. Just remember that every loan comes to a cost. So instead of getting 100 k from 2 houses is better get 200 k from one house. Better to go 90% LTV in one house than 45% LTV in 2 ( example considering same value).

100% equity means you can have house empty and not have to deal with mortgage payments.

I have some houses fully paid giving 5% return. My money was in the bank receiving 1%... so why pay 4/5k to get a loan and pay 4% in interest? No reason to me... i considered the 5% as diversification, and i looked also for some capital gain... so yes, 6% can be good, 7% awesome... but you need to analyze each case individually...

@Mike Crouse

The more i read your posts the more i believe your situation is similar to mine.

Being specific, in your situation, considering you want to leverage a bit your portfolio, i would NOT start leveraging the houses you buy as investment.

You can refinance your own house.

The good thing is that being your primary residence, interest will be lower than interest in an investment property.

Remember, money cant be stamped. You refi your house and buy cash a new property. Gets proceeds and pay your home mortgage.

Buying cash, you will face less closing costs, and might give you an edge in negotiation ( maybe even better price, although nowadays seems to be hard to find good deals)...

@Waylan Liu - I think you are confusing ROE and cap rate. $14k/$220k = 6% but that if the property is worth $220k then that is your cap rate (all cash basis). 

If you refi and pull out 75% ($165k) meaning you still have $55k left in the deal say at 3% for 30 years, then you would pay the bank $8,400 leaving you with net cash flow of $5,600.

$5,600/$55k is your cash on cash ROE or 10.2%.

Keep in mind that is simply cash flow. Your property will appreciate (figure another 2%-3% on $220k - or 8%-12% on your equity) coupled with paying down the debt. So you really should be above 20% as far as your absolute ROE. 

@Waylan Liu if you trade your equity, you can use it all to go up. Why refi and leave 20% or more of your equity stagnant? Brush only 80% of your teeth and the rest will get cavities. You have a quarter million in equity that's a path to cash for your next seller. Make offers with the houses on a 2 million dollar property. Increase your cash flow, appreciation, depreciation, and utilize leverage. If what I'm saying sounds like a different language, learn more about Equity Marketing.

@Waylan Liu if your plan is BRRRR I'd consider heloc over refi. Keep the current cash flow on your properties, low closing costs, only pay for it when your using it... on the other hand, now is a good time to refi into a fixed 30 year for super low rates... this is a good problem to have but you definitely need to put that equity to better use IMO.