Pull out appreciation to break even and/or buy 2nd property

11 Replies

Hello BiggerPockets friends,

I guess I need some help in understanding the benefit and strategic advantage of cashing out appreciation on a property and using it to buy another property.

If I appraise a property, I am borrowing that against another loan to pay some of the original mortgage and/or buy second property? But what I do not understand is you still have to owe on another loan.

Also, I want to know if this strategy not only helps in buying another property. But mainly to contribute towards my first property principle to break even when I rent it out. I guess my question is is this the best strategy or are there other strategies to break even on the first property to be able to be ready financially to buy a second property and keep the first one. I guess I do not see it any other way except putting in your own cash.

Thanks,

Kapil

@Kapil Patel , aah, the age old dilemma: how can I live for free, and, without working?

A more correct way to start your second paragraph is: If I appraise a property, I am borrowing against its unborrowed equity to buy second property". 

Question: How else could you (quickly) come up with the deposit to buy that second property?

So yes, your ongoing cash flow will be less once you borrow more, but, the reasons you'd be buying that second property are: it's undervalued; and/or it has potential for you to value-add using your specialist skills; and/or even when you refinance all your deposit back, it'll still be paid off by the tenants, with no further regular payments from you. [Meaning, when you retire, you'd still get all its cash flow, even though it effectively cost you nothing!] All the best...

@Brent Coombs I appreciate your feedback. Say I pull out my equity (your reference to "all your deposit back"), then wouldn't the monthly mortgage go up? So renting it out would be difficult, the whole idea is to increase principle so I can break even on rental / mortgage???

Also, what about pulling cash out based on appreciation. (I assume this would be another loan, which would be pointless to borrow against your own profits, basically depreciating the appreciated profits by borrowing against it).

Originally posted by @Kapil Patel :

@Brent Coombs I appreciate your feedback. Say I pull out my equity (your reference to "all your deposit back"), then wouldn't the monthly mortgage go up? So renting it out would be difficult, the whole idea is to increase principle so I can break even on rental / mortgage???

Also, what about pulling cash out based on appreciation. (I assume this would be another loan, which would be pointless to borrow against your own profits, basically depreciating the appreciated profits by borrowing against it).

 It's not "pointless", because you do get to buy more property/ies by doing so!

The monthly mortgage going up does not make it more difficult to rent out. But yes, finding deals where refinancing your deposit back and still cash flowing positively can be difficult - but not impossible! Hence, before buying, always ask yourself - is this deal a real "deal"? Cheers...

@Kapil Patel to me, it's all about cost-ownership basis. Yes, your relative cash flow may decrease some by virtue of being responsible for a bigger loan amount, but you can use leverage to own more property for the same price. Let's look at a (very simple) refinance example:

Assume you bought a $100K house for $20k down. At this point you have a loan of $80k and thus a loan to value (LTV) of 80%. To make things simple, assume rents and interest rates stay the same and the home value appreciates, so you're not spending any additional money on value-add activity , to $120k. Now your LTV is 66.67%.

You could, in theory, refinance this property (without putting any additional capital down) to get back to the 80% LTV. 80% of $120k is $96k. You use this $96k to pay off your original loan of $80k and are left with $16k which you can use to acquire another $80k property.

So yes, you now have 2 loans (which your rent should cover) but you've increased your total portfolio by $80k for no additional money!

This is very simplified as it doesn't account for paying down your original loan, changes in interest rate, increased rents yada yada but it should serve to get the point across.

@Michael Bishop I appreciate your breakdown of the numbers, I am following. I understand if I'm able to pull 96k the first property can be paid off completely. Thereafter, I am left with 16k which I can buy another property for 80k. Rent from first property can cover my mortgage on second property.

Now I have to pay the original 96k borrowed (LTV). How is this usually paid? I'm sure this type of loan is not like a mortgage with amortization period with higher interest in the beginning on fix 30 years? I am sure the interest rates are higher than a conventional mortgage rate.

@Kapil Patel it depends on where the market is at at time of refinance. Part of the appeal of a refinance is the potential to get a new loan at the same or better terms. There's no set in stone terms for a refinance / equity event and favorable terms are a possibility.

In assessing the use of equity you must also understand that due to the opportunity value of cash buying cash flow with equity to create artificial cash flow is extremely expensive. Equity does not increase cash flow it creates a separate income stream on the property that reduces the cash flow on the property itself. Every income property has two separate income streams, the property itself and your cash. Cash/Equity creates artificial cash flow.

For investors equity has a opportunity value of minimum 10%. With a 100K property having 40K in equity the opportunity value of that equity is $333/month. The return on your cash is the first deduction you must account for off the top of your rental income. By pulling equity and investing with minimum down on more properties you are increasing your total property income at a lower cost than simply buying cash flow on a single property.

Equity will at some level reduce a properties cash flow to a negative number and turn that investment into a liability. Dead equity kills cash flow.  

Basically in a nutshell, leveraging equity to buy properties is good but too much leverage can cause dead equity?

@Kapil Patel All of these discussions are very good.  The amount of equity you have in the property also has to be considered before you can really determine the effect it will have on your cash flow.  For example, last year I did a cash out refinance on one of my rental properties that I have owned for over ten years.  The new loan amount per month was actually lower than my previous loan, so I was able to increase my cash flow by over $200/month.  In addition, I was able to buy another cash flowing property of $450/month.  Every situation is unique.  Just make sure you do all your calculations correctly before deciding if this type of move actually will make sense for you.  Good luck!

Originally posted by @Kapil Patel :

Basically in a nutshell, leveraging equity to buy properties is good but too much leverage can cause dead equity?

You were right to put a question mark at the end (indicating you weren't sure how to say what you wanted to say). But yes, too much leverage can result in zero/negative equity quite easily. 

That in itself isn't the problem, provided that the properties' income always more than cover their liabilities, and, the banks don't call in the Loans, and, you don't need to sell in a hurry.

It all comes back to: how much leverage is too much? [Hint: There is no definitive percentage]...

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