How To Factor An Equity Pull-Out in Cashflow Calculation

Question

Hi Folks,

We have a SFH that we are refinancing with an appraised value of about $350,000. We will raise rents again in a year but our calculations currently show only $22 in monthly cash flow.

Notes:

- 5% Cap-Ex, 5% repairs and maintenance, 2% vacancy are factored in. - For various reasons, we cover the utilities for this property.

So, my question is, if we didn't pull out $75,000-100,000 this property would cash flow about $400-500 per month. So, the deal looks worse than it is since it only cashflow $22/month but it's also covering the interest on the $75-100k that we can use to invest in more properties.

Should I ignore the fact that it's only cash flowing $22, as it is actually good since it includes the equity pull-out?

What is your opinion?

Here is a link to the calculation: LINK

Thanks!

Joe Villeneuve · Answer

If you have 80% in equity, then you you're equity is losing value.

Joe Villeneuve · Answer

This is a great example of how investors try to rationalize poor cash flow by saying the equity will cover it as an investment.  This is also an example of not understanding that REI should NOT be a CF or equity question.  When you have equity, and not cash flow, that's a reason to sell.  Take ALL of your equity, and put it into a property that has both.

Poor cash flow is just negative cash flow waiting to happen.

Equity just growth in the same property, that gets over 30-40% of the property value, is losing money.  When you buy a property using 20% down, that equity is really worth 5 times its face value.  When a property appreciates, it adds $1 in equity for every $1 increase in PV.  That means it reduces the power of that equity.

Example:  Property purchased at $100k; 20% down = $20k; $20k in equity

1 - Property appreciates $20k; PV = $120k; Equity = $40k;  Property Value is now only 3 times the face value of the equity.2 - Property appreciates another $40k;  PV = $160k; Equity = $80k;  Property Value is now only times the face value of of the equity.

3 - Sell property in step #1 and invest the equity/cash ($40k) at 20% DP; New PV = $200k ($80k higher than if property not sold)4 - Sell property in Step #2 and invest equity/cash ($80k) at 20% DP;  New PV = $400k ($240k higher than if property not sold).

Also, there will be a huge increase in CF.

Lionel Johnston · Answer

@Joseph Cacciapaglia Thanks for your response. Yes, this is exactly my plan (pull out cash, save a reserve, and invest in another property. I thought I'd ask here since at face value it doesn't look good based on CF but overall this puts us in a good position on this property. We just renewed the lease but will continue to bump it up each year. If I really wanted more CF I could pull out less, but I want to roll it into more deals. I agree on the very little downside comment, too. I appreciate your insight.

Joseph Cacciapaglia · Answer

This is a great example of how many investors get too attached to cash flow to their own detriment. The fact that you're asking the question shows that you're too smart to fall into that "CoC above all else" trap. At your current level of cash flow, how long would it take for you to accumulate $75K? By my gorilla math, it's over 10 years. Why not take that cash now. Put a little extra in reserve, if it makes you feel more comfortable with the lower cash flow, and reinvest the rest. If you look at your return on equity, instead of cash flow, it will almost always make sense to pull cash out. Of course, you have to balance this fact with the additional risk you're taking with higher leverage. If you're still leaving a decent chunk of equity behind and holding reserves, I see very little downside.

David Lutz · Answer

For those of us that aren't risk adverse the goal is clearly to stay as leveraged as safely possible. Selling is just a question of whether you think that you could use that last 20% of capital more effectively than keeping the current property.

There are some huge transaction costs to selling. Refinancing avoids capital leakage. On the flip side, you hopefully made your money by buying at a great price compared to what's it's worth now and scored solid CF along the way. Refinancing basically resets the deal to the equivalent of buying at market value and gets you iffy cash flow.

So the question for that last $70k is if you can get enough of a better deal redeploying it to offset the $25k'ish in transactional costs you're going to pay to get it. You have an idea for how to better use that money?

If the house isn't worth holding onto leaving 20%, I don't see how it becomes more attractive leaving 30%. At that point you're buying unleveled CF and the goal is to be using opm.

Lionel Johnston · Answer

@Joe Villeneuve I made a mistake in my response to you. After the refinance we'd have only 20% equity (but I said 80% which clearly is very different.), but our cash flow would be much lower if we pull out say $75k. If I don't pull out as much cash as possible though, that still fits your comment about the equity losing value, I believe.

Lionel Johnston · Answer

@Joe Villeneuve Thank you for your detailed response.

I agree with this comment, "When you have equity, and not cash flow, that's a reason to sell.", and where I was looking for insight is just that if I don't pull out the cash bringing me to 20% equity then it technically does have both equity and strong cash flow, meaning I wouldn't want to sell.

You've given me more to think about on this. I appreciate it.

Lionel Johnston · Answer

@Joe Villeneuve Thank you for your detailed response.

I agree with this comment, "When you have equity, and not cash flow, that's a reason to sell.", and where I was looking for insight is just that if I don't pull out the 80% equity then it technically does have both equity and strong cash flow, meaning I wouldn't want to sell.

You've given me more to think about on this. I appreciate it.

How To Factor An Equity Pull-Out in Cashflow Calculation

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