Underwriting when refinancing is part of your plan...?

Question

Aloha BP community!

REI newb here with a question about underwriting when a cash-out refi / BRRR / HELOC / HELOAN is part of your plan.

I often hear in the podcasts - especially the Real Estate Rookie Podcast, talking about using your home's equity as a vehicle to finance your next purchase.  I currently own 1 LTR that I've had for about 8 years (thanks to a VA loan and a 2.5% COVID-era interest rate) and a MTR (an ADU on my residential property).  I have significant equity in my first home - the LTR, and am considering taking some out to help buy my next deal.  But I have no experience with this.

Everyone makes it sound like a BRRR or other strategies like this are super easy to do because after you add value or do a light rehab you can just "take out the money for another home!"  But the truth is - that money STILL isn't yours to keep, right?  You STILL have to pay it back to the bank.  So it's not something you get just free-and-clear.

So - my question is - how do you factor this into your underwriting?  I feel like no one talks about that part.  How do you know you're getting a good deal - even though, after you refinance and take out your money - you now have an even BIGGER bill/mortgage to pay??  There is no way to really know what your interest rate or monthly payment will be, or even what your new home value will be - when you're initially looking at buying the property.

I understand writing conservatively.  But I just feel like this is a step that is never talked about.  Would love to better understand how to factor this part of the process in when you're looking at value-add opportunities.

Kyle Mccaw · Answer

@Cassandra M Stanton

You’re right. A cash-out refinance is not free money. It is new debt.

Do not base the deal on the current payment. Base it on the payment after the refinance.

Use safe estimates for:

• The property’s value
• The loan amount
• The new interest rate
• Taxes and insurance
• The new monthly payment
• Cash flow after all expenses

Also ask:

• What if the appraisal is 10% lower?
• What if rates go up?
• What if the lender only allows 70% instead of 75%?

If the deal only works when everything goes perfectly, it may not be a good deal.

BRRR works when you create equity through the purchase and repairs. The refinance helps you get some cash back, but the property must still support the new loan.

Be careful about replacing your 2.5% loan. That is very cheap debt. A HELOC or second loan may be better than replacing it.

The goal is not just to get your cash back. The property must still make money after the refinance.

Dan Handford · Answer

Cassandra, your instinct is right: cash returned at refinance is borrowed capital, not profit. I would underwrite the deal twice. First, test the property with the acquisition financing through a realistic renovation and stabilization period. Second, build the permanent-loan scenario using a conservative value, a lower leverage limit, a stressed interest rate, lender-required reserves, and the resulting debt service. The smaller of the value-based loan and the income-supported loan is the one that matters. I would also model a delayed refinance and a result that returns materially less cash than planned. With a 2.5% existing mortgage, include the cost of giving up or adding leverage to unusually inexpensive debt. A refinance can recycle capital, but the post-refinance property still needs durable cash flow and reserves.

Dan H. · Answer

I have done quite a few brrrr (virtually always extracting my full investment).

There is really 2 distinct underwritings:

- the underwriting associated with the purchase, rehab, and appraisal.  This underwriting dictates how much of the investment is possible to extract.   Note it is not necessary to extract the full investment for this to be successful.   For example if you added $100k of sweat value ($100k in excess of rehab costs) and are stuck trapping 5% of investment, this could be a great investment depending on the next bullet.  I will add that in my market refi appraisals are very conservative.  I underwrite refi appraisal coming in 10% below what I could sell for.

- then there is the underwriting associated with the sustained hold.   This is where brrrr currently breaks down in my market.   After max LTV loan (even with a very conservative appraisal), the properties bleed cash when properly allocating for vacancy and sustained expenses.   You could go with a lower LTV loan but that is buying cash flow and underwriting will show this to be a ROI killer.  I do want to question one of your statements, if a property has positive sustained cash flow (meaning including vacancy and all expenses including sustained capital ex) who is paying the mortgage?   My thinking is the tenant is paying the mortgage.  Something to consider.

Brrrr were easy prior to 2022 rate increases.  In my market the cash flow with a conservative refi appraisal was not good, but it was not horrendous like it is today.  In my market virtually everyone (everyone I can think of) that was doing brrrr prior to 2022 have pivoted.   I see some inexperienced investors try it and I look at the primary numbers and question what they are thinking.  They typically do not have the margins necessary to flip and if I did the underwriting they would be projecting crazy negative hold (often 4 digit negative per month).

I invest in residential RE for life changing impact and have successfully done this.   My general rule is to extract my full investment in no more than 4 years without being negative forward.   Traditional brrrr is not meeting my goals in my market.  So I have pivoted.   In fact, my last 2 purchases that could have been brrrr never had the refi executed.   Both have been home runs (I made over $1m on each of them) but the refi traditionally is a ROI booster so their ROI is below my traditional return.

My view is brrrr is on life support.  By this I mean there are very few good brrrr opportunities.   If you think you found one, be very careful with your numbers as I suspect there is a better chance that your numbers are aggressive than that you found a good brrrr.

You asked some good questions that indicate you are cautious.  Cautious is good in this environment.

By the way, my son (23 yo) just purchased his first flip. He has led 2 rehabs, many tenant flips including one extensive tenant flip that went over budget.  So he had good experience on the rehab side.  I told him I would have passed.   Too big for a first flip ($1.125m purchase, I believe projected $200k projected expenses (rehab, holding (with family friendly rate), selling cost) for $1.45m ARV).   I believe in this market a first flip should be half this size.  Margins too tight for a highly successful flip.   He proceeded anyways.  Ignoring dad is what adult kids often do.   Hopefully he makes a profit.   Regardless I suspect he will gain some education.

Good luck

Underwriting when refinancing is part of your plan...?

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