Using my equity

[Luis Lozada]

im new to rental property investment.. we own our home with approx. 65,000 in equity and would like to use some of it to buy our first rental property here in the states ( we have on STR in Dominican Republic). How do you recommend we go about getting this goal of the ground ?

[Nathan Gesner]

Your equity is not a savings account from which you can withdraw whatever you want. If you cash out equity in a property, you are "borrowing" that money from the lender. Upfront expenses and monthly payments must be considered when calculating the return on your investment.

EXAMPLE
I will provide details below, but here's the short version for those who hate to read or do math. The new investment earns $24,000 a year, but the mortgage + the equity loan cost will be $22,332—and that’s before you account for taxes, insurance, maintenance, capital expenditures, vacancies, etc. Borrowing from the equity must be done wisely, or you will end up with negative cash flow and be at high risk due to over-leveraging.

NOTE: I use interest rates much lower than they currently are in 2024!

Borrowing Against Equity: Costs and Expenses

1. Cost of Cash-Out Refinance or Home Equity Loan:
   • Interest Rate: Assume a 4% interest rate over 30 years.
   • Monthly Payment: Approximately $716 per month.
   • Total Interest Paid Over 30 Years: Approximately $108,000.
2. Closing Costs:
   • Typically, 2% to 5% of the loan amount. For $150,000, this could be $3,000 to $7,500.

Investing in a Rental Property: Costs and Expenses

1. Down Payment and Closing Costs:
   • Down Payment: Assuming you buy a $300,000 rental property, you need a 20% down payment ($60,000).
   • Closing Costs: Typically 2% to 5% of the purchase price. For a $300,000 property, this could be $6,000 to $15,000.
2. Mortgage on Rental Property:
   • Loan Amount: $240,000 (assuming 80% financed at 4% interest over 30 years).
   • Monthly Payment: Approximately $1,145.
3. Other Expenses:
   • Property Taxes: Estimated at 1.5% of property value annually ($4,500).
   • Insurance: Estimated at $1,500 annually.
   • Maintenance: Estimated at 1% of property value annually ($3,000).
   • Property Management Fees: Assuming 10% of monthly rental income ($2,400 annually if rent is $2,000 per month).
   • Vacancy and Turnover Costs: 5% of annual rental income ($1,200).

Total Initial Investment and Annual Operating Expenses

1. Initial Investment:
   • Total Borrowed from Equity: $150,000
   • Down Payment for Rental Property: $60,000
   • Closing Costs for Rental Property: $10,500 (average)
   • Total Initial Cash Outlay: $70,500 (initial investment from equity) + $10,500 (closing costs)
2. Annual Operating Expenses:
   • Property Taxes: $4,500
   • Insurance: $1,500
   • Maintenance: $3,000
   • Property Management Fees: $2,400
   • Vacancy and Turnover Costs: $1,200
   • Total Operating Expenses: $12,600 annually

Expected Return

1. Rental Income:
   • Assuming $2,000 per month, annual rental income = $24,000.
2. Net Operating Income (NOI):
   • Annual Rental Income: $24,000
   • Minus Annual Operating Expenses: $12,600
   • NOI: $11,400
3. Debt Service:
   • Mortgage Payment on Rental Property: $1,145 monthly, $13,740 annually.
   • Total Debt Service: $13,740 (rental property) + $8,592 (equity loan) = $22,332 annually.
4. Net Cash Flow:
   • NOI: $11,400
   • Minus Debt Service: $22,332
   • Net Cash Flow: -$10,932 annually (negative cash flow initially due to high debt service).

Cash-on-Cash Return

• Initial Cash Investment: $70,500
• Net Cash Flow (first year): -$10,932
• Cash-on-Cash Return: Not applicable initially due to negative cash flow.

Long-Term Appreciation and Adjustments

1. Property Appreciation:
   • Assuming a 3% annual appreciation, the property value could increase by $9,000 annually.
2. Rent Increases:
   • Assuming a 2% annual rent increase, rental income will rise, improving cash flow.