Help understanding using equity to obtain more props

[Fred Shandler]

I know this is a very amateur question, but I don't understand how exactly equity is actually used in (or helps in) obtaining more properties.

For example, investors typically buy at 70% of market value, less repairs. Well, I thought banks only allow a 70% cash out refi? So in this case, wouldn't a cash out refi be irrelevant?

Isn't that what using one's equity is -cashing out through refinancing? Or do I have the wrong idea?

Clarification would be greatly appreciated!

-Fred

[Christian Malesic]

We always called the use of equity in currently held properties to buy new properties “the shell game”.

We will start simple. For explanation purposes I will make the math easy. Let us say that your bank's rule is that they will give you 75% LTV (Loan to Value ratio). That means that the bank will give you 75% of the appraised value of the property. Let us also assume that by some odd coincidence, every property you want to buy appraises at $100k exactly (again to make the math easy).

For the first purchase, you negotiate a savvy deal and are able to purchase the property for $53k. Add $2k in closing cost and $5k in rehab costs to round you out at $60k. That means you now own a property you have invested $60k in that is worth $100k (as appraised). You have 60% LTV. You decide to hold it and look to buy the next one.

Low & behold, you find another property that appraises for $100k. You negotiate to buy it for $73k with $2k in closing fees and $10k in rehab costs for a total of $85k. But, the bank will only give you $75k (75% LTV) so you are $20k short. Where do you get the $20k? In our example, you have the bank put a 2nd lien on the 1st property for $15k (bringing that property to a 75% LTV) and you cough up $5k out of pocket.

This is how currently held property can be used to buy new property.

Of course there are a number of assumptions used in the above, which are covered by me and others in other posts. Such as: (1) Will banks lend 70% LTV, 75% LTV, 80% LTV, or even 90% LTV? The short answer is: expect 75% LTV or less in this market. Also, (2) banks are giving 75% LTV of the appraised value OR purchase price, whichever is LOWER. This also cramps the style of new investors. It does not, however, affect the shell game. In fact, this is where the shell game shines. The difference being, of course, the initial cash needed for the initial property.

Rather than me going on and on, hit us with other questions and either I or others will try to give a better answer.