As a rookie armed with equity, what would you do?

Question

I’m a rookie RE investor who’s new to BP and looking for some guidance.* First, though, I have to say that I’m amazed by the depth of knowledge on BP and the willingness of the community to give helpful advice in an otherwise very competitive arena. Thanks to everyone in advance for what I’ll learn here!

I’m hoping that by spelling out my current situation, which should be fairly common, the experts here on BP could help lay out the best strategies to help me and other newcomers just starting out. Here’s my situation:

Primary residence in Charlotte, NC

• 3/2.5 SFR (2,353 sf); Value ~$345K, mortgage ~$227K (@3.875%), equity ~$118K

Rental property in Matthews, NC (Charlotte suburb)

• 2/2.5 SFR (1,180 sf townhouse): Value ~$145K, mortgage ~$97K (@3.875%), equity ~$48K
• Rent $1,125/mo; PITI: $744/mo; HOA $202/mo; Mgmt fee (6%) $67; Net ~$110/mo (before capex)

For context, the townhouse was my former residence, which I bought new in late-2007 (oops!), and wasn’t intended to be a long-term rental. Fortunately, its value has bounced back, which makes selling an option.

I know there are endless options when it comes to investing in real estate, so what I’m really asking is, generally, what would you do, given the equity available in these circumstances?

If this post is still way too generic to provide any helpful guidance, I can at least tell you that my long-term goal is to hold multiple cash-flowing rentals and pay down those mortgages ASAP. Happy to provide more info if necessary.

Thoughts? And THANK YOU in advance!

*Again, I’m a newbie, so please forgive me if I’ve violated any terms or unwritten rules for the BP forums with this post!

Dave Foster · Answer

@Brad P., Your real equity is actually less than you think.  Selling would incur costs and probably a negotiation on price.  So in a sell and redeploy scenario your accessible equity might be significantly less than the paper equity.

Similarly, in a refi scenario you will only be able to borrow up to 75% of value as @Joel Owens said.  So your liquid equity in a refi is really only maybe $20 - $30K.  Amazing how fast that goes isn't it!

If you want to look at expansion There's a couple of different paths you could explore.

Sell the primary, move into smaller, invest the rest.  Sometimes pain is a by product of growth.  Deliberately downsizing to create investment income is one of those painful things that might benefit you in the long run.  But the counterpoint to that is that your loan is at an incredibly advantageous rate.  So you'll need to really proforma the net results to see if that's a viable path.

Sell the rental - either 1031 or simply sell.  You may not have a terrible gain situation.  But beware depreciation recapture.  Use the proceeds to get into a better cash flow asset.  As with any condo the HOA kills you.  But it must alleviate some cap ex potential.  So again mucho proforma is needed.

Stay the course and save money to build your war chest until you have enough equity for a sale or refi to be a benefit to you.  And then you can add outside cash to your purchase and really make the cash flow sing.

Joel Owens · Answer

You didn't mention have much money you make per year with your job or business.

The plan might be different if you make 50k a barely squeak by versus 100k and some additional income.

Regeneration of capital on a monthly basis is a key factor. Someone making 300k a year tends to have more free cash flow monthly to keep reinvesting proceeds.

These 2 properties most lenders only allow access up to 75% LTV so most of your equity would be trapped because it is at the top line currently.

What you have to model is your current returns versus what could you get if you redeployed on  other investments? Could you land less headache and higher monthly returns with more back end equity growth? If you 1031 one of benefits is you could put the full 100% equity into another property.

Dave Foster · Answer

@Brad P., Yep the 1031 shelters both gain and depreciation recapture.  You'll still want to run the calcs to make sure that there's enough gain and depreciation recap to justify the 1031.  The depreciation clock would have started when you moved out and started renting it so depending on that date you could have a bunch or not so much depreciation recap.

Your gain will all hinge on what your adjusted cost basis is.  You'll figure that by first taking the lower of purchase price or retail value on the day you put it into service  as a rental I believe (a lovely little "getcha" from the IRS).  Your accountant has probably already done this.  Add to that capital improvements and then subtract deprecation.  Take this number and subtract from the net sales prices.  that is your total gain made up of profit and depreciation recapture.  That number will tell you whether a 1301 is worth it or not.

There's nothing inherently difficult with a 1031 other than some compressed time lines that force you to shop hard early and decisively.  With that kind of down payment and income you'll probably have little problem locating something you want and being able to get it.  I'm hearing from Charleston folk that Charleston proper has been a little picked through but outlying areas still have some good pop.  So keep broad search parameters geographically and you'll be good.

Stephen Richerson · Answer

@Brad P.  I would get a HELOC with your primary (at least $20k) and sweep away the mortgage on both properties.  Depending on your monthly income and expenses you could have both mortgages paid off in within ten years.  Again, it depends.

I might sell the town home cause your cash on cash return in not great.

So what do you really want?  If you want to keep working and be a part time mediocre investor then keep coasting along.  If you really want to be financially free within the next five years then go back to school and get into what we like to call an "intense apprenticeship phase".

Find a local mentor or platform that has a solid track record and program.   Invest in yourself and quickly build a portfolio that takes other investors decades to build.

If you don't know how to sweep away debt, feel free to reach out.

Patricia Steiner · Answer

I don't see equity use as the issue here. The rental might be.  If you can get out of it and then take your time finding the right rental, you'll be ahead of the game.  I also like to see my clients have equity in their personal residence to boost their net worth - while using non-recourse financing for their investment properties that are titled in an LLC.  Sounds like your "issues" are the ones that a lot of investors would like to have!

Brad P. · Answer

@Stephen Richerson I consider myself a full-time mediocre investor, haha. Thanks for the pep talk, though. Could you clarify the "sweeping" strategy? I've read a bit on it, but it seems like playing with fire. Maybe I'm misunderstanding something.

Brad P. · Answer

@Patricia Steiner Good points. I tend to agree about the rental -- it's just not optimized to be a cash-flowing rental -- and I'm leaning toward selling. Thanks for your input!

Brad P. · Answer

@Dave Foster Thanks! Yep, the equity is a bit of a mirage, but your figures are about what I was projecting: ~$30K after costs of selling the rental (into 1031), plus ~$30K-50K in primary equity available via HELOC, depending on the lender (75-80% LTV).

If I’m thinking about this correctly, that would give me at least $60K, which should be plenty for 25% down, to redeploy into a rental property with much better cash flow … right? Also, I was under the impression a 1031 would shield me from both capital gains and depreciation recapture. Is that correct? Any other potential landmines?

Brad P. · Answer

@Joel Owens Thanks! I didn’t mention W-2 income because I’m not relying on it to fund any properties -- they should pay for themselves and then some. But I do see your point, so let’s say I’m in the “100K and some additional income” with monthly surplus.

The way I look at it now is that the rental barely pays for itself (before maintenance), while the return on any equity is 0%. Couldn’t/shouldn’t that equity be put to better use? Or am I undervaluing something?

As a rookie armed with equity, what would you do?

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