How much debt should I obtain to continue to by and hold?

Question

I am in CO. My husband and I own a primary residence. We took out a HELOC on it along with borrowing against my 401K to buy, reno and rent a rental property. I have the real estate bug in my blood and I want to build a portfolio of rentals. I am looking at a SFH for our family to move into as a primary residence. The home is somewhat better than our current home and it's a fair price. My basic question is how much risk and debt should we get in to, to build our portfolio with little money down? Should we instead hunker down a few years (while the values go up) and pay down debt and save a big lump of cash to lower the LTV and risk?

We would need to take a HELOC out on the Rental #1 to get enough for the down payment and closing costs for our new primary and rent out our current home. Without counting the rental income on rental #2 on the current SFH home we would be at about 47% DTI. With rental income it would be lower DTI but it makes us nervous to have everything mortgaged so much. Colorado values are going up a lot and the inventory is very low so that is what makes me think maybe we should acquire more properties.

How do I know that the values will keep rising and this risk it worth it. the low inventory and numbers trend the right way but how do we even calculate if the risk is worth the potential future equity?

What would you do?

1. Rental #1 Cash Flow $710 per month - Maintenance as needed (Is there a standard % for this?)

2. Rental #1 Equity = 330-197-47=86K (I subtracted the HELOC on my home and the 1st mortgage on it). Take out about 30K for closing & down payment on the next primary. That would put us at 70% LTV

3. "Turn my current Primary into a rental #2" Cash Flow 3k-2,570 = $430 - Maintenance as needed. It is mortgaged at 90% LTV already.

4. Get a 4.75% FHA loan for the next primary residence with 3.5% down due to high balance FHA loan and Fair credit scores. It would have a 96.5% LTV

Bill S. · Answer

@Loretta Chavez here is my two cents. 1) you are not likely to obtain a HELOC on a rental property (lending on non-owner occupied units is not the same as if it was your primary residence).  Based on that, your scheme breaks down. Now you might be able refi the money out of the Rental #1 but again the loan to values are fairly conservative so it will be hard to get at the equity with that route.

Let's just say you are able to get to the equity in Rental #1. I think your approach is very risky. Too much debt and too little cash flow. It's my opinion that rents will stagnate in the next year or so. There is so much supply coming on line and in your price point you would be competing with it. You could see extended vacancy how will you cover the mortgage and expenses? Then what if you lose a water heater in one unit and a furnace in another? Your margins are so thin, that you will need to have lots of reserve cash somewhere.

My opinion is you need to wait and build some cash. Get frugal and/or Get a 2nd job (maybe in real estate) or some means to grow your cash. In addition, lots of debt strains relationships. Think about how your kids or spouse will feel if they get told "no" because you are feeding the alligators you bought.

Painful as it may be. Patience is the word of the day.

Brian Garrett · Answer

Loretta,

My wife and I are in a similar boat and just starting out.  We have a significant amount of cash saved up (enough to pay off the existing mortgage) and over 2/3rds of our mortgage paid off (when factoring in what we have in savings.  So we're well positioned to start our journey (which I'm actively investigating).  Also, about 11 years ago when we got married, she owned a home and I owned the home we continue to live in.  At the time we got married we financially couldn't afford to have both homes with a renter in one and have the renter miss a single payment - or move out in search of a new tenant.  So for safety we sold the first home.

I'm not a big fan of the HELOCs because of the terms and the interest rates.  I'm thinking more long term rather than short term and because of our cash position I'm looking to get our feet under us from that perspective first.  If that goes well, then my plan is to refinance our house to take the equity out.  This allows us to lock in a fixed long term expense vs. the shorter terms and variable rates of the HELOC.  I could be wrong about this, so take that for the grain of salt that it is.

Now - with regards to your questions:How do I know that the values will keep rising and this risk it worth it.

You don't - it could all come crashing down tomorrow, or it could grow at the rate we are at for the foreseeable future.  Things I look at are areas like, current available inventory on the market, new building starts, demand, unemployment and other growth factors in the Parker area (Parker is just stupid hot from what I've seen).  IMHO Parker is a good area for continued growth.

The low inventory and numbers trend the right way but how do we even calculate if the risk is worth the potential future equity?

I'm not entirely sure how to approach this - but initial thought would be to assign a value to the pain point taking into consideration of "what if the property suddenly sits unrented for several months" - you could draw out all the doomsday scenarios you can think of and then walk it back.

What would you do?

1. Rental #1 Cash Flow $710 per month - Maintenance as needed (Is there a standard % for this?)

2. Rental #1 Equity = 330-197-47=86K (I subtracted the HELOC on my home and the 1st mortgage on it). Take out about 30K for closing & down payment on the next primary. That would put us at 70% LTV

3. "Turn my current Primary into a rental #2" Cash Flow 3k-2,570 = $430 - Maintenance as needed. It is mortgaged at 90% LTV already.

4. Get a 4.75% FHA loan for the next primary residence with 3.5% down due to high balance FHA loan and Fair credit scores. It would have a 96.5% LTV

I think I could make an argument for any one of these options depending upon what the goals are.  Are you looking to do more cash flow?

Regardless - it's a tough call on how to best approach it.  I know our long term goals is cash flow.  Any equity gains are just funny money until you cash them out in one way or another.  And if you pull on the equity string of an existing home, it drags the passive income down because you'll have a higher mortgage to contend with.

Definitely areas of struggle I'm working though.  :)

How much debt should I obtain to continue to by and hold?

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