Calculating Rental Property ROI With a HELOC?

Question

Hi everyone. I'm hoping that a clever, experienced investor can help me. Maybe I'm just terrible at mathematics, but I'm struggling to figure out how to calculate ROI from a house purchased via my HELOC.

The numbers I'm giving below are just examples.

Let's say that I find a rental property which costs $50,000. Let's also assume that this would be the total cost of purchase, repair, etc.

Guesstimating with the 1% rule, let's suppose that this property can reliably provide $500/month rent. And for the sake of conservatism, let's guesstimate that the total expenses of the property (maintenance, water utility, property tax, insurance, management, and vacancy) will equal 50% of the monthly rent, or $250/month in expenses.

So, thus far, we would be earning $250/month, or $3,000/year. If we were to pay the $50,000 cost in cash, then our return would be 6%.

This cash-on-cash return is easy to determine, BUT...

Let's say I have a HELOC on my own house, and my mortgage is completely paid off. For ease of calculation, let's say my HELOC can go up to $100,000 so we can more than pay the $50,000 needed for the property.

However, my HELOC is a little weird. Unlike some HELOCs which have interest-only periods, my HELOC requires a minimum monthly payment of 1.5% of the loan. The variable interest rate on the loan is currently 4.5%.

So, if I were to draw 50,000 from the HELOC to pay for this rental property, my minimum payment for the first month would be $750, of which about $188 would be interest, and the remaining $562 would go towards the principal. Each month, these costs will be a little different, obviously, because the minimum payment will recalculate lower each month as the principal is paid down. (After 60-something months, for example, our minimum monthly payment will be only $384-ish on the remaining $25,360-ish balance.)

But obviously we already have a problem from the beginning.

Monthly rent: 500

- Monthly expenses: 250

- First Month Financing expenses: 750 (188 interest, 562 principal)

Net cash flow for the first month: -500

Unless I am just being a total idiot, this doesn't look good to me at first glance. At the beginning of this loan, anyway, I'm having to pay the $500 remaining principal out of my own pocket. So it is basically the equivalent of paying cash for the property (similar to a down payment, I suppose, which doesn't seem bad when you look at it that way).

But it will take a long while for this property to "break even": only when the balance of the loan falls to about 16,600 does the 250 rent income after expenses cover it fully. By that point, I will have paid $33,400 out of pocket (technically a little less, maybe 25k, since the rent would start to cover more of it eventually?), unless I'm mistaken... Then we wait a while longer for the remaining 16,600 to be paid off by the renters. Eventually, once the house has been paid off completely, the 250 after expenses goes to my pocket. That would be $3000/year, and I guess that would mean my annual return would be 8.9% at this point (3000/33400 = .089 = 8.9%).

While that 8.9% sounds all fine and whatnot, and suggests that using the HELOC in this way is eventually a better return than paying the entire 50,000 in cash, I'm really struggling to grasp whether this is a correct way of thinking about things.

After all, if I were to pay 50,000 in cash now, I would start getting the 6% return right away. But with the HELOC I essentially get zero return (or negative return, I guess?) for years before finally getting an 8.9% return. Or am I thinking about this incorrectly? Because the principal is still getting paid down, should I consider that my "return"? I have no idea. Sorry for being so bad at basic math.

Additionally, is there is a better way to use this HELOC to buy rental property? What would be the best method, assuming that I am looking at 50,000 properties which could generate 500 gross rent, or 250 after expenses? Should I use my 1.5% minimum payment HELOC towards this investment at all? Please help if you can, because my brain is threatening to give up now. :)

Jim Goebel · Answer

@Jessica Steele

Wow, long post!  Hopefully I can help a little.

So, the way we think about your question is treating your HELOC payment more as a 'holding cost' that counts against your rehab budget, as more than likely, your HELOC balance should be re-payed back down to zero, once you achieve the rehab and cash out refinance / convert the stuff to the long term fixed rate financing.

Part of the benefit of thinking of it this way, is that the HELOC payment is temporary while you use that revolving line of credit.  That HELOC is, by the way, revolving by design.  So it's meant to go up and down.  Another benefit to thinking of it and doing it this way, is that it's motivating from a schedule perspective.  When you analyze your equity position pre and post project (acquisition) - the longer the project takes you, the worse you're doing from a performance perspective on that equity analysis.  If you are not understanding what I mean by equity analysis let me know.  Kind of simple - you want to know how the property affects your wealth, and your cash position.  If you buy that 50k house at a discount, put 10k into it, and it's an 80k house, net change of net worth or equity is 20k.  Then, you think after you get a bank to lend on that nice 80k house, what's the change in your cash position - as you'd be paying down your revolving balance with funds from that refinance.

Your ROI analysis is more your 'steady state' kind of way of approaching things - so you'd only start introducing that when you're looking at your rent vs your ongoing costs - (income) vs what you have invested.  Note Cash on Cash and Return on Equity returns will be different and there's a place for thinking about both.