Interesting Approach To Approximate Optimal Time For Equity Cash-Out

[Bryan Hancock]

I have blogged about optimal leverage a few times and nobody ever seems to have a really good explanation about their approach to it for real estate investing or when it makes sense to take cash out for other investments. I found an approach this evening while reading that makes a great deal of sense:

Step 1. Calculate Maximum Loan Amount.
An intermediate step is to calculate cash available for debt service.
Cash available for debt service = NOI / DCR
(get DCR by shopping lenders)

Maximum loan amount = Cash available for debt service / loan constant

Step 2. Compare the amount of equity proceeds accessible in Step 1 and the costs associated with the loan and the difference in debt service.

Example:
Old Financing
-Own home worth $200k, with $100k debt
=> With 80% loan of $160k, $60k is available with $2.5k in refinance costs
-Current mortgage is 30-year @7.5% with an original balance of $150k
=> Payment = $1,049
-Been paying for 17 years with 13 left

New Financing
-New loan is 15-year 5.25% with an original balance of $160k, closing costs $2.5k
=> Payment = $1,286

Analysis
Payment delta = $1,286 - $1,049
Annual payment delta = $2,844
Equity proceeds from new loan = $60k - $2.5k = $57.5k
Divide increased payment by equity proceeds => $2,844 / $57,500 = 4.9%

4.9% represents the minimum you can accept on the equity proceeds to replace the increased payment amount. In this case it is quite achievable and thus refinancing makes sense. In the cases where equity is smaller the numbers make far less sense. For instance, if equity proceeds equal only $10k with $2.5k in closing costs. With the same loan terms you would need to make 38% to break even.

Thoughts? Opinions? This seems like a pretty simple way to try to find stray equity in your portfolio that can be put to use more productively in new projects.

[J Scott]

Originally posted by Bryan Hancock:

I’m not sure how a NPV would help here. I understand that the time value of money is needed to be more precise, but this analysis is for a property one has held for some time presumably. The decision is whether or not to refinance the property to access equity. How would one use a NPV for this?

You'd do an NPV analysis of the project you'd be doing with the money you cashed-out. The discount rate would be the "cost" of the refinance.

If NPV > 0, the cash-out is essentially a positive leverage transaction.

Normally, you can't compare NPV values to determine if one investment is better than another (only use non-negative values to determine that a project is profitable), but in this case, with the cost of funds relatively equivalent across all projects being considered, you could probably do multiple NPV analyses at different leverage point (different amount of cash-out), and determine which amount of leverage is optimal.