New investor looking for answers, what do these things mean?

Question

I am 17 years old and very new to real estate investing. As I listen to more podcasts, read more books, and watch more videos, I have more and more questions. The following are things I heard or read that I didn't understand and did not get a very clear or simple answer from google.

What does it mean to under write a multifamily?

Cash out?

Cash out refinance?

Balloon Payment?

I understand the concept of buying properties with value add opportunities because appreciation now affects the property at a higher price and I understand that through this you also build equity because with a 30k value add instead of having 20k equity in a 100K property you have 50k equity in a 130k property. (I think but I could be wrong on both) But what does this actually mean? How can you use this to your advantage? Can I take out a HELOC and use 70% of my 50k to put a down payment on a new property? (just a hypothetical) Or does that not work because in the eyes of the bank do I still only have 20k in equity? A lot of people talk about how important equity can be but without a real understanding Its hard for me to see that importance.

Sorry for questions that probably seem elementary to most of you, just looking for some clarity.

Kerry Baird · Answer

Last paragraph:  yes, we buy a house that needs some rehab so that we can renovate that house and "force appreciation," with the right improvements to the house.  So I might put in a $25,000 kitchen and will improve the value of the house by some amount.  That amount of value improvement will be identified only through an appraisal, and that done nearest to the refinance.

The new kitchen might get a big boost of value in an area where new kitchens are valued higher.  Or it might get a smaller boost in an area where doing that doesn't add as much as I paid for the kitchen.  I have to look at other recent sales to see what kind of finish the other houses have in their kitchens and reason it out.

It is possible to spend a ton of money on "improvements" for which I will not get much of a boost in equity.  Really, fancy windows are an amazing thing to have when I owner occupy a house, because our energy bills will reduce and the house will look prettier...but they don't add a ton of value in an appraisal.

On appraisals, there is a form that the appraiser uses to look at Quality and Condition.  Look for this document.  I like to identify where my house is on the Q/C sheets and choose some items that will boost the house value to the next level up.

As an example:

Q6 Dwellings with this quality rating are of basic quality and lower cost; some may not be suitable for year-round occupancy. Such dwellings are often built with simple plans or without plans, often utilizing lowest quality building materials. Such dwellings are often built or expanded by persons who are professionally unskilled or possess only minimal construction skills. Electrical, plumbing and other mechanical systems and equipment may be minimal or non-existent.  Older dwellings may feature one or more substandard or non-conforming additions to the original structure.

I don't buy Q6 dwellings...they take too much money to make this house sturdy, livable and saleable...and to the point of your question @Liam Marshall, I'd have to throw too much money at this type of house to get a good appraisal.

By the time you hit Q3, you have this description: Dwellings with this quality rating are residences of higher quality build from individual or readily available designer plans in above-standard residential tract developments or on an owner's site. The design includes significant exterior ornamentation and interiors that are well finished.  The workmanship exceeds acceptable standards and many materials and finishes throughout the dwelling have been upgraded from "stock" standards.

Lastly, too high up in the stratosphere of most (but not all) renovators Q1: Dwellings with this quality rating are usually unique structures that are individually designed by an architect for a specified user. Such residences typically are constructed from detailed plans and feature an exceptionally high level of workmanship and exceptionally high grade materials throughout the interior and exterior of the structure.

Why does this matter?  Because appraisers are ticking boxes to see where the house lands on this sheet.  If you can put a few small more expensive features in a "stock" or "contractor grade" house, you will boost the value without spending an arm and a leg.  An example: I put a piece of expensive remnant stone in a smaller bathroom, and a less expensive stone in the kitchen of my vacation rental house.  We might do a bedroom in hand planed wood plank flooring and tile in the expanses of the house.  Also, external features matter...a coat of paint is an amazing boost.

Long, but last comment...we have sunk money into the house, doing these renovations.  Your question, ultimately, is about value increases.  How do you get a return on that investment?  We either refinance or we sell.  My wealth building has been almost entirely from equity.  The cash flow is just what it takes to keep holding until we can tap into the equity.  Boom!

Daniel Marklin · Answer

Brittany nailed it; one add, "underwriting" is the process of "running the numbers." Looking at the income, expenses, cash flow and evaluating the ability to pay for the required debt (banks concern) and provide returns (your concern).

I'll take a stab at your last paragraph. Value-add comes down to increasing the value in the property, more than what you put in. Simple example-- if you buy a property at $80k and put $20k into it, if the property is only worth $100k afterwards, then you didn't gain any equity. It works when you buy a property for $80k, put in $20k, and then it's worth $130k. In that case you made $30k of value!

Now, you can still HELOC or Cash-Out Refinance and the amount you will receive is based on the new value (usually ~75%), regardless of how much equity you own vs how much existing debt you have.

You are touching on the BRRR method-- read the book twice and it will start to make sense; that principle is the golden principle in all of real estate, no matter the class-- it just takes larger scale and time in some asset classes.

Brittany Minocchi · Answer

1. Underwriting: this is when your loan is evaluated by the lender. They're making sure that it fits into their "box" and you meet all qualifications for the loan for them to agree to lend you the funds.

2. Cash out/cash out refinance: pulling equity (cash) from a property you own. Those funds pay off the existing mortgage, and then you get a portion of the remaining equity back at closing.

3. Balloon payment: if you have a loan for 5 years with a balloon, the entire balance will come due at the end of 5 years. You'd need to have a plan to refinance out of your short-term loan before that.

I'm not following the last paragraph of your post, so can't offer any advice there.