Cash Out Refi for rental?

Question

Lately I've been contemplating a cash out refi on my primary residence (because of the 5% rates); I was reading some old forum posts on refinancing and thought about this:

Why would someone cash out refinance in order to purchase a rental property?

It seems like the increase in PI payments and cost to refi would eliminate any potential cash flow on the rental! - Brandon

Mike H. · Answer

I understand there's a difference between net cash flow and all the other things that can go wrong.  But if you have a net cash flow of 4 or 5k a month, you can cover almost anything that can go wrong. I guess that would be my point.  But I agree that 4 or 5k per month net cash flow is not going to be enough to replace a job making the same amount. Because the chances of getting that over the year is slim to none.

However, in looking at this year's returns, my total out of pocket for all my expenses (and I had an eviction, an A/C and a furnace) came in less than the $75 per month per house number.  So this year I actually did get that much net income..... :-)

But back to his question. Its still you're much better off taking out some cash in a refi of your primary residence and buying a rental with it - than not.  Its the cheapest financing you're going to get and it also allows you to get a better deal because you can do all cash offers.

Jon Holdman · Answer

Property management?  Perhaps you're earning that your self, but you are earning that, the property is not producing it.  That may be do-able for a handful of properties, but it will become a full time job when you get to 50-100 properties.  Around here, $1400 a month with one vacancy a year would cost you about $3000 a year, or about $250 a month on average.

Vacancy?  None?  Every?

Capital?  Eventually every house needs a new roof, new water heater, new furnace, etc.

Legal fees?  Hopefully small, but potentially large.  Again, a few properties for a few years isn't the same a large portfolio for a several decades.  With a large portfolio (which I don't have) evictions become just another routine expense.

CPA fees?  Mine charges about $600 a year, though only a portion of that can be attributed to real estate.

Lengthy, messy evictions.  Hopefully rare, but again, one of those things that will happen "over the long term".

Tenant damage.  I've had a couple of incidents of fairly minor damage that still ended up being more than the security deposit.  I've sent bills.  Never seen a payment.

A few properties for a few years is like playing ten hands of blackjack and winning seven.  That certainly happens.  But losing seven out of ten is actually more likely.  That's equivalent to having a few properties and having something horrible happen (like the poster who bought the duplex, discovered a drug dealer lived above her, ended up living in her car because she was so afraid to go in, and spent thousands of dollars getting rid of the guy).   Hopefully nothing horrible happens.  But some of those things I like WILL happen to you over the years.  As long as you realistically estimate your true cash flow, build up some cash reserves, and mentally prepare that one of these bad situations is just part of the business, you'll do OK.  If you only address the obvious, ongoing expenses and spend what's left (not saying you're doing that) you can end up in a bind.

Mike H. · Answer

I guess I should have put some real examples in there to justify my numbers. But based on where I'm at, the 80k for a house is what I'm paying and I'm getting rents of $1,300 to 1,400 a month depending on the area.

So when I say 850 to 900 a month cash flow, that is including the maintenance ($50 to 75 a month depending on the age of the property).

Here are my last 3 houses I bought in Illinois:

Lansing -  Rent $1,350, mortg 400/mo, taxes 350/mo, ins 75/mo, repairs $75/mo = 900 month total.  Add some vacancy in there as well but I'm still getting 400/mo.  This was bought with a hard money loan and refi'd (rate and term) into a conventional loan (5-10 financing) so I had no money out of pocket.

Lynwood - Rent $1,400  (mortg 440, taxes 380/mo, ins 80/mo, repairs $75/mo = 975/mo).  Also bought with a hard money loan and refid into conventional loan (5-10 financing) with no money out of pocket.

Crete - Rent $1,400 mo, a little over 1,000 in PITI and repairs.

So the net cash flow with a mortg is about $400 a month. $350 if you add vacancy factor although I haven't had any turnover in any one of them because I'm actually under market on my rents - at least for Crete and Lynwood.

So my actual net cash flow on these 3 properties is $400 a month or so. If I didn't have mortgages, though, it would be between $800 and 900 a month of actual net cash flow - albeit you really would have a mortg on it because you'd be paying $350 a month on the 80k you're pulling out of your primary residence.

Bottom line is that its well worth pulling that money out as you'd be netting anywhere from $450 to 550 per month. But I guess I should clarify that with - depending on where you live. :-)

Jon Holdman · Answer

Neither of those numbers is "cash flow".  Cash flow is what's left from the rent after ALL expense and debt service are covered.  If rents are $800-900 and your debt service is $350, a better estimate of "true cash flow" is $50-100.  Now, if you have no cash into a deal, and you have tenants are paying it down, that may be a perfectly acceptable deal.  But if you think you can spend that $450-550 a month of "phoney cash flow", you better have cash on hand to deal with the inevitable problems that will crop up.  Not to mention just paying the annual taxes and insurance payments, since those aren't included in the payment you're making on you primary.

And, if you're going to take cash out of your primary to buy rentals (or anything else) you need to be very, very sure you can cover the new higher payment even if your investments turn into complete losses.  Buying a single SFR cash is unlikely to turn into a completely loss (though not impossible, if, for example you choose to self-insure and have a fire), but if you take that cash and leverage it into a larger property, a total loss becomes much more possible.  You don't want you investments to end up putting you out on the street if you lose your residence.

Mike H. · Answer

Why would someone cashout refi their primary to buy a rental?

Thats easy. You get better rates on a primary residence refi - even with a cash out - than on an investment property loan. And because its a lot easier to get a loan on a primary residence than an investment property. And because, once you have that cash, you can make cash offers on REO"s and get better pricing.

As far as being able to cash flow more on a rental to make up the difference, thats a no brainer.  In this market, you're going to make more money from a rental than what your payments are going to go up - well, in all but a few areas, at least.

Example: If you take out 80k on a cash out refi of your primary res, your payments would be about $350 a month more on your refi payment. You would then use that 80k to buy a rental and your cash flow should be about $800-900 a month (before paying your $350 a month payment).

So your net cash flow would be $450 to $550 a month (800-900 minus the 350).  If you were to get an investment loan, your cash flow would typically be about $350 to 400 a month.  Rates are higher and pricing/terms (amortization period, etc) can be less attractive.

Jon Holdman · Answer

Ah, so you currently have a Citi first and a Chase second, and Chase is willing to refi the first.  They would then have both notes.

You might try asking for a modification of the second, too.  As it stands, that second is worth much less than its face value (the amount you owe.)

Keep in mind the passive losses you can't take do accrue and can be taken when you sell.  That may not apply if you bought at the height of the bubble.  But if you bought before the bubble and did that second during the bubble, you can still end up with a gain on the sale, even though you actually have to accept a short sale or make up a shortage.  So, do keep track of your carry forward passive losses.

I think we're a lot longer than a "few years until the market comes back".  The bubble was an abnormal event.  I think it will be many years, if not decades, before prices return to the peak of the bubble.

Sounds like refinancing may make sense, despite moving out your payoff date.  It would help with cash flow, and that's really your problem right now.

Michelle G · Answer

Jon,
Thanks for your response.. Citi is 1st and chase will have to agree to remain Subordinate.  Ihave been told it is usually not an issue because increasing my cash flow will only help their position.  The reason I didn't get rid of it up untill now is that we took the loss and it kind of worked out after taxes.. Now we make too much w2 income and can't take any loss.  I would lose about 60k if I sold I was trying to hold on for a few years untill the market came back.. My husband is a former general contractor and can build or replace anything including electric or plumbing so costs for repairs are kept reasonable and the vacancy for the past 5 years has been less than 2 months.  So it eeks by.   Thanks

Jon Holdman · Answer

An old thread revived and my old predictions are out in the open.  We're not actually too far off those 3-4% investor rates.  Wow!  And a long ways from 9-10% even through its been three years.

Got that one right in most areas, though.

Anyway, Michelle  G, is Chase aware of that second?  If you refi your first with Chase, it will move into second position and the current second will become the first.  If you're underwater, I really doubt Chase or any lender would let you do that.

Is there some reason to hand onto that loser property?  You're significantly in the hole every time you have a vacancy or a bill other than taxes or insurance.  Do a short sale (if possible) and move on.

Michelle G · Answer

Similiar question.. have a sfh (used to be my primary residence) that has a neg cash flow of about 100-200/month.. Have a Good Faith estimate from Citibank and will reduce my payments by 300 month but extend 7 years back to 30year.  Cost about 6000.  I can't sell at this point as I have a 2nd that has 7 years left making me underwater. here are some numbers current monthly - 1265 plus 400 tax and insurance plus 260 on second.  new would reduce 1265 to 960.  My rents are at 2000/month there are two separate apts here each $1000.  What do you think???

Jon Holdman · Answer

I think its a good time to be buy and holding.  Be careful getting overleveraged because prices could continue to drop.  I don't expect to see 3% or 4% investor loans, and do expect that at some point, maybe three years, maybe six, we will see 9-10% rates.