Best Way to Use Equity? Cash Out or Not?

Question

Hello all,

Sorry for the long post, but I wanted to give as many details as I could.

I recently purchased (1.5 months ago) a foreclosure (my second rental property) utilizing a 15% down construction loan that looked like this:

• Purchase price:  $107,500
• Down Pmt:  $16,125
• Closing:  $2,280

The Bank provided an ARV Appraisal at $160K, so I had ~$44K to do renovations including my down pmt. I have since completed the renovations and I would be able to close out the construction loan at $131K.

Based on a couple of renovated properties that have recently sold on the same street as my property, I believe the home should now appraise for $190-$200K and not the $160K the bank assumed before the renovations were complete.

I have come up with a few options of what to do with the equity, but first I want to give an overview of my current COC if I were to just roll the $131K construction loan into a 3 year balloon loan with no closing costs at 5% and a 20 year amortization:

Rent:  $1875

P&I:  $868

Taxes:  $175

Insurance:  $140

Maintenance:  $100

Vacancy:  $100

CapEx:  $93.75

Total Cash Flow:  $398.25 *12 = $4,779

COC:  $4,779/($16,125 (Dwn Pmt) + $2280 (Closing)) = 26%

Here are the options I am considering and need help with:

• If I roll the construction loan into the above mentioned 3 year balloon, the bank can provide a second mortgage utilizing the equity I have in the property for up to 85% of the appraised value of the house to use for the down payment toward another property. This would provide about $30K for additional properties. I have to wait 6 months from the date of the purchase to do this.

• I also talked to another bank that will offer close to the same, but as a cash out option. The interest rate on the cash out loan would be 5% as a 5 year balloon with a 20 year amortization. This would bring the P&I to about $1066, but would provide around $28K Cash (assuming a $190K appraisal and ~$2500 in closing) which is almost enough for two additional properties. Also, I don’t have to wait 6 months from the day I bought the property to do this; I can do this starting tomorrow. This would give me much less cash flow, but still around a 13% ROI on the current property assuming the same numbers as above but with the increased P&I.

• If the property appraised for $195K, I could do a 30 year fixed at 5% with a 75% LTV cash out and get about $12K after closing costs. This option offers less cash, but a fixed rate is always attractive to me. (Two brokers I talked to said the 5% is significantly higher right now with COVID for a cash out than a non cash out option which would be about 3.5%). The ROI at the 5% interest rate would be 31%, but I would only have about $12K available after closing costs for my next property.

• I could also opt for a noncash-out loan, roll closing costs into the loan amount, and get 3.5% for 30 years. This would increase my ROI to 43.5% and Cash Flow $667.25 a month, but I would have to save for my next property rather than using equity in some way.

I am leaning toward option 2 because I like the idea of being able to pull the cash out to use as a down payment toward additional properties rather than use an additional loan with the equity like option 1 for additional properties. Does a 5 year balloon loan scare anyone? Would it make more sense to get the fixed rate (option 3 or 4) and save up to buy another property to secure the fixed rate?

Any advice or help you could provide would be greatly appreciated!

Thanks!

Brady

Jaysen Medhurst · Answer

@Brady Bulmanski, that's correct. The more equity you have, the lower your ROE.

Brady Bulmanski · Answer

@Jon K.

Yes, it is in my personal name. I’ll be calling more banks in the morning to find what you did.

Thanks for the info!

Brady Bulmanski · Answer

@Jaysen Medhurst,

Thanks for your detailed reply! Yes, this is a SFR.

The renovation came in right under $40K with updated electrical and plumbing, renovated bathrooms and kitchen, new AC, all new windows, new hot water heater and a roof and furnace both four years old. That is the reason for the low maintenance and capex. Sorry I wasn’t clear with the reno cost.

Thanks for pointing out the Property Management part. I’ve read a lot before about including that, and I stubbornly didn’t include it because I want to do it myself. I’ll add that back in.

I don’t think I’m familiar with ROE but I’m guessing that the more equity you have the worse the ROE?

I like the fixed rate also, just wanted to pull out money now and not and 6 months and also at the 85% and not 75%. I’m being impatient!

Jon K. · Answer

@Brady Bulmanski Is this property titled in your personal name? I just got a rate of 3.35% paying 1 point on a conventional cash out refi on a 30 year fixed at 75% LTV. It of course depends on the variables (Credit, DTI, etc) but there's no reason you can't still do the same.

Jaysen Medhurst · Answer

@Brady Bulmanski, is this a SFR?

Based on what you've shared I would go with option 3 to lock in that long-term very attractive rate. At the same time, see if the lender will do a HELOC to allow you to tap into the additional equity you have.

I also think you would be well served to underwrite a bit more conservatively.

• 10% combined for CapEx and Maintenance is low. You only did $20k of work and that won't keep the wolves from the door for very long.
• What about Management? You should always include Management in your underwriting, even if you plan to self-manage at first.

I bet you end up cash flowing $200-250/month when all is said and done. That's pretty darn good, especially if you can pull all of your cash out at refi. One thing to keep an eye on is your Return on Equity (ROE). You're going to have up to $60k equity in the property. That works out to only about 5% ROE, which isn't great. Now if you're able to tap into some of that equity for doing future deals, that changes things a bit.