Using a Heloc to BRRRR first long term rental question

[Anna Sarvis]

My parents are interested in buying a property in their neighborhood using a HELOC to buy it for cash. We are brand new to real estate investing and are not sure how to go about this deal. The property is listed for $259,900 and needs new floors and updating to the kitchen and bathrooms. Their current house that they live in is fully paid off and has been for many years and is worth around $350,000. Can someone explain how using the Heloc to purchase the property with cash, then rehabbing it, then renting it out and then refinancing the home would benefit them in this scenario? They like the idea of owning this property as a rental and then eventually having it for a family member to retire in since it is one story and in eye shot of their current home.

I just don't understand how a cash out refinance works and what the benefits would be for it as opposed to simply purchasing the home and renting it out without doing the reno and refinance part of it.

Would love any advice or clarification here!  

[Janet Pritchett]

With a HELOC, they could take some of that equity out - sometimes as much as 80%. So, potentially $280,000. HELOCs usually have higher interest rates, but if they are bringing in rental income that offsets that cost, it could be worth it.

The other option could be doing a fix and flip loan, if they have reserve money and then refinance into a DSCR loan, they could be into it for less money than a conventional investment loan or DSCR from the begining.

I am happy to talk it through with you! :)

[Denis Ponder]

I would echo what Janet is saying. I would explore hard money or bridge loans and maybe use the HELOC to fund a downpayment or something. Use someone else's money when you can and keep your own money available for emergency situations. In your proposed situation, here is what I would do:

1) Make sure you have a good/solid/reliable contractor that can actually do the work and has capacity to handle the project.

2) Apply for the max HELOC and get it established. Other than closing costs and loan fees, they are free to have. Then you have the full amount available to you, ONLY IF YOU NEED IT.

3) Secure funding for the property using someone else's money. Hard money, private lender, bridge loans, etc. Use the HELOC for down payment and closing costs, if needed. You will also have the rest of the HELOC available to you if things don't go according to plan. But, that will add to your holding costs so make sure you are in a position to support the payments in the interim.

4) Purchase the property

5) Fix the property

6) Rent the property

7) Refi the property (Private, DSCR, Conventional, etc)

[Mike Klarman]

I would not, if it were me, let my parents sink all their free and clear equity of their primary into a fix and flip.  What if something goes wrong?

Let me walk you through the deal using financing.

Your parents get the house under contract for 259,000. It needs 50,000 in work lets say. That brings you to a 310k project cost (purchase + rehab). Let's divide that number by .75 = 413k. That's what you need the house to be worth ARV to make this a worthwhile deal. So that is check 1. I'm sure your parents know what houses go for around them, is 413k for a new or freshly remodeled attainable there?

Let's say it is. Let's say the ARV is 425k - 430k. I assume this is deal one but as long as they have good credit they can get entry level bridge loan terms. That means they put 20% down of the 259,900 = about 52k plus pay closing costs of another 5k - 7k. Let's say to close on the house costs them 60k. The 50k in rehab money goes into an escrow account and held there until enough work was done in the house that a draw can be made. The rehab funds are for completed work only so your parents would need to front the contractor like 15k let's say to get started and then they get their deposit back at the end of the project because they added 15k to the rehab funds with their deposit so 15k will be left over in the escrow account when job is done. So you can see they can be in for 75k instead of 310k. Their capital exposure was reduced by 200%+.

So now they own the house and work is being done.  They request draws as the contractor tells them he his ready.  Now house is done and you worked with an Agent or a Prop manager to get a tenant and you have a lease in place and have collected security deposit.  You now can apply for a refinance. 

They can get a 75% cash out refinance based off the ARV. Let's say that it is 430k. 75% of that is 322,500. Now, they have a bridge loan of 250k to pay off (that first loan that came with rehab funds). That leaves 72,500 extra. Closing costs on the refi will be 5k let's say so that goes down to 65k let's call it and that goes back to your parents who by this time have gotten their 15k back from the contracting and are only left in 60k. So they now own a house that is rented and the rent covers the mortgage payment by a ration of 1.25:1 or so and they have 5k extra in their pockets and their Heloc money, which they only needed 75k - 80k of - so 100k HELOC should be plenty - was enough. to get through the lifecycle.

Do not let them drain their equity from primary and just sink it into a project.  It doesn't have to be done that way.

[Anna Sarvis]

Thank you everyone for your insight here! @Mike Klarman Thank you for that breakdown - it is super helpful! The property hit the market and went under contract in one day so they did not end up making an offer. 

[Evan Polaski]

@Anna Sarvis, I understand the property they were first looking at is likely no longer available (likely because houses fall out of contract all the time).

There are a lot of ways to skin this cat. At the end of the day, since they are using their HELOC, they will likely want to have a way to pay that off with a long term mortgage on the rental. You/they would need to talk to lenders about terms and figure out the monthly payment.

They would need to understand what rent they realistically could get on the property, and then beyond their mortgage, insurance and taxes, plan for some maintenance from time to time, improvements, and holding costs when it is vacant.  

Even if they cannot pull all of their equity out of the deal, their personal goals may make buying a rental worth while.  If they neighborhood is still appreciating, if rents in the area seem to keep growing, and if interest rates come down, could all turn an "okay" deal into a great investment.  

But, if repairs come up and they don't have the money to fix them, if they put a bad tenant in that does a lot of damage, or in general, if the neighborhood starts deteriorating, it could turn into a bad investment.

These are all things to think about with any real estate investment.