Category: Real Estate Investing

3 Reasons to Do a Cash Out Refinance of an Investment Property

One benefit of real estate investing is being able to take your initial capital out of the deal and still own the property. My wife and I just did this through a cash out refinance on investment property we’ve owned. It is fairly straightforward, but let me try to explain the mechanics and benefits we saw.

Simple Explanation

The simplest example would go like this: Let’s say you bought a $100k property and put 20% down, so you have $20k of equity and $80k of debt. you bought extremely well and it turns out your property just so happened to be the next hot area. You appraise the house and its new market value is $175k. Because total assets = liabilities + equity, if your mortgage was still $80k (in real life, it would probably be paid down some), your implied equity would now be $95k!

You could sell the property and take the proceeds or you could do a cash out refinance of your investment property.

How much could you take out?

Since this is an investment property, a lender will typically only lend up to 75% LTV against the property for it to qualify for Fannie / Freddie backing (which gives you access to low interest rate, 30 year loans).

The way the lender looks at it is, if you were to buy the property today we’d feel comfortable giving a 75% LTV loan, so we shouldn’t care where the money is going per se. You could still sell the property and take the money so in this case, they are agnostic.

The mechanics are pretty simple. A new mortgage is done on the new property value, they pay off the original mortgage and cut you a check for the difference. In this scenario, you could take out $51,250! That’s 2.6x your initial investment and you still own the property!

Now, obviously you may decide that taking all the equity out is better for you, but for us, we didn’t want to sell the property and wanted some liquidity so it added up for us.

Cash out refinance example

To be clear, this is real estate we are talking about here, so don’t expect to be able to take out your equity immediately. We did ours after owning the property for 10 years. We could’ve done it earlier, but the timing lined up and rates moving lower made it an attractive time. There are closing costs that can be a few thousand dollars, so you want to make it worth it.


So some of the benefits of a cash-out refinance are obvious, but let me lay out my favorite: 

  • Able to Take out Initial Equity with Limited Tax Consequences

As shown in the example, we were able to take out our initial equity, which we can now use for other investments. But the even better part is that the cash doesn’t count as taxable income or a gain on sale, because we are technically taking out a loan.

That is a sweet benefit. You will also be able to claim the interest as a expense on your tax statements going forward to reduce taxable income. I view it as a win-win-win.

  • Can Redeploy in Another Investments, including Real Estate

Many people use cash out refinance proceeds to invest in other real estate properties, but my wife & I decided that we should (i) put some money back into the investment property (ii) use some of the proceeds for some projects around our personal home and (iii) fund tuition savings account.

I personally like the idea of building a real estate empire on cash out refinances. Personally, our proceeds that we received could easily go to buy two new properties. In about 8 years, we probably could take our equity out of all three again and go buy two more properties. You can do a cash out refinance many times, as long as you have enough equity built where it makes sense to cover closing costs. Its a “Get Rich Slowly” scheme.

At the end of the day, you could use it for whatever you’d like!

  • More attractive rates than a Home Equity Line of Credit (HELOC)

I often see people debating a HELOC vs. a cash out refinance. We went with a cash out refinance because we had built up significant equity and even though we were refinancing a primary residence loan with an investment property loan, since interest rates have gone down our total monthly payment didn’t move much.

The interest rate on a cash out refinance can typically run 50-100bps wider than what the primary residence market is (we got ours at 4.25% when market rates for primary residences were around 3.60%) and will obviously depend on credit score.

HELOC’s are akin to getting a second mortgage on a home, because you are tapping the equity behind the existing mortgage. Therefore, if first lien mortgages are already higher than primary, you should expect second lien mortgages to have an additional risk premium built in (i.e. come at a higher rate).

In our situation, a HELOC was going to be high-4%-5% range and has faster payback terms (5-25 years). We preferred to lock in a new 30 year mortgage at an attractive rate. HELOC interest also isn’t tax deductible anymore.

HELOCs do have lower closing costs, though, given in a cash out refinance a lender will want the typical closing items: appraise the property (fee), you’ll need a real estate attorney in many cases (another fee), a title search for the lender (fee) and other closing costs.

 

Cash on Cash Return of Real Estate – Will #COVID19 Create Opportunities?

COVID-19 has already produced some interesting investment opportunities in the stock market. Fortunately or unfortunately, part of investing is being prepared to buy an asset that others NEED to sell. Perhaps the cash on cash return of real estate will improve

This happens in the stock market all the time, but I think real estate could again become attractive given unemployment is rising, there has been disruption in the mortgage market, and a cease in travel may pressure liquidity of those who bought short-term rental properties (think airbnb). Since I am seeking investment opportunities for myself, I figured I would share. My wife & I already own one investment property purchased in 2010 and I can clearly see the benefits.


Here are a few positives of buying real estate:

Cheap leverage:

You can finance around 75%+ of the purchase price with very cheap, 30 yr debt. Our property is an investment, so interest rates are around 50-75bps higher than the national average, and we are paying 4.25% over 30 years.

Compare that to buying a cash flow producing business and you’re likely going to have to pay 8% and carry risk that the business fails, whereas you can generally have decent protections in real estate (location, location, location)

Asset is then paid for by tenants:

The next best thing is that you have that rate locked-in for the tenor of the loan, but rent typically rises each year or over a long period of time. So you’re typically getting “more profitable” each year. Also, you’re not the one paying for it – the tenant is!

Rinse & Repeat – Taxes are favorable:

Thanks to 1031 like-kind exchange rules, when you sell a property (hopefully for a gain) you can roll your original investment & gain into another property and avoid paying capital gains. In other words, it’s akin to a deferred tax account.

You can buy a property on the cheap, realize gains & maybe move rent up to a market rate, sell for a profit & repeat. Also, mortgage interest is tax deductible.

You can essentially conduct a dividend recap on the property:

Also known as a cash-out refi, we did this with our rental property. The lender will appraise your property and allow you to re-lever back up to 75% LTV. So a new mortgage is created against the higher property value, the old mortgage is paid off, and the bank cuts you a check for the difference.

This is a great feature because you can buy a place that needs to be rehabbed on the cheap, fix it up, rent it, and then go and refinance the property on likely a higher value and take out all of your original equity! This has also been called the “BRRR” strategy, Buy, Rehab, Rent, Refinance, Repeat.


I do, however, have a few complaints.

Not quite passive investing:

I can go out tomorrow and buy a bond fund that pays interest and pay the manager a few basis points for their trouble. Real estate though is tough. If you’re managing it yourself, you need to find tenants (a challenge) and be prepared to find someone to fix an issue at any time. A property manager can ease this concern, but there still is generally some back-and-forth here.

Are the returns really that great?

This is what I plan on investing in this post. My wife & I just hired a property manager, but there have been times while we were self managing the property where we asked ourselves if it was all worth it in the end.

Liability:

You can finance properties in an LLC, but typically that interest rate won’t be nearly as good. You can instead get insurance to help cover some of the liabilities involved with renting properties, but will you lose sleep wondering if its enough? (biggest fear for me is a party where someone falls off a roof railing or something like that – personally I should be covered in several ways there, but still a concern in the back of my mind).


Understanding Cash-on-cash returns vs. IRR vs. Cap Rate in real estate

There’s a lot of jargon thrown around in investing, particularly real estate. First is probably cap rate, which is your NOI (net operating income) over the asset value (or purchase price). NOI is just the annual rental revenue less the operating expenses (such as ongoing maintenance costs, utilities, property taxes), but does NOT include financing costs. It’s just a rough proxy for what the return on the property will be unlevered. So it’s likely a lower rate of return given you probably will finance your purchase.

I sometimes look at cap rates, but only as a quick proxy for value, similar to EV/EBITDA — in fact, a cap rate is really just EBIT/EV. So clearly, it is missing financing costs (interest) as well as any capex needs and I prefer to know what my cash returns are as an equity holder.

Cash on cash return removes what we just discussed. This takes out financing costs and any recurring annual capex to find out what a real cash on cash return is.

Note, by financing, I just mean interest cost. That’s because a pay down of principal is paying down debt permanently and therefore building your equity (as I’ve said before, when a company pays down $1 of debt, this is a $1 to the equity). Some investors add the principal amount to cash flow, but I don’t do that because I’m not actually benefiting from that cash flow in the period. Doesn’t make intuitive sense to me.

Example:

I wanted to share some math that I’ve been looking at so, here is a spreedsheet snapshot I’m working on (perhaps this is a legible picture…). Hopefully the assumptions are clear enough. This assumes purchasing the property at a ~6% cap rate and a 8% cash on cash return, which I would say is somewhat typical.

I also highlighted when you could expect to refi out around ~95%+ of your original equity. Not bad – I can cash out my equity by year 8 and still own the asset. I could probably then go buy another property with that cash.  Unfortunately, as of right now, the areas I am comfortable investing in are more like 4-5% cap rates… not that great.

One thing that should be somewhat obvious is that the more equity you put down, the closer your cash-on-cash return will be to cap rate.

What does this mean from an IRR perspective?

The IRR in this example was around 9%, including closing costs on both sides of the transaction. Clearly that is much closer to the cash on cash return. The problem with IRR is it basically assumes you can reinvest each dollar you receive back at the project rate, which may not be realistic.

That brings me to another thing to focus on: total return. Just add up all the costs in vs. costs out. This ratio is called the multiple of money. I like to use it to compare returns. Subtract 1 from it and you have the % total return as well.

All-in-all, these returns aren’t bad. Especially for a “stable” asset class. That said, I have to think about the balance between buying this asset, some of the headaches that come with it, and not have much liquidity. I’d need to either find a way to put less equity down (to juice returns) or find properties at a steeper discount.

If you want to look at some properties yourself and run the math, you can check out this company called Roofstock, which to me seems like its trying to make long distance relationships & real estate a thing. Its an interesting concept and I have to commend them on their tools as well. You can even buy fractional shares in a home on their site (not sure how the financing and taxes works though… I’ll have to give them a call), though inventory seems limited. I’m not getting a kickback from them or anything, but I do monitor their site so thought I’d share.

COVID-19 Throws the Mortgage Market into Turmoil #COVID19 $REM $OCN $MORT $NLY

The mortgage market is in turmoil right now. While congress passed the “CARES Act” to provide relief to families impacted by COVID-19, there were clearly some unintended consequences.

First Mortgage Market Issue: Possible Bankruptcies in the Servicer Space

The CARES Act allows homeowners and renters can stay in their homes in the case they can’t pay their monthly dues during this crisis. This establishes a 120-day mortgage payment moratorium option for borrowers with agency-backed mortgages (i.e. those loans backed by Fannie, Freddie, and Ginnie which constitute about 60% of the entire mortgage market). This created significant uncertainty in the mortgage market that I hope to walk through.

How the mortgage process works:

When a lender provides a loan for you to buy a house, odds are that lender will originate that loan, package it along with other loans into a mortgage-back security and effectively sell the risk on to investors. They will retain some mortgages on their books, but they do this so that they can continue to originate loans, possibly generate a gain on sale, and generate fees.

Typically, when a homeowner is paying interest and principal, another company called the “servicer” handles the payments and divvies it up to investors, tax authorities, etc. In exchange, they receive a small, fixed fee as a % of the principal balance they manage. This is how the mortgage market typically functions.

The problem: Mortgage servicers are required to pay principal & interest to holders of the mortgages, even if there are missed payments.

Mortgage servicers are not huge companies raking in tons of money off of this service they provide. Banks would be much better prepared to fund this gap.

Therefore, if 5, 10, 15% of people with mortgages decide to defer payment, this could bankrupt the servicers and cause turmoil in the function of the mortgage market.

If 10% of GSE loans are delinquent for 3 months, that would be roughly $6BN in cost – something the servicers don’t have lying around (assumed based on $4trn GSE loans @ 4% WAC). This also doesn’t include taxes and insurance.

Lastly, if Ginnie borrowers can’t be brough back to current on their loans, then the servicers need to fund the buyout of those loans while modifying and re-pooling the loans.

Investors may not receive payment in securities they thought were very safe (remember, backed by government sponsored enterprises like Fannie & Freddie & Ginnie). These investors may also be levered to juice their returns on the securities which may throw them into bankruptcy as well.

Investors were trying to shore up liquidity ahead of some of these unforeseen and unknowable outcomes (i.e. they are selling securities). Agency MBS spreads over treasuries widened to ~140bps compared to ~30bps from Dec 2019 through February 2020. Then the Fed unleashed unlimited QE on agency MBS, so that helped calm the market a bit.

Still, if this is the way we are going to operate, the Fed or the servicers should come up with a liquidity facility for the servicers. Ginnie Mae announced it will launch a liquidity facility in the weeks to come (details TBD) but we need a much more encompassing rule.

Another issue here is in the originators warehouse. Let’s say you are a bank with a “warehouse”, which is like a revolving loan in which you ramp up loans before you sell them off. In a simple example, let’s say in normal times you can originate 2 loans in your warehouse per month, sell them off to investors, and start the process over with capacity in the warehouse for 2 more loans next month. If you originated a loan that isn’t performing, you cannot sell that to investors… that freezes credit. Now the originator is stuck with a bad loan and his capacity to make new loans is drastically reduced. This has me worried about the flow of credit when it is needed.

Second Mortgage Issue: Margin Calls on Mortgage REITs

Take what you know from above and apply it here: widening spreads on previously high quality assets can have negative impacts on levered vehicles.

The agency MBS spreads widened materially and since interest rates and prices move in opposite directions, that causes agency MBS to fall. Mortgage REITs (mREITs) use agency MBS as collateral to back their short-term financing in the repo market. The falling bond prices triggered margin calls on them and we saw many names were unable to meet their margin calls.

After the Fed announced it would buy unlimited agency MBS and treasuries, this helped calm the market, but clearly a lot of damage has been done. The Fed buying mortgages actually helped trigger margin calls. This is because mortgage originators protect their loan pipelines with interest rate hedges to buffer the impact of market rates moving higher than “locked in” rates. These hedges are profitable when MBS prices fall, but the Fed’s massive purchases pushed rates lower. Therefore, broker-dealers put out margin calls and stressed lenders’ liquidity positions.

This also still leaves the non-agency resi and non-agency CMBS space in turmoil, which we’ll discuss next, as names like Annaly is down 62% from the peak in late February. REM, the mREIT etf is down 70% as is MORT.

Third Mortgage Issue: Little bit of both

Fannie and Freddie have allowed multifamily landlords whose properties are financed with performing loans to defer payments by 90 days if they’ve had hardship due to COVID-19. In return, they can’t evict someone who isn’t payment. However, this is just multifamily and just agency-backed names… that leaves 75% of the commercial real estate mortgage market in trouble.

Many other landlords won’t be able to service debt if their tenants enter forbearance or cant pay interest. I’m not sure the system can handle that (i) wave of requests and (ii) that many missed payments. Ultimately, what we will and probably already are seeing is a freeze in the CRE lending market. This too, is causing margin calls on the CRE mREITs.


Its fine to think “ok well, we can get past this. People understand the credit crunch and can forgive a missed payment here and there.” But you have to remember credit drives this economy. The credit cycle = the business cycle, which is why the Fed has gone through great lengths post-2009 to keep rates low and lending on the rise. This system is more connected than ever before. What happens now when maturities come due? There are many questions still left unanswered and this is a truly unprecedented time!