Leveraging the equity in an investment property is one of the primary strategies used by investors to scale up in their real estate assets and access capital for other investments.
Three of the most common ways to gain access to the equity in a property include cash-out refinancing, home equity loans, and home equity lines of credit (HELOC).
While these are all great options, there are cautions to be taken in each these methods.
Never Over Leverage…period. That is, do not get a new refinanced mortgage, loan, line of credit, or any combination thereof for more than what the property is worth or would be worth if the market were to drop by 15%-20%.
A generally safe guideline is to not have total debt of more than 80% of the market value of the property.
Fortunately, in today’s real estate lending environment, there are very few lenders who will let you get anywhere near a Loan-to-Value Ratio (LTV) of more than 80% on an investment property.
Ensure to Maintain a Healthy Cash Flow. Another caution is to make sure that the rental property will still safely cash flow after the new mortgage or loan payments kick in.
The new refinanced mortgage total, or existing mortgage plus new home equity loan or HELOC, will be higher than the original mortgage. Therefore, with few exceptions, the total monthly payment is more than likely going to increase. And that’s fine, as long as it does not increase so much that it erodes your monthly cash flow to an unhealthy level where you’re upside down or too close to it.
If that’s the case, then the monthly and annual loss is simply eating into the cash that you just realized through the refinance or loan. And once that lump sum of cash you took out is invested elsewhere, then its gone and not available to pay for any maintenance emergencies or vacancies.
If you’re a Cash Flow Investor, then you know that Rule #1 is “invest for cash flow”, and always strive to keep a healthy cash flow in your properties.
Be Careful of Closing Costs, Interest Rates, and Minimum Balances. Keep in mind that both cash-out refinance and home equity loans are new loans, and as such will have fees and closing costs associated with them. Make sure that the cash amount that you’re getting based on the equity available is worth the costs and fees associated.
Also, a caution with HELOCs is that the interest rate is often variable, and therefore can change from month-to-month. You need to know the maximum the interest rate could increase and make sure that the property will still cash flow against the HELOC payments even if they go up.
Additionally, with HELOCs, be sure the terms do not require that you hold a minimum balance, which could negate one of the major benefits of a line of credit.
Conclusion While leveraging the equity in investment properties is one of the great strategies in real estate investing, it should be done wisely. The idea of getting all that cash out is very tempting. But do not do it at the risk of over leveraging, negative cash flow, or high loan costs. Any one of these factors could essentially cancel out the total benefits of using the equity.
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