Many real estate markets in the U.S. are in prime positions for refinancing a rental property to be able to invest in additional properties. But, how do you know if you should refinance or continue with your current mortgage? It’s all about the rental market and the numbers.
Why should you consider refinancing?
If you’ve owned a rental property for any significant amount of time, you’ve likely seen a considerable paydown on your mortgage. You think, “yes, real estate is worth it, and my tenants are paying off the property.”
Equity is the holy grail of rental property.
In the paydown of your mortgage, you also are building equity in the home. You can now pull money out of the property through refinancing to purchase more cash flowing property.
Three things to consider before refinancing your loan…
First, is the interest rates. Luckily here in the U.S., interest rates keep dropping. Will the rate cuts last is a discussion for later, but for now, interest rates are favorable to investors.
The second item to consider is loan terms. What amortization periods is your bank offering investors? Does the new payment leave you with cash flow? The loan term is essential, especially if your property is currently cash flowing. The goal is to increase that monthly cash flow income.
The third factor is market conditions. If you are pulling out, equity can be risky unless you’re going to purchase a new property at a decent price range and location. You want to find a property that’s going to be cash flowing in the first month. No, it may not be a windfall, but positive cash flow is the key to a good purchase. Consider purchasing a rental in a B class rental neighborhood if the prices are reasonable. Buying in the right area will increase the chance of bonus appreciation, if and when that occurs.
If what you’ve discovered about interest rates, terms and market conditions are leading you toward refinancing, you now want to evaluate the costs.
How to evaluate your current mortgage and cash flow…
Be conservative on purchase amounts and weigh all your decisions heavily on cash flow. Cash flow must always be positive. If you need to put more money down than you want to, or to speculate on rent increases to justify your purchase, you shouldn’t do that deal. Know your numbers and base your decision solely on those numbers.
If the numbers are favorable to refinance your loan and purchase additional property, when should you say yes, to looking for the new property?
There are real estate mentors out there who teach a “buy, refi, and repeat” model of purchasing rentals.
Try to stay more conservative. You should have funds set aside for the “just in case,” factors you could run into in the first five years of ownership. If you have very little equity because you pulled your downpayment back out of the property and used it on something else, you could be in for trouble.
You also don’t need to wait until the home is almost paid off…
If you can:
Refinance your loan,
Pull out enough for a 20-25% downpayment on a new rental property,
Both properties cash flow;
Then moving forward with a refinance seems like a good deal.
Otherwise, your equity is dead money you can’t retrieve until you sell the property.
There are a few other factors you want to consider before pulling out equity in a rental property such as the ability to get new financing, giving up cash flow, starting over to build equity in a new property.
What are some other benefits to refinancing and additional property other than cash flow?
One benefit is tax deductions. Do you remember those? When your mortgage interest payment for the year was reasonably high, this deduction made an impact on your tax statement. As the loan decreased, so did the interest payment and deduction amount.
The second benefit is counterintuitive. New properties often require renovations. However, if you improve the rental, not only can you write off significant renovation costs, but you can increase the rent amount.
There may be other items you can depreciate as well as the building itself. I’m not an accountant, so speak to your tax professional for advice specific to your situation.
The third benefit is your net worth increase. Yes, technically, your liabilities also increase for a short time. However, your net worth will continue to rise for as long as you gain new equity.
The fourth benefit is you will own property to hold long term. If you wait until you have a significant amount of equity before refinancing, you’ll have steady growth in real estate acquisitions. You are growing your portfolio nicely over time.
The fifth benefit is that your cash flow increases over time. You’ll now have additional cash flowing property paying you. As this new mortgage gets paid down, the margin will increase, giving you even better cash flow than when you purchased the property.
Break out the bubbly; it’s winning all around.
Share the wins…
Here is a short example of some investors who held a rented property for ten years.
They were looking over their numbers and found they were break even every month. If they had any repairs in a given month, they were losing money on that property.
They had never refinanced their loan. With each renewal, the investors kept the monthly payment the same while decreasing the amortization time. Following the same payment plan created an extreme paydown situation year after year.
They realized the home would be paid off within five years. They also realized they had between $60k-$70k locked up in the equity of the house.
After looking at other rental markets and discovering they could use the equity for possibly three down payments, they ran the cash flow estimates for new properties.
They found they could double, and possibly triple their monthly cash flow in the first year if they refinanced the property to invest in additional rental units.
While you may not be sitting on as much equity as this couple, consider what a new loan down payment would cost and the potential upside of owning a new property. If it fits your portfolio style, you may want to start researching to see if refinancing is right for you.