As you’re using arbitrage to capitalize on real estate equity (as previously pondered here)…
One of the most important factors is cash flow management.
The loan you’re taking out and the investment you’re making must align in a way that doesn’t expose you to a cash flow and liquidity crunch.
Let’s take a deeper look at risk management …
Step 1: Understand the Risks and Benefits of Harvesting Equity
Cash-out refinancing is an amazing tool for real estate investors to harvest equity, but it comes with risks. The biggest benefit is that it provides access to capital that can be used for future investments. This helps us take advantage of opportunities that may arise and expand our real estate portfolios.
However, cash-out refinancing also increases the amount of debt on a property and can potentially increase monthly debt service. This increased debt service must be carefully managed to ensure security and control of the property and/or portfolio.
Step 2: Evaluate Each Property and Market
Before considering cash-out refinancing, evaluate each property and market to determine if it’s an investment that you want to hold long term. Is refinancing the best way to harvest equity or should a sale be considered?
If you have multiple properties with equity, analyze each separately to find out which ones could provide you the most cash for the least increase in debt service. It may make more sense to just max out the properties with the most potential rather than restructure debt on the entire portfolio.
Step 3: Calculate the Cash-Out Potential
Once you conclude to hold onto the property, the next step is to calculate how much cash you may be able to walk away after considering closing costs. A high appraisal is extremely helpful!
Simply multiply the value of the property by the maximum loan-to-value (LTV) for that property type. Then subtract any current financing that would need to be paid off and an estimate for the closing costs. The result will be your potential cash out.
If you’re not sure what the maximum LTV and closing costs would be for your property, we’re happy to help you with this analysis during a Personal Strategy Session.
Step 4: Calculate and Manage Cash Flow
Managing cash flow is critical when leveraging real estate equity through cash-out refinancing. Investors must ensure that the increased debt service cost is more than covered by the increased investment yield (or comfortably covered by other current cash flows).
Calculate what your new debt service will be (mortgage payment calculator here) and figure your new cash flow.
Make a plan to manage your new cash flow. Some investors are simply stockpiling positive cash flows for a future investment fund and by reallocating this cash flow into a cash out refinance today, they get to pull that future investment fund into the present.
Will you have negative cash flow?
In some cases, it may make sense to accept some negative cash flow on a specific property in order to take advantage of an opportunity to acquire additional properties or to make investments that will ultimately increase overall returns.
For example, let’s say an investor has a portfolio of five properties, and one of those properties has been cash-out refinanced to fund improvements that will increase rental income and property value. In the short term, this property may experience negative cash flow due to the increased debt service (perhaps the other properties generate enough cash flow to cover the negative cash flow on this property). If the improvements are successful, the property’s rental income and value will increase, ultimately increasing the overall portfolio’s cash flow and providing a positive net return on the investment.
Of course, this approach should be carefully evaluated and managed to ensure that the overall portfolio’s cash flow is sufficient to service the debt. Our team can help you quickly do the math on varying scenarios.
Step 5: Invest Your Tax-Free Cash-Out Proceeds
Now you have capital to invest! And because this cash came from a refinance rather than a sale, you don’t pay income or capital gains tax … Debt is not taxed. In fact, debt service is oftentimes tax-deductible! Of course, verify these tax benefits with your CPA.
Even if you don’t have a specific investment ready to go into immediately, you can seize the timing for a high-valued appraisal to increase your opportunity fund so that when a good deal comes along you can make a move quickly.
Meanwhile, if you borrowed at 6-7% and parked the funds in a money market fund at around 4%. The net cost while you wait is really only 2-3%. Not bad!
Leveraging real estate equity for investment through cash-out refinances is a proven investment strategy for investors. Careful management of cash flow is essential to ensure that the increased debt service cost is more than covered by the increased investment yield. As with any investment strategy, it is important to evaluate and manage risk to ensure that you are ultimately achieving your financial goals.