In our November 25th article, The Power Of The Buy & Hold Model, we laid out 5 benefits of holding rental property. Over time, 2 of these benefits lead to the “BIG E” – EQUITY.
What is the BIG E?
Equity in a home is simply the difference between the value of the home and the amount of money that is owed on it. For example, if you own a home that appraises for $250K and you owe $100K, you have $150K in equity. Equity is very powerful and, if used correctly, can be a tremendous wealth building tool.
Equity grows in 2 main ways. The 1st way is through price appreciation. The median home price in the United States at the end of 1990 was $121,500. At the end of Q3 2019, the median value was $310,900. Median prices grew over $180,000 during this time frame.
The second way that equity grows is from mortgage principal pay down. Each month a mortgage payment is made on a property a portion of the payment, assuming it’s not an interest only loan, goes against the overall amount owed on the property (principal). What’s great about rental property, assuming that it’s a cash flowing unit, is that you, as the owner, get the benefit of this without actually having to pay for it. The rent you collect pays off both the principal and interest. Each and every month the equity balance is credited to you and, given the way that most loans are amortized, the amount credited to you actually increases every month. How cool is that?
Equity Looks Good On Paper, But What Can I Do With It?
You can get more houses! If done correctly, using your equity to acquire another property can kick off a virtuous cycle of wealth building.
Many investors are focused, as they should be, on ROI (return on investment). It is a great metric to use when analyzing the quality of a deal, especially when comparing it to other potential deals. It measures how much money you expect to get back relative to how much you put at risk.
Another compelling metric to focus on is ROE (return on equity). How much return are you getting on the equity in your investments? A paid off rental property that is worth $200K will cash flow nicely, but consider this. The ROE on that property is exactly 0%. There is $200K of equity that is sitting idle. It is sleeping. It is not working. Savvy wealth builders know that one of the keys to building wealth is to mobilize all available resources while controlling risk. They get their money working for them.
How To Get Your Equity Working For You
A Good Tool: Home Equity Loan – Most banks generally will lend against a property as long as the borrower is qualified and there is 20%-25% equity in the home. Let’s say an owner has a property that is worth $300K and they owe $100K ($200K in idle equity) They can go to a bank and get a 2nd loan on the property for up to $140K. (Total outstanding balance of $240K on value of $300K = 80% loan to value and 20% equity)
Now if they are a non financially disciplined person and decide to use that money to BUY non appreciating or non cash producing assets, things or frivolous experiences, then they are destroying wealth. But if they use that money to ACQUIRE a cash flowing rental home, they are building wealth. Think of it like this. Instead of the $140K being fast asleep in the guest bedroom of the 1st house (doing nothing), it is simply moved to an “office” in the rental home where it is “printing” more money and creating the potential to build even more long term equity.
If the owner wants to get more aggressive, they can use the $140K to acquire multiple homes. For example, they could buy two $150K homes with $70K down on each or 4 $150K homes with 35K down on each.
A Great Tool: Cash Out Refinance – A cash out refinance is similar to a home equity loan with the added benefit of being able to potentially reduce the payment relative to the existing loan (depending upon interest rate and amortization schedule.) Additionally there is benefit to having 1 loan on the property vs 2 loans as is the case if you do a home equity loan on a house with an existing mortgage. Home equity loans, if they are 2nd loans on the property, may have a higher interest rate because lenders view them as slightly more risky because they are in 2nd position. Not so with a cash out refinance.
There are 2 additional things to point out about home equity loans and cash out refinances. You get CASH and when you are going to buy that next rental property having cash gives you a competitive advantage over others who want the same property as you but need a loan to get it. They will be relying on the potentially cumbersome and time consuming process of getting external financing. Not you, you are your own bank.
Secondly, the cash you get came to you TAX FREE. Getting a check for $140K after processing your home equity loan or cash out refinance came to you without having to pay taxes. Don’t underestimate how powerful this is. It is like having to work for a year at a W2 job where your salary is $215K per year. Think about that. How cool is the BIG E?
A Greater Tool: HELOC – A HELOC is a Home Equity Line Of Credit. While there is some risk to be managed since HELOC’s often come with variable rates, for the disciplined real estate investor there may not be a better tool to accelerate wealth building. HELOC’s have all the benefits of home equity loans and cash out refinances, plus so much more.
One of the down sides to home equity loan or cash out refinance is that you start paying interest on day one after you close the loan. This puts pressure on you to deploy the money quickly. There is pressure to find deals and the risk of choosing a non optimal deal increases. On a HELOC you don’t have to pay interest until you actually deploy the funds. You can be very diligent in your deal selection. You are in the driver’s seat.
Many HELOCS offer an interest only option. For non disciplined investors, this introduces more risk. For disciplined investors, this is awesome. Why? Say you get a $140K HELOC. Your payment is not locked into an amortization schedule where a percentage of the payment goes to principal and a percentage goes to interest. For most home equity loans or cash out refinances, if you have extra money to pay down the loan, it doesn’t change your monthly payment amount, it simply reduces your principal owed (increases trapped equity that lazily dozes off to sleep).
With an interest only HELOC if you have extra money and make a payment that is larger than the required payment, you immediately gain benefit. You gain benefit by having the amount outstanding on your HELOC reduced. When the amount outstanding is reduced, what happens to the monthly payment on an interest only loan? It reduces it for the next month. When you use the extra cash flow this creates (and any other spare funds) to further pay down the loan, it starts to compound on itself. You create a virtuous cycle of increased cash flow which is used to pay down the HELOC which creates still more cash flow. Who doesn’t love a rapid virtuous cycle?
What’s more, you can put ALL of the cash you have to work immediately, but also GET IT BACK IF NEEDED. Instead of having reserve cash or an emergency fund sitting in a bank account earning 1% or so, it can be working for you in a cash flowing property with a much higher return. If there is a need for the cash, you simply take it back from your line of credit. If you find another great deal, you pull the money back off the line of credit to acquire it. This flexibility gives you much more control than other financing options.
There are more benefits to a HELOC. Banks will often waive or have minimal closing costs to open a HELOC. Closing on the other two types of loans come with transaction fees that are not insignificant. When you close on your investment property, you don’t have to pay transaction costs on a new loan for that property. Another significant savings.
Thinking Differently
The conventional narrative in our country is to do well in school, so you can get into a good college, so you can get a job, so you can buy a home. A home that you work at your job for 30-40 years to pay off. Is it smart to pay off the home you live in?
When you pay off your primary residence, you will certainly decrease your expenses. But, what if instead of paying off a 4.5% loan on a primary residence (and lose the tax benefit of being able to deduct mortgage interest from income) you acquire another asset that pays you a 10% return and comes with other benefits of property ownership?
There is a significant population of people in the country (a lot in California) who have owned their homes for 20 + years and are sitting on a significant amount of equity. They have a big ole suitcase of value sitting in their closet collecting dust. Even those with a low tolerance for risk can, through a HELOC, efficiently and powerfully use that suitcase of value to create cash flow, build wealth and move themselves closer to a position where they are not as reliant on that 40 year career at the company.
Summary
Remember the 5 benefits of owning long term rentals with smart debt:
Cash Flow
Appreciation
Mortgage Principal Pay Down
Tax Sheltered Income
Inflation Hedge
Over time 2 and 3 will lead to the Big E – equity, and equity has the power to get you more houses and more houses, over time, have the power to get you more houses and….
