In November 2019 I closed on a cash-out refinance on my primary residence to pull out $106,000 to invest into Denver rental properties. As discussed in earlier posts, the equity in my home is an opportunity cost.
The new loan increased my monthly mortgage payment by $480. This post will walk you through all the details of my decision-making process to pull the trigger and why I'm happy to spend $480/mo to have $106,000 to invest now.
This post is part of the Investment Property Anaylsis Course. The course teaches you how to analyze a rental at purchase and how to review it annually to optimize your returns.
Three Learning Options:
- Listen to episode "#123: IPAC #6 - Case Study: Investing $100,000 from a Primary Residence Cash-Out Refinance" on the Denver Real Estate Investing Podcast
- Watch the YouTube video at the bottom of the page.
- Read the blog post.
Determining the Amount of Equity
My wife and I are house hacking by having her mother live with us to help reduce living expenses, namely daycare for our little ones. All of us wanted separate living spaces. Unfortunately, we couldn't find a home that met our needs with an existing mother-in-law suite. Instead, we bought a home with a walkout basement.
In 2018 we remodeled the basement into a beautiful mother-in-law suite. The original budget was $75,000, but it ended up totaling about $100,000. Damn scope creep! Well, it was expected. The basement is about 1,400 sqft and now has a full kitchen, living room, master bedroom, master bath, and a guest bedroom. The finishes are quite a few steps above rental grade finishes.
Spending $100,000 to remodel a basement is a lot of money, but it's a complete win/win from a personal and financial perspective. From the financial perspective, my MIL didn't want a monthly mortgage payment, and we didn't want to outlay a huge chunk of cash. My MIL sold her previous home, spent $100,000 on the remodel, and we will take care of all the on-going costs and the mortgage.
Estimating the new value was very hard to do because there are no good comps. Typically, one can pull some comps to get a quick ballpark or have an agent run a CMA (Comparative Market Analysis.) I spent a couple of hours looking at the MLS but couldn't find anything.
During a cash-out refinance, who determines the value of the property? It's not me, you, or the market. It's the appraiser.
Spending $100,000 in upgrades does not directly translate into a $100,000 value increase. Generally speaking, the total amount spent on upgrades will NOT increase your home's value by the same amount. Home upgrades typically give you a very poor ROI. Even if I got 50 cents on the dollar, I could still pull out some money to invest between the upgrades and some market appreciation.
I called up Joe Massey at Castle & Cooke Mortgage to start the cash-out refinance paperwork. It's $600 for an appraisal. Worst case scenario, I'd be out $600 if it didn't come in at a value of $700,000 or higher to make it worthwhile for a cash-out refinance. I started the paperwork and paid for the appraisal.
Since I'm an agent, I see more appraisals than the average investor. Here's the interesting thing, you can have three different appraisers appraise the same property and get back three different values. And all three are correct! The appraiser is giving his or her expert opinion based on their knowledge and available data. Appraisers determine the value by talking with agents who sold properties they are using as comps, using information that they have compiled over the years, and using data on the property from the MLS.
I scheduled the appraisal for when I was home to walk the property and answer his questions. Before the appraiser came over, I made copies of all the receipts, work orders, budget plans and anything else related to the basement remodel. My goal was to provide him as much data as possible, so he could accurately value my house.
We spent 45 minutes walking the property, discussing the upgrades and answering his questions. If you've never met with an appraiser or read a report, it's nothing exciting, but it was 45 minutes well spent.
He left, and the appraisal came back a few days later...
It appraised at $775,000!
It was above my $700,000 threshold to make the cash-out refi worth it. YES!
Reviewing the Cash-Out Refinance Options
I'm not a lender nor an expert on cash-out refinances. Make sure you talk with a lender to get details specific to your situation as there are many different options available.
My existing mortgage balance was approximately $430,000. The new cash-out refinance has to pay off the existing mortgage amount. The difference (minus closing costs) is the cash that I get to take out.
Consideration #1: Loan to Value (LTV)
If you've read my investing strategy, then you know I'm a fan of maximizing leverage while holding high cash reserves to minimize risk. The same concept applies to the cash-out refinance on my primary.
A 75% LTV is typically the sweet spot for maximizing a cash-out refi, while also getting the best interest rates. Since it's my primary, an 80% LTV option was available, but it came with a higher interest rate. The higher interest rate was NOT worth the trade-off for pulling out a few more dollars.
75% of $775,000 = $581,250. The 2019 conforming loan limit for Douglas County is $561,200. If I did a 75% LTV, then my loan would fall under a "high balance loan." I don't know the details of it other than it has a higher interest rate. The extra $20,000 that I could pull out was not worth the higher interest rate.
For my situation, it made the most sense to maximize to the conforming loan value of $561,200 or a 72.4% LTV.
Consideration #2: Buying Down The Interest Rate
Joe presented me with four different interest rate options. The original interest rate required no discount points. The lower the rate goes, the more money I have to pay upfront to buy the interest rate down. Below is a table that breaks everything down. Descriptions of each row are below the table.
Interest rate - This is the final note rate for the 30 year loan
Loan amount - It stays the same at $561,200 which is the maximum amount for Douglas County, CO in 2019.
Closing costs - It stays the same at $3,122. Here's a break down:
- Processing fee: $745
- Underwriting fee: $795
- Discount points are included in here but have a separate row (see below.)
- Appraisal fee: $600 (I paid this directly and outside of the closing table)
- Title - Settlement fee: $240
- Title - Lender's title insurance policy: $1,175
- Mortgage recording fee: $167
Discount points - The amount I'm paying to buy the rate down. 1 point equals 1 percent of the total loan amount. For example, take the discount point of 0.75% x $561,200 = $4,209. The row shows the percent and the dollar figure.
Cash-out - The total amount of cash I walk away with.
Monthly P&I (Principal and Interest) - My monthly mortgage amount is before taxes and insurance.
Break-even period (months) - How many months will it take for me to break even between the amount spent on the point buydown and the monthly savings. The monthly mortgage payment savings on the 3.75% loan vs the 5.125% loan is $456 ($3,055 - $2,599). Simply divide the discount points paid by the monthly savings, to determine how many months it takes to break even: $14,030 / $456 = 31 months, or about 2.5 years.
I chose the 3.75% rate option with the $14,030 point buy down.
I spent a couple of days debating which option to go with. Ultimately, the 3.75% option won out for me. Here's why:
- From a personal budgeting perspective, I wanted to keep my PITI (Principal, Interest, taxes, insurance) to around $3,000/mo.
- The $14,000 cash-out difference doesn't move the needle on buying more rentals. Getting a $100k+ does.
- My original mortgage payment is $2,118/mo for PI. The 3.75% option "costs" me an extra $480/mo to get $110,000. The 5.125% option would "cost" me $937/mo for $124,000. Spending twice as much each month for an extra $14,000 wasn't worth it to me.
The above table shows the estimated cash-out refinance numbers. After all the documents were signed, I walked away with $106,500 for my cash-out refinance. Why the $4,000 difference? It's because:
- The original estimates assumed a closing at the end of the month. We ended up closing early the following month, which had a much higher amount for prepaid interest (28 days vs 2 days)
- The actual loan payoff for my existing mortgage was higher than in the estimates.
Investing the Cash
Some investors will only do a cash-out refinance if the new rental property's cash flow is equal to or greater than the difference in their new mortgage payment. I would like to see the cash flow be greater, but it's not a hard and fast rule for me since rental cash flow is not everything.
I will NOT be using the cash flow from the rental property to pay the difference in my new, higher mortgage. One of my current investing rules is to keep my personal finances and investment income completely separate. My budget allows for the extra $480/mo in my mortgage payment. I look at it as a small loan where I'll happily pay $480/mo to access $106,000 right now for investing.
Going beyond cash flow and optimizing return on equity will give me a far greater return over the next 30 years. If I can keep the $106,500 amount growing at 10%+ a year, I'll be very happy with those returns! Using the power of leverage and repositioning equity, I'm confident that I can.
3/2 Aurora Condo Investment Example
I'll reference the 3/2 condos in Aurora that we purchase regularly for modeling purposes. For the sake of simplicity, I plugged them in as one property into the rental property analyzer spreadsheet . I doubled the expenses and rents as appropriate. It may be off by a few dollars, but it's close enough.
The total initial investment needed will probably be $111,000, possibly a few thousand dollars more if any initial repairs are needed. The difference of $5,000 between my cash-out refi is something that I can make up.
1st Year Returns
- Cash-on-cash return: 7.3%
- Cap rate: 6.6%
Return on Investment Quadrant™
Cash flow comparison:
- My higher mortgage is +$480/mo or $5,760/yr
- The cash flow from the two condos is $8,191/yr
The rental property cashflow is $2,431 more than my increased mortgage payment. Win!
It's an estimated 25% ROI on my money. Win Win!
Don't forget about depreciation at $3,091/yr. Another win!
Don't forget about depreciation. That should bring in another $3,091 a year in cash flow come tax time. Think about this. The depreciation benefits alone cover more than 50% of my higher mortgage payment. Another win!
The Big Picture (and Big Win!)
Too many people get hyperfocused on the cashflow difference between the rental property and their new mortgage payment in the first year or two. Go beyond cashflow and beyond a few years to evaluate the big picture.
In 10 years, the two condos should return:
$81,910 in cumulative cash flow (assuming no rent increases) and $297,000 in equity.
The new mortgage payment difference will cost me $57,600 ($480 * 12 months * 10 years.) Remember, this is a 30 year fixed mortgage, so my payment amount does NOT go up.
Is spending $57,600 to make almost $400,000 a good investment? Yes!
Assuming you take all your rental profit and simply save it in a bank account, you should have enough to buy one more rental.
What's the equity opportunity cost on $297,000? A lot depends on how good these are as rentals in 10 years. Perhaps the complex shifts from investors to owner-occupant, and it's time to cash-out. Who knows! With that much equity, you'll have options to refinance or sell to buy more rental properties.
Remember, this is 10 years out on the 30-year refinance loan. What's the return look like over 30 years saving cash flow and maximizing equity opportunity costs a few times by selling or refinancing? It looks pretty good to me. I wouldn't mind repeating my Reno, NV condo to a fourplex in Westminster, CO transaction a couple more times!
Hopefully you understand why I pulled cash out from my primary. As I'm typing this blog post, I haven't bought any rental properties yet with my cash-out refi. I'm expecting that whatever I buy will make far greater returns than my new higher mortgage of +$480/mo. The cash flow will get reinvested, and the future equity will get tapped into at some point.
Please share your thoughts and questions in the comments below. If you need help running numbers and scenarios for equity in your primary residence to invest with, then let's get together for a real estate investing consultation.
Webinar recording - Watch it here or listen on the podcast.
- Overview: Investment Property Anaylsis Course (IPAC.)
- Module #1: The Four Returns in Real Estate: Cash Flow is NOT everything
- Module #2: Rental Property Analysis Spreadsheet Tutorial
- Module #3: Return on Equity: Playing Adult Monopoly
- Module #4: Refinancing Your Primary Residence to Purchase Denver Investment Property
- Module #5: Tapping into Your Primary Residence Equity Updates - Part #2
- Module #6: Case Study: Investing $100,000 from a Primary Residence Cash-Out Refinance