Should I Do a Cash-Out Refinance?

A lot of people buy an investment property, rent it out and then they pay the mortgage every month and eventually pay it off.

Sounds like a great retirement plan, right?!

Maybe Not…

While there are benefits to paying off loans, chances are, it isn’t the right investment strategy.

Last year I pursued a cash-out-refi on one of my small multifamily properties, and that’s what I originally wrote this article about. Now, at the end of 2018, I’m rewriting and updating it to include information on that refinance, but also on the refinance of my scattered asset portfolio.

The core question is if I should pay the loans down, or refinance and acquire more.

What is a Cash Out Refinance?

In it’s simplest terms, a cash-out refinance is simply a new loan that pays off the original loan in the process.

When getting a loan, your option is to get a 2nd mortgage to capture the equity, or to pay off the original loan and get a new loan that is larger.

Often, the 2nd mortgage has a higher interest rate and shorter amortization than the first loan, so the payments are much higher. This is because the 2nd lien is much riskier for the lender, so they need to be compensated for that risk.

To avoid the increased monthly payments and higher interest, you may want to just replace the first loan with a new one. You get to keep the difference between the first loan and the new loan.

Last year I decided to pursue a cash-out refinance of one of my properties. I purchased it in 2012 and it’s appreciated quite substantially since then. I owed about $106,000 on it but it’s worth around $220,000 meaning my LTV was around 48%.

Though the cash flow is amazing, I have around $165,000 in equity I could be using for something else.

Do you think I should have done the cash out refinance or just left it alone?

How Does a Cash Out Refinance Work?

Let’s say you have a 75% LTV loan where the house is worth $100,000 and your loan is $75,000.

Now, you do some work to improve it. Or, perhaps you’ve had it for a few years or the market changes and your property is now worth $125,000.

You have two options to refinance.

#1 Get a Second Mortgage.

Assuming you could still get a 75% LTV overall on the property, that is $93,750. If the first loan still had a balance of $75,000 (obviously not realistic since it would have been paid down a bit, but go with me for simplicity).

The 2nd mortgage would be $18,750 ($93,750 – $75,000) for a second mortgage.

Let’s do some quick numbers.

Let’s say you have a $75,000 mortgage with 30-year term at 5% interest.

Total principal and interest = $403

The second mortgage of $18,750 is shorter and at a slightly higher interest rate, let’s say 20 years and 6.5%

Total principal and interest = $140

Total = $543

#2 Cash-Out Refi.

Your new 75% LTV loan would let you borrow $93,750 for 30 years. But, you might not get the same 5% interest rate as you had before since interest rates have been going up. So, the new interest rate is at 5.25%.

Total Principal and interest = $518.

So your total payment is about $25 less/month.

In this case the cash out refinance makes more sense than getting a 2nd mortgage.

Other Reason to Refinance

I have commercial loans on all of my properties. This isn’t common for residential property, but it’s how I run my business.

The problem with commercial debt is they actually forbid you from getting a 2nd mortgage on your property.

That leaves ONLY the option of doing a refinance on the investment property rather than a 2nd mortgage.

Why People Pay Down Their Mortgage

It really comes down to two things. First, they may not understand how returns are calculated or second, it may be part of a risk mitigation strategy.

So, people who pay down mortgages are either really savvy or have no idea what’s going on.

Alright, I’m exaggerating a bit, but it’s kind of interesting to juxtapose the two opposite approaches, right?

The Way Average People See Real Estate

Most people consider real estate to be like a bank. You park money in it, it grows fast enough to cover inflation (plus some more if you’re in a good market). 

To most people, it’s like a forced savings plan.

Your tenants pay the bills and maybe you get a few bucks out of it, but in the long run, the value is in the building.

After 20 or 30 years of paying down the mortgage, you’ll have an asset that is completely paid off and then the cash flow will be great! Instead of paying say, $1,000 per month, you’ll get to pocket that and it will pay for your retirement.

Not a bad strategy, right?

The Way Savvy Investors See Real Estate

Real estate is beneficial for 5 reasons –

1. Income from cash flow
2. Depreciation effect on taxes
3. Equity pay-down by tenants
4. Appreciation
5. Leveraged returns,

These benefits are offset by risks – bad tenants, insects, weather, economy, changing preferences, etc.

There are numerous ways to offset risk in real estate. You can get good property management, find real estate that has broad appeal, and insure against weather among other things.

But, the biggest way to dramatically reduce risk is to deleverage.

Yes, that’s right. Lower leverage means lower risk.

Lower leverage means less debt. Less debt means lower debt service. Lower debt service means you can have lower cash flow and still cover the operating costs.

The Savvy Investors Business Life-Cycle

When investors are starting off, they are in the growth phase. This is where they are buying anything and everything, adding a lot of value and working hard.

Eventually, this gets old and the investor wants to sustain what they have. They may seek some opportunistic investments to still achieve some growth, but generally, they are focused on just maintaining what they have.

Eventually, the investor wants to deleverage and/or divest. They will sell the properties with the lowest yields to reinvest the capital in safer investments. They may also deleverage the entire portfolio by paying down some debt or paying off some assets completely.

This all happens because people age. Older investors are generally focused on asset preservation, as the time horizon to recover losses may exceed their remaining lifespan, so taking large risks won’t make sense.

An investor that is 30 can take a huge hit that takes 10 years to recover from because they have 50+ years in their horizon.

So, a savvy investor will utilize leverage to maximize returns during the growth phase, and deleverage to reduce risk as the portfolio ages.

Compare Cash Out Refinance Rental Property to Paying The Loan Down

Let’s go back to the 2 examples above. There is also the third option.

Option #3 is to completely pay off the mortgage.

Let’s just completely take appreciation out of the picture for a moment (houses don’t actually appreciate in the long run, anyhow) and just focus on the cash flow of a rental property.

Just to keep it all super simple, let’s say your property is rented for $1,250 and you have monthly operating costs of $500. This leaves $750 for your net operating income.

If you have a loan balance of the original $75k ($403/month payment), this leaves you with cash flow of $347/month.

You have a total equity of $125,000 – $75,000 which is $50k.

So, your total return on equity is 8.3%

If you pay the mortgage off completely, you’ll have $750 in cash flow but $125,000 in equity. Your ROE would be:

$750*12 / $125,000 = 7.2%

Your return DROPS by paying it off.

Here is a quick video explaining the difference between ROE and ROI

Doing a Cash Out Refinance

Now, your other option is to cash out refi. You’ll have a total equity of $31,250 and have a total cash flow of $750 – $518 = $232.

$232*12 / $31,250 = 8.9%

Is Paying Off a Loan or a Cash Out Refinance Investment Property Better?

The obvious answer is that the cash out refinance gives you a much higher return on your equity. That’s why you should usually try to refinance loans.

But, only if you have a place to put the money! If you cash out and put the money into a bank account, your overall return will drop. For example

You cash out and put $18,750 into a bank account at 1% interest.

The total return on savings account – $187.5

Total cash flow from investment property – $2,964

Total return – $3,151.5 / $50,000 = 6.3%

So, you only want to refinance if you have a place to invest the cash!

Cash Out Refinance One Property to Buy Another

Assuming I get a 75% LTV loan on the property, I can pull out roughly $62,000 in cash from the deal.

As I showed in the example above, my cash flow will drop but the total ROE will skyrocket.

But, only if I have a place to put the money.

I’ve put a property under agreement nearby that has a total cost of $250,000 and requires a down payment of… $62,500.

So, I’ll be leveraging all the equity from one deal into the purchase of another deal.

Now, I’ll get:

• Any appreciation on both properties
• Reduced operating costs due to economies of scale
• Overall increased revenue
• Even more equity pay-down
• Even more tax incentives due to depreciation

The negative is that I will be extending out my payments by 5 years and will also incur additional debt on a new property. But, since these are all covered by rents, the risk is limited and acceptable.

So, this is a deal with very little downside and an extremely high upside potential.

You can see how powerful the cash out refinance can be!

Refinance Rental Property Portfolio

After the great experience refinancing the first property, I decided to refinance a good portion of my portfolio. 

With all the value I have added and all the appreciation we have seen in the last few years, my overall leverage on the entire portfolio was only around 45-50%, so there was a ton of equity I could be using to reinvest!

Here are a few things I learned

Most Banks Don’t Refinance Portfolios

Banks will finance one deal at a time, but many hate doing portfolios. The ones that will do a portfolio may want to do it as 5 or 7 different loans (high transaction costs) or they may want higher interest rates to take it down.

So, I went to a mortgage broker to help me out.

Unfortunately, we wasn’t able to help me very much so I went back out shopping on my own.

After calling about 5-10 more banks, we were able to find a bank that was willing to do the loan. Phew!

Portfolio Loans Have More Ratios to Consider

We’ve discussed debt to income ratio, debt service coverage ratio, and some others that you might need to know.

My bank required a 1.25x DSCR, which is pretty standard, but they had another ratio I’d never had an issue with.

The global debt ratio.

What the?

The global debt ratio is the amount of income you have on paper as compared to the monthly debt service on ALL of your properties, not just the ones under consideration.

My bank required a 1 to 1 ratio.

While this seems relatively easy to achieve, the bank loves to whittle away your actual income and add in a ton of expenses on top of what you already have. 

By the time they’re done, you look like you can barely afford to eat.

Reducing Loan Balance

Since they wouldn’t budge on my income or expenses, the only way to get the ratio in line was to reduce the loan proceeds… by over $300,000 from what I actually wanted.

Overall, it wasn’t what I wanted, but I still cashed out a ton of money and I still have the option to add a line of credit on top of the loan (since this bank offers that option!). 

So, I’ll file my taxes the earliest possible day, and apply for that while the appraisals are still good (they are good for 6 months).

Now it’s your turn, do you think you should cash-out refinance a deal or pay off the loan?