Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.
This is a quick Ask Marco episode. I’ve been getting a number of questions related to cash-out refinancing, and some of these are strategy-related questions. So I’ve put two or three of them together here that I will attempt to answer and cover as best as I can.
Download your FREE copy of The Ultimate Guide to Passive Real Estate Investing.
If you missed our last episode, be sure to listen to AMA: Does it make sense to withdraw IRA funds early for a down payment on a rental property?
So before I do that, I’m sure everybody has been watching the real estate news and seeing what has been going on around the country in terms of price appreciation, tight markets, multiple offers situations, and just how incredibly on fire real estate has been in the US and I’m talking in general terms here, obviously it’s market by market and very much market specific, but we are just seeing an incredible here this year. We will probably close out again. This is on average the year with over a 16% average annual nationwide home price appreciation.
This is more focused on new construction than existing sales, but the existing home market has also been just as strong if not stronger. And I’ll have more information on that in coming episodes. I don’t have that data in front of me, but I don’t think the next two years, 2022 and 23 are going to be as strong in terms of price appreciation. And when I say strong, I mean, as crazy as what we’re seeing here, but everything is incredibly strong. Existing home sales have been strong, existing home values this year, just from one of the indices I follow has just broken 20% year over year, which is unbelievable. The month of supply out there, meaning the amount of inventory in the resale market is a whopping low 2.6 months worth, which means that if there was no new inventory, the existing demand for that would basically take all the inventory off the market in two and a half months.
So again, we’re living in crazy times and interesting times, but I will have a little bit more to say about the US housing market health and the pulse of it, as well as some single-family rental stats in an upcoming episode today, I want to just focus on some of the questions that I’ve been getting in terms of cash-out refinance. And so I’ll cover two, maybe three of them here they’re related, and there is some overlap, but the scenarios are different. So I thought it would be interesting to just talk about that. So the first question comes from Casey and Casey writes in and says, hello, thanks so much for all the great content and resources I’ve been listening for about a year now. And I, your show, I’m learning so much. I worked with Melissa and recently closed on my first investment property.
Well, congratulations. And I’m glad to hear that you are building your portfolio. It was a great experience and I’m excited to continue growing my portfolio with Norada. My question is how do you decide when it’s time to do a cash-out refinance on a property? What factors should I consider other than making sure I can cover my expenses? And third, do I wait until I can pull out my original investment? In my specific situation, I purchased a Memphis property for 120,000. I financed 90,000 and it appreciates, or it appraises for 145,000. It was already occupied and currently rents for $960 a month. But the market rate per the property manager is closer to 1,035. I don’t necessarily need a high cash flow, but I would like it to pay for itself. I also have a reserve of four months rent set aside. My short-term goal is to acquire two to four more properties in a hundred to $125,000 range over the next two years.
Cheers, Casey. All right, Casey. Well, thank you very much for this great question or questions, I guess. So let me address these in order here. So to your first question, you know, when is it the right time to do a cash-out refinance on a property, or how do you decide? Well, first and foremost, whenever you do a cash-out refi, most every lender will have a maximum loan to value that you can refinance to pull cash out. So the typically will not go over 75% loan to value. Sometimes they’ll go as high as 80%. If you have exceptional credit, like seven 60 FICO score and above, but there’s other factors that are involved in there for the sake of argument. And as a general rule of thumb, let’s just call it 75% loan to value. So when you have a property and you take the value and you look at seventy-five percent of that value, if that number is higher than your existing financing, whatever liens or debt you have on that property, if you have any margin outside of that, that would be the cash-out amount you could take out.
So you obviously want to have your loan as low as possible and your market value as high as possible. So the difference between the two, the Delta is as wide as possible. Anything over that 75% loan to value threshold or minimum would be equity that you can pull out on a cash-out basis. That’s pretty simple to understand. So hopefully that wasn’t confusing. Now, having said that if those numbers pencil out and you have the equity there above that 70 or 75% LTV that you can pull out, you can look into doing a cash-out refi. Now, when you do that, you know, you’re asking, how do you decide? Well, you want to make sure that your cash flow is not negative. And if it is, it’s not largely negative, having a negative cash flow is not a bad thing as I’ll explain here in a minute, but you don’t want to have a lot of negative cashflows nor do you want to have negative cash flow across a lot of properties because you want to be overall cashflow positive.
Now, there are some exceptions to this rule, but generally speaking, you don’t want to be carrying negative cash flows on properties. It just is much easier to weather downturns, recessions, or, you know, disruptions in the economy or the local market. If you encounter a situation where you have to lower your answer, you’re going to experience higher than normal vacancies. So just think about that, you know, logically and objectively, but there are opportunities that come along. And when those opportunities present themselves that have greater upside potential than just holding onto that one property that you could do a cash-out refinance on, then it would probably make sense to do the cash-out, refinance, pull some of that equity out. And this is a tax-free event. You take those funds from that refinance, and you use that to make your next investment. In this case, we’re talking about real estate.
So you would use that as your down payment to put towards the next purchase, your next rental property to build your portfolio. Now, this is a very good strategy. And one that helps you build your portfolio faster than just through the process of saving up through your income or your business profits and whatever else. If you have equity, if you have lots of it, then you can tap into it and put it to work. I call it dormant equity. Sometimes I’ve referred to it as dead equity. The thing is, is it’s there. You own it. It’s part of your net worth. It’s part of your overall asset profile. But if you can’t put it to work, it’s really not doing anything for you other than just being a number on your balance sheet. So this creates the cash to invest. You don’t spend it on cars or vacations.
You use it to put, to work. You want to leverage it. And that’s what you’re doing is you’re just basically moving it from that one property to another property and putting it to work, growing your portfolio and faster. So as long as there’s greater upside, and as I’ll talk about here in a minute, you will find that your greater upside is when you have properties that are amortizing alone and appreciating where those returns that are being created from the new property purchased by that cash out equity is larger than the cash flows you would have had if you kept it in the property and not done the cash-out refi. In other words, if you’re giving up $200, let’s say per month in cash flow on the property that you just did a refinance on, but you’re making 600 or a thousand dollars a month in cash flow and equity growth on a new property that you’ve purchased using the equity you’ve taken out in that cash-out refinance.
Well, that’s a big difference. That’s a huge Delta. You’re now accelerating your wealth creation and potentially even your cash flow in this refinance scenario. So that’s the thought process that I take and that you should take when you’re trying to decide whether it’s time to do a cash-out refi or not. It’s just, what’s the highest and best use of that equity. Where is it going to work the hardest for me? So your second question here is what factors should I consider other than making sure I can cover my expenses? Well, obviously, you know, I just talked about it, but the cash flow, is it positive, neutral, or negative? If you have the ability to raise rents, as you mentioned here, you’ve got the ability to bump it up. Maybe not this month, but when the lease expires or it’s time to renew or time to bring in a new tenant, we’ll certainly increase the rent as much as you can without, you know, inhibiting your ability to lease that property out.
So raise the rents. If that refinance also allows you to lower your interest rate on that mortgage, where you are lowering your monthly mortgage payment, well, even better now you’ve increased your cash flow as well. So that’s the second way to increase your cash flow. So refinancing is not just about pulling equity out above your property refinancing. Sometimes it’s about lowering the cost of capital on the financing, the loan on your property to lower your monthly payment. And then another point I’ll make here is that, you know, you’re budgeting the cost of the refinance, which for the most part is an expense. So you’ve got to budget the cost of that refinance. There’s going to be a cost in doing the refinance. It might be a couple thousand dollars. It might be a little less or a little more, but that’s an expense. Yes, it’s a tax deduction.
It’s something you can write off, but you know, also keep that in mind, that is not a big deal. That should not be a make or break factor because the cost of doing the refinance should never be so high, that it makes the decision, you know, a poor decision. It’s just a cost of doing business. And then your third question here, do I wait until I can pull out my original investment? No, not necessarily because if that’s your goal or your objective is to pull out your original investment, meaning the down payment then like in your scenario with your Memphis property, it’s $120,000 when you bought it at $90,000 finance, that’s a $30,000 down payment. If you’re going to wait to get to the point where you can pull out that 30,000, you’re going to be waiting longer, maybe much longer, depending on the rate of appreciation in that market.
So it typically doesn’t make sense to wait until you recoup your original investment and it makes more sense to figure out, okay, what can I net out in terms of equity from a refinance that I can now apply towards the purchase of one or more new properties? So in your case here, you have a Memphis property appraising for $145,000. If you do a 75% LTV cash-out refi, then you’re looking at 108,750. That’s what you can refinance the property for subtract original mortgage of 90,000. You’re left with just close to $19,000 of cash-out capital that you could use. So at this point, without letting it sit for a little longer, you can pull $19,000 out approximately and use that towards the down payment of another property. Now that might be a little short unless you’re looking at a property that’s 80, maybe $90,000, but if you’re looking at a property, that’s more, let’s say it’s a hundred, 120, 130, $150,000.
You’ll just add to it. You’ll just put in some extra capital yourself in addition to the cash-out. And that’s just a way to do it because you’re tapping into some equity plus the savings you have now, you’ve got the down payment for your next property and that’s how you build it up. And now you’ve got two or more, but two properties that are now appreciating. And so you wait to see what happens over the next year or two or three years, and keep track of how much equity growth there is. And if it’s enough to do it again, then you keep refinancing the properties that have the most equity that are not being put to work. And again, keeping your eye on the cash flow situation, but this is how you snowball your growth of the portfolio you have, and that’s you’re building. So anyway, I think I’ve made my point, Casey.
I hope that helps, but that’s essentially a strategy and a way to figure out when, and if you should do a cash-out refinance on your properties. Okay. The next question here is from Jim. And he writes in and says, hello, Marco. I really enjoy all of the great content that comes from your podcast and look forward to new episodes every week, while I apologize for the last couple of weeks that I haven’t put out an episode, I’ve been traveling quite a bit. There’s a lot of things going on this summer here with some projects I’m working on and I’ll be sharing more of those projects that I’m working on here in the coming months. So stay tuned for that. Jim says, my question is focused on if there is a point at which it is wiser to not pull out the cash from investment properties that has accrued from appreciation and or principal paydown.
I guess that’s the question. If you start with a property that is cashflow positive, and then you have the chance to do a cash-out refinance because the property goes up in value, should you pull out funds even to the point that on that one particular property, the cash flow goes negative because it has had a cash-out refinance, but you would have more properties bringing in cash flow to make up for the negative cash flow on the first property, or do you recommend only pulling out funds to the point that the property is at a breakeven point? Question mark. That was a long mouthful of a sentence, but I get your question. Thank you so much for your time. And I look forward to your insight. Okay, Jim. So I guess the short answer to your question is yes. When yes, it makes sense to do the cash-out refi when, and then I’ll give you kind of the, my following bullet points.
If you will, the total cash flows across all your properties balanced themselves out. So if you’ve got three properties, one of them is negative. Two of them are positive and on the whole you’re net positive. That’s kind of a myopic way to look at this, but it’s just one way to look at it. So I would say overall, it’s best to be cash flow positive and cash flow negative. You’re going to have ebbs and flows. You’re going to have market fluctuations. You’re going to have vacancies. You’re going to have maintenance and repairs and things that come up. So ideally you want to stay cash-flow positive because ultimately longer term, you want to be in a position where you are generating a significant amount of passive income from your properties. You build up to that in the beginning, especially if you’re younger, you want to be in growth mode.
And what that means is you’re building your portfolio as large and as quickly as you can. But again, not getting into a situation where you’re going to be cash strapped or financially strapped because you’re having to carry and service all the properties, the properties that need to pay for themselves, but the need to carry themselves. Meaning that when all said and done net, net, net, they are covering all their costs, including debt service, short term, it’s okay to be negative. If you’re making a strategic move to acquire more property and then convert them or increase the rents on those. So they are cashflow positive, but ultimately you want the rents to increase as your mortgage is paid down. And then at some point you’ll accelerate the payoff of those mortgages to the point where if this is your strategy, you’ve got them all paid off and now you have no debt service and everything coming off, the property is just the net operating income from the properties are all net cash flow to you.
And that’s when you really start to see, you know, some significant numbers, monthly and annually, that support you financially in your lifestyle. But you know, if you’re in growth mode and you’re just building things up, this is how you have to look at it. You have to look at it strategically. And how can you accelerate the growth of your portfolio? So you can have maximum cash flow later. Now, if you’re doing this at the age of like, let’s say 65, that obviously is not the best strategy, not ideal. So the total cash flows are one thing to consider when the upside is greater with the refi to build a larger portfolio. That’s when again, you consider the refi and taking on a breakeven or negative cash flow, I guess to your question, I don’t necessarily shoot for a break-even point. First of all, you can do that on paper and you can project or do a proforma and you can figure out what is your break-even, and then work backwards from there and figure out, okay, what is my maximum cash-out refi?
And you could do it that way, but I don’t think that’s the optimal way to do it. I think it’s better to just look at what is the most I could take out and work backwards from there. So if the maximum amount of equity that you pull out through a cash-out refi is large, then maybe you don’t need that much and you scale it back. And if you work backwards from there, you can see at what point you’re going to have a new mortgage on that property that you’re doing the refinance on. You can check to see at what point you get to break-even based on your monthly mortgage payment. So for me, rather than looking for a breakeven point, I start with what is the maximum possible cash-out refi I could do? And if it’s more than enough, if it’s too much, I scale it back.
If it’s not enough, then I rethink it and I reconsider, how much do I really need? Is it even worth doing a cash-out refi to pull out, you know, five or $10,000 for a down payment, which is something, but it’s not really enough. So consider that the last point I’ll make here. And this is true for all questions about cash-out refinance. You have to look at the math, run the math, do the math, look at the numbers. You know, if you have a negative hundred dollars cash flow on your first property, call it property. Number one, I’m using yours as an example here, and you have a negative $100 cash flow per month, but you have two other properties that have a hundred dollars positive cash flow each, and I’m talking small numbers here, but simple math, just for the sake of illustration. Then across those three properties, you have a net positive, $100 net cash flow.
Now you can play with bigger numbers or you could play with this example using 10 20 properties, but then, the illustration or the point is the same overall. You want to be cash flow positive. Also, it’s best. If you have short-term negative cash flows, meaning that if you’re negative on a property for six months or a year, because you have the ability to raise the rent, but you just can’t do it now, or you’re not ready to do it. Keep in mind that you can get yourself out over time out of a negative cash flow situation, assuming you’re in a good market with good fundamentals and you’re in a good neighborhood, not, you know, a neighborhood that will struggle in harder economic times. You want to be in solid bread and butter communities. What I like to call your B B plus, and A minus class neighborhoods, those tend to fare best in good times and bad.
So, you know, look at it, not just today, but look at it. What will it be like a year from now two years, three, five years down the road, and then last but not least, and this is kind of a major point, and I did an entire episode on this. So if you get the chance and if you haven’t heard this episode, go and listen to it. And if you have heard it, maybe it’s worth listening to it again. But I believe the episode was titled The REAL Returns of Real Estate Investing. I’m pretty sure that was what it’s called. The real returns or real rate of returns of real estate investing. And what I illustrated there is the following. A lot of people are focused on cash flow or the rate of return your cash on cash return in terms of the cash. And that’s important.
And that’s great. That’s all well and fine. But what you need to understand is that your cash on cash return initially, let’s just call it in your first year of an acquisition might be anywhere from, let’s say, low, low end five to 6% cash on cash to a high of let’s say nine, 10, even 11, 12%. That’s your cash-on-cash return. That’s the cash flow, the net cash flow from the property as a return over the course of that year compared to your down payment. So it’s really your annual cash flow divided into your down payment. And so that gives you your cash on cash return. And that, like I said, it could be anywhere from, let’s say 5 to 12%. That’s a wide range. It probably is more like realistically six to 8% today on many properties that you’re going to be acquiring from a rental perspective.
But at the same time, over the course of that 12 months, when you’ve bought that property, you know, everything else being equal here, you know, we’re making the assumption that I’m not changing the purchase price, the down payment, the net cash flows were, you know, we’re looking at a fixed interest rate and I’m assuming a 4% rate of annual appreciation and a 4% inflation rate. When you look at two other returns, your return on equity, meaning the amortization of the loan. And you look at the appreciation, which we just said was 4%. What you need to do is look at what your returns are on those other two elements. And if you are purchasing a property with 20% down and you’re amortizing alone, a 30 year fixed rate mortgage at 5%, that first year, you’re looking at about a 6% return on that equity. Now that’s obviously not liquid it’s illiquid has.
It’s not a realized gain it’s in the form of equity, but it’s still a 6% return on your down payment. Plus let’s not forget the appreciation, assuming a 4% rate of appreciation, which today sounds very low. But historically speaking, you know, it’s going to be between four to six, maybe four to seven or even 8% depending on the market and the location, but on that same property with the same down payment and that mortgage in place, that appreciation would be the equivalent of a 20% rate of return. So if you take that property at a 4% appreciation and divide that into, again, your investment, which is your down payment, you’re now seeing a 20% rate of return. So if you look at those numbers, you have a cash-on-cash return. That’s in the somewhere in the 5 to 10% range, but you also have two others.
So even if you have negative cash flow, let’s call it zero. If you have zero cash on cash return, you still have to unrealized gains in the form of equity, growth, and appreciation tune of 6% plus 20%. So you just made 26% unrealized gains in this property with zero cash flow. So if you don’t need the cash flow today, you could live without it for the next year or maybe the next several years, because your strategy is to grow your portfolio and have as much property as possible. And those properties plural are appreciating and gaining equity because of the amortization of the loan. Well, you’re still getting ahead. You’re still gaining. You have a running gain in your portfolio, even though it’s not liquid cash spendable cash today. So you always have to keep that in mind that there are more than one ways to make money with real estate.
You have multiple dimensions in terms of rates of return. And so it’s not just the cash flow, that’s something you obviously want to build, and you will over time as you grow your portfolio, but you have to ask yourself, where are you in your investment game plan? All right, Jim, I hope that helps answer your question, and I hope that it’s helpful for everyone else. So I’m going to stop right here. I know that I try and keep these episodes between 20 and 40 minutes with 30 minutes being the sweet spot. So I will just wrap it up. I appreciate the questions. I love every one of them. So keep them coming in. I’m going to do my best to get to as many as I can.
I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. We’re releasing one every week, sometimes two, and I would not like it if you missed an episode. There’s just a lot of great nuggets and good content sprinkled throughout this show. If you have a question about real estate investing or finance, simply go to passivereaestateinvesting.com and click the Ask Marco button. I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco. Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See our available Turnkey Cash-Flow Rental Properties.
Please give us a RATING & REVIEW (Thank you!)