Pulling equity out of your home to buy your next rental can feel like free money, but it isn’t. Whether you use a HELOC or a cash-out refinance, if you don’t run the numbers the right way, it can eat up your cash flow…fast. But if you get it right, the equity you’ve already built can fund your next down payment without draining your savings, while growing your portfolio!
Welcome back to another Rookie Reply! Today’s first question comes from an investor who has owned a long-term rental for eight years, with significant equity. Now, she wants to use that equity to buy her next rental, but doesn’t know how to account for the new debt. We break down how a HELOC (home equity line of credit) and a cash-out refi actually work, and how Tony used a HELOC on his own home to help cover his next down payment! We also run through the one test every deal has to pass before you tap your equity.
Ever wanted to help a family member find a stable place to live? We go head-to-head on whether to buy a condo or build an ADU, and share how to protect your investment (and your family relationships) if plans change. Finally, if you’re ready to hire a property manager so you’re not the one taking every tenant call, we’ll walk you through how to vet one, which fees to inquire about upfront, and the questions to ask before you hand over the keys!
Whether you’re tapping your equity, housing someone you love, or handing off the keys, this episode will help you make your next move with confidence!
Ashley Kehr:
Today’s rookie replies about the decisions that happen after the first deal looks possible. A lot of rookies know the strategy headline, but the real risk is in the next layer, the refinance payment, the HOA rules, the property manager, and the people who will actually help you operate the assets.
Tony Robinson:
Today, our questions are coming from rookies who are asking about things like how to underwrite a refinance before it actually happens, or a family member trying to buy housing for a disabled relative and a new property manager asking how investors actually find property managers.
Ashley Kehr:
This is the Real Estate Rookie Podcast. I’m Ashley Kerr.
Tony Robinson:
And I’m Tony J. Robinson. And with that, let’s get into our first question, which today comes from Cassandra in the BiggerPockets Forums. Cassandra says, “Hey guys, I’m new here with the question about underwriting when a cash out refi, burr, HELOC, or loan is part of your plan. I often hear in the podcast, especially the real estate podcast, talking about using your home’s equity as a vehicle to finance your next purchase. I currently own one long-term rental that I’ve had for about eight years and a 2.5 COVID era interest rate and an MTR, an accessory dwelling unit on my residential property. I have significant equity in my first home, the long-term rental, and I’m considering taking out some equity to help me buy my next deal, but I have no experience with this.” Everyone makes it sounds like a burr or other strategies like this are super easy to do because you add value or do a light rehab and you can just “take the money out for another home.” But the truth is that money still isn’t yours to keep.
You still have to pay it back to the bank, so it’s not something you can just get free and clear. So how do you factor this into your underwriting? I feel like no one talks about that part. How do you know you’re getting a good deal even though after you refinance and take the money out, you have an even bigger bill or mortgage to pay? There’s no way to really know what your interest rate or monthly payment will be or even what your new home value will be when you’re initially looking at trying to buy that property. Okay, so this is a great question, right? Cassandra’s basically asking, if I want to use the equity for my current property, how do I account for that cost as I go look to purchase my next property? But let’s just define a few things here for Ricky’s because she threw out a few terms.
I just want to make sure that we get those defined for you first. So she said cash out refi, burr, HELOC.
Those are all slightly different ways. Well, slightly different strategies and ways of accessing your capital. Let’s talk about HELOC versus cash out refi. A HELOC is a home equity line of credit where your original mortgage stays in place. So for Cassandra, her 2.5% COVID era interest rate loan, that stays in place, but she then adds basically a second mortgage in addition to her current property. So the current mortgage stays there, but she gets the second mortgage that allows her to tap into some of that equity. And a home equity line of credit operates like a credit card where you really only get billed for what you use. If you’re not using it, you’re not paying for it. Once you use it, you got to pay it off like you would a credit card. A cash out refinance is replacing your current mortgage with a new mortgage and you get the difference between the balance of what you originally owed and what the balances of your new mortgage.
So if your original mortgage was $300,000, your new one’s $400,000, you get that difference of 100K as part of your new loan. So I just wanted to define those so folks understand as we talk through what this looks like. I actually just did this on my own primary where before we moved out, we pulled the HELOC and then we use that HELOC as part of our down payment for our next property. And the way that we did the math was we said, okay, once we pull this HELOC, we know what the rate’s going to be, at least ballpark, and we just want to make sure that we account for that in the underwriting of this new deal. And can our old house, can the one that we’re moving out of with its rents cover both the current mortgage and this new second mortgage? That’s the way that we did it.
But if you’re looking at it from an investment perspective, then you simply say for the deal that I’m about to buy, if I also include the payment for this HELOC, can this new rental cover its own mortgage, its own expenses and the HELOC payment as well? So that’s one strategy to make sure that you’re accounting for those costs.
Ashley Kehr:
Cassandra, you have a really good point asking about the interest rate. You don’t know what your interest rate is going to be when you’re ready to refinance, whether that’s three in the months from now, six months from now, 12 months from now. And obviously it’s easier to estimate when you are closer, when you know you’re going to be refinancing in three months. But what you can do is look at the worst case scenario. Worst case, what do you think this interest rate will be? There was a lot of people during COVID that went and got these bridge loans and needed to refinance later on, but interest rates were like 3%, so they were getting these good deals. But then when interest rates shot up, those weren’t good deals anymore because their mortgage payment had gone up so much. And some of them couldn’t even refinance because the bank wouldn’t lend to them because it wouldn’t make sense on the deal anymore.
So you are asking a really great question. So the first thing is when you’re doing a bur, what is going to be your timeframe? So the shorter you can make your timeframe, the better, the less risk of interest rates changing rapidly. Especially if you’re a rookie, you shouldn’t be taking on a huge full gut rehab that’s going to take over a year to get done anyways. So you’re starting with something smaller. All of my first properties were cosmetic rehabs. I wasn’t ripping down vaults. I wasn’t putting in all new plumbing, anything like that. They were mostly cosmetic. So it was a very short period of time before I had to go and refinance. But you’re going to run the numbers with putting some caution in place and you’re going to look at what’s the worst case scenario of the interest rate. So play around with it.
What would happen if the interest rate jumped two points? If it went from say you’re getting 7% now and then it went all the way up to 9%, what would that look like? Would there be any cash flow left? So that would be my recommendation is use a worst case scenario number. And I don’t know exactly what that would be, I would say depending on the timeframe, but try and look and see what’s your worst case of what percentage does this property no longer cash flow for you? And then you’re going to have to try and gauge whether you’re going to take that risk that you can refinance in a period of time before interest rates jump that much. For interest rates to jump up 2%, I don’t see that happening within a three month period. Maybe in a six month period that actually could happen.
Over a year period, it definitely could. So I think gauging what your timeline is for your rehab to refinance along with looking at the worst case scenario of what’s the highest your interest rate actually could be before you’re losing money and kind of gauge that as to like, okay, how much do I feel comfortable with this deal?
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Ashley Kehr:
Cassandra’s next question is about underwriting the next debt payment before she makes a move. Our next question is about underwriting something harder to put in a calculator, a family driven housing decision. Okay, so here’s Elizabeth’s question. “My brother is disabled and needs a stable place. He receives disability. After a series of unfortunate events, he is not in a position to receive any housing vouchers. My father is helping him find a place, but my brother is a difficult person and often finds himself kicked out of roommate situations. While this is not ideal for a first time investment situation, it is the reality. So here are some of the options I’ve come up with. Invest in a tiny house in my dad’s property, but I have no idea how to recover the investment if I do.” So I think in this scenario, Elizabeth is saying she would buy a tiny home and place it onto her dad’s property.
So the second option is to invest in a relatively lower price condo nearby, which would be 99,000. If we did this, we would put down half the value of the sale price, so 50,000 and mortgage the rest so that the mortgage payment plus the HOA fees, utilities, and the weekly cleaning fee would be in range of my brother’s disability income while still giving him enough to live on. So here’s the advice that I would need. We live in Washington state. My brother lives in Texas. Who would you recommend for accounting and educating us on the tax income implications? Two, what other considerations am I missing for option two? And three, how would you recover your investment of either the tiny house on the property of a parent or looking at the condo? Thank you in advance. So great question. And I also love that this is something you want to do for your brother.
And I think that real estate investing is something that gives us the opportunity to do things for the people that we love and we care about that a lot of other investments or careers wouldn’t allow us to do. So the first question is that she needs advice on recommendations for accounting and educating them on the tax income implications. So I’ll give you my two cents and then we can give you a recommendation of an actual professional because remember everybody who’s been listening, I failed my first ever CPA exam, so I am not the person. So for the tiny home, so purchasing the tiny home, because you’re putting it onto a lot that you don’t own, you will not get any of the real estate tax benefits from that. So I potentially don’t see any tax write-offs like depreciation, property taxes, things like that. If you are charging your brother rents though, you will have rental income and you can offset some of the expenses you may have, like if you’re going to be covering any of the utilities or any expenses you’ll have to have to maintain or repair the property, you’ll be able to write off to offset the income you’re collecting from your brother.
So that’s one thing to think about with the tiny home. The second thing is the condo. So the condo, you will be owning a piece of real estate, so you will have more tax benefits than you would if you were just then putting the tiny home on your dad’s property. For the condo, when you sell the property, since you’re purchasing this as an investment property, you will have tax implications for the sale of that. The same with the tiny home as if you’re purchasing it, you’ll have to sell it at some point. With the condo, you could get more tax benefits with it because you’re owning the piece of property where with the tiny home, you wouldn’t.
Tony Robinson:
There’s another way too that we can approach the kind of tiny home is can we actually build a true ADU on a fixed foundation? And one of the things that she mentioned was how will I actually recover the investment into that property if I do? There are companies out there because ADUs are becoming more and more popular, so naturally the markets respond and there are lending options out there that help folks finance the cost of ADUs. And much like when the short-term rental industry started picking up a lot of steam post – COVID, there weren’t a ton of financing options in 2020. There are many, many, many today. The same thing is kind of happening in the ADU space where you’re seeing more lenders offer financing options to build out ADUs. So that is one way that you could potentially, not even necessarily recoup your costs, but just have less costs in general to get into it.
And then on the other hand, say that you were just going to kind of pay cash to build out this property, maybe the way that you can recoup that cost is by then refinancing your parents’ property. I don’t know what their interest rate is or what that looks like, but now that they’ve added this ADU, if they go back and get it reappraised, does that then give them the ability to get some cash back to repay the cost of building this out? I don’t know if there’s any right or wrong answer to this, Ash. It’s a very kind of deeply personal situation and a lot of kind of emotional part inside of here, but my gut I think would be to probably do the ADU on the back of the parents’ house because I just feel like from a mathematics perspective, it’s what I think would probably make the most sense.
Ashley Kehr:
I love these moments, Tony, but I’m going to disagree with you. We’re going to get into a heated debate right now. I’m going to go with the condo because with the condo, it’s two family members. It’s Elizabeth and her brother. With the tiny home, it’s her investment, her dad’s property, and then her brother living there. I think about what if the dad and the brother get into a dispute? The dad doesn’t want the brother there anymore. They don’t like living there. The brother doesn’t want to live there. It’s not like, are you going to be able to go and now rent this tiny home out on your dad’s property to somebody else? So I like the condo because it’s less personal because this is the dad’s home because she does say we will put half down. So I don’t know if the dad’s chipping in or something onto the condo or whatever, but at least it’s not the dad living there and it’s not his home or whatever.
So I think it makes it personally less complicated for the family if it is the condo. If it doesn’t work out with the brother and they decide that it’s not working out anymore, they can at least take the condo and rent it or sell it to recoup their investment. Where with the tiny home, I feel like that’s more restricted as to how they can recoup their investment if the brother doesn’t end up living there anymore with it being the dad’s property. So that’s how I look at that situation. So I’m going to say the condo.
Tony Robinson:
That is actually a great point, Ash. And the only thing that comes to mind for me is maybe a counter. And we’ve talked about this before and guys, I’m not an ADU expert in any sense because I’ve never done an ADU, but I know that we’ve interviewed Leika, Dave, Thatch Point has talked about this as well, where they’re building these ADUs and they’re actually separating them off as their own parcel. And again, there are probably implications to the initial, the main homes, maybe appraised value or even potentially the mortgage. And I’m not sure what that approval process looks like, but I wonder if they are able to do that, does that then solve that situation? So the brother’s still close, she can hopefully recoup back some of that cost of building it out and she then doesn’t have to worry about the co-mingling of her investment with her parents’ property.
Ashley Kehr:
One last thought too as to how I’ll be nice today and I will say one positive towards your choice, your situation is that she did say the brother didn’t live well with roommates and things. So maybe it won’t work out in the condo because he’ll be in apartments and he won’t get along with the neighbors or something like that, where at least at the dad’s house, he’s with the dad and you don’t have to deal with people complaining because they’re not getting along or things like that too. So there is another personal side where maybe it actually is more beneficial, but I think financially the condo is the safer bet as an investment. But also looking at the HOA too is making sure they allow it for rentals and what you can do with it as far as that too, if the brother does move out too.
All
Tony Robinson:
Right. Our last question today guys comes from Blanca Munoz and she is asking from the property manager side, but the answer is actually incredibly useful for rookie investors too because it tells you what a good property manager should be doing for your own portfolio. So the question is pretty straightforward. It says, how do investors find property managers and are investors simply interested in hiring property managers? So let’s answer this question, but again, we’ll talk about it from maybe more so from the perspective of being an investor. Well, first I think rookies need to decide, do I want to self-manage or do I want to hire a manager? And there are different reasons why different people come to those conclusions. When I bought my first long-term rental, I just didn’t have the confidence that I could self-manage it myself. It was several thousand miles away. I’d never done anything like that before.
Didn’t necessarily have someone in my corner who could guide me through that process. I was working a full-time job. I just had all these things swirling in my mind to say, I don’t know if I can do this. So I made the decision before I even bought the property that I was going to hire a property manager, just lifestyle, all those things, skillset, confidence, I just didn’t have it. So I knew that I wanted to hire someone. And my approach for finding that person was I just searched, I think I went on even just Google. I think I even checked in the BiggerPockets forums. It was a smaller town though, Shreveport, Louisiana. It’s not a major metropolitan area, but I found a handful of property managers. I emailed them all and just said, “Hey, here’s who I am. I’m looking. I don’t have anything yet, but here’s what I’m looking for in this market.” And I just sent them a few questions that I think I scraped from somewhere in the BiggerPockets forums like, “Hey, ask these questions.” And I was just trying to get a sense of who they are, how they operate, how many units are they managing, how long have they been in business, some kind of key highlights from their management agreement, like what do they charge for, what’s included, just trying to get a good sense of who they are and how they operate.
And I think of the, I don’t know, five or six that I emailed, only two of them actually replied to my email. So that weeded out a lot of them from the beginning. And then when I actually went out there, when I was closing on the property, I met with a couple of them in person and the ones who I liked more, that’s who I ended up going with. So that was my motivation for hiring a manager, and then that was my process for actually trying to source or identify which manager was a better fit for me personally.
Ashley Kehr:
Your first step is going to go to biggerpockets.com/pmfinder. I found a nice little link for you guys to go to, and you can search and find property managers in the market that you’re looking at. For me, I definitely did it wrong when I was looking for a property manager when I decided I didn’t want to do it anymore. I didn’t want one of the big huge companies that manages thousands of rentals and commercial buildings and all of this. So I looked for smaller ones. My mistake was that I found a property management company that was in its growth phase. So they had never done any large apartment complex before. And with my partner’s properties, we were giving them all together to property management. He had large apartment complexes and they would be his first. And that’s very different than managing single family and small multifamily units.
So not getting clarification on what their experience is as far as managing. Then the second thing was not getting clarity on the fees and if the fees can change. So after probably a year of having management in place, they sent a letter to every owner saying that they are going to start doing inspections in every single unit twice a year and it’s going to be like a $80 fee to the owner to do it. Well, okay, that doesn’t 80 bucks, but you’re doing it twice a year. If you have one property, that’s going to be a decent amount of your cash flow. But also too, if you have a large apartment complex, one was a 40 unit and $80 per unit, that adds up to quite a bit of money. And then once they go in, they would say like, “Okay, here’s all of these different things that we think you should do.” And some of them needed to be done.
At one point they said that the smoke detectors should be updated in the 40 unit apartment complex. “Okay. Yeah, we should do that. That’s a safety. We don’t want them to fail. Let’s update it. They need them. They quoted us a price to just like, if I were to walk into Lowe’s and buy it off the shelf, that’s the price. Between the two 40 unit apartment complexes, we’re buying 80 of these. So 80 of them, we can’t go and get bulk pricing somewhere. So asking about the cost, the pricing, a lot of that stuff, especially at a larger scale is something I did not do ahead of time. So if they’re doing a turnover and they’re doing the remodeling, are you getting a bid? What is their project management fee? I think theirs was like 10% on top of doing the project, which is fine.
They’re coordinating it all, getting the materials, things like that, plus the hourly labor. So I would just become knowledgeable about what all those fees are and how their maintenance process works. So some maintenance companies, they’ll let their tenants know and we will respond within 48 hours. For an issue like this, we will resolve it within four days. They have kind of expectations they put out to the tenants when they rent with them. So ask, do they have anything like that? How does a tenant get a hold of the property manager on the weekend? So if it is an emergency, is there someone on call? Does it go to a voicemail? What is that process? I didn’t ask enough questions about the tenant side of things. And when your tenant is not happy, it’s ultimately going to cause problems for you. Even if you have the property manager as the middleman, over time, you’re going to see more vacancy because people don’t want them as a property manager, don’t want to move in there.
They leave because it’s not great property management.
And then eventually the issues are going to have to come to you because they’re going to raise a big enough stink about things. So I would say just ask as many questions as you can. Ask AI, be like, “Here’s the property management company I’m looking to interview. Scroll through anything and find me any Facebook posts, any reviews, anything that mentions this company in this market, Reddit.” They could be anywhere, especially if it’s bigger companies. And I want you to give me a summary of what you found about this company and then give me 50 different questions that I should ask them and then you can kind of weed through them and see which ones you actually want to ask the company to. But that’s where I would start. Well, thank you guys so much for joining us today on this episode of Real Estate. Rookie, if you have a question, you can leave it in the BiggerPockets forums and we may answer it for you on the show.
I’m Ashley. He’s Tony and we’ll see you guys next time.
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