REAL ESTATE DOLLARS AND SENSE

Let’s begin by identifying the two scenarios and the corresponding assumptions for each. Scenario 1: No “Cash-Out” Refinance of Current Rental (i.e. Property A) Refi terms: 2.99%, 15-yr term, $295K Loan Amount Mortgage Payment: $2,035/mo Additional Principal Payment: $600/mo Rental Income: $3,355/mo Expenses: $720/mo Monthly Cash Flow: $0/mo Pay Off Date: 11 years from today Scenario 2: “Cash-Out” Refinance of Current Rental (i.e. Property A) and Acquire Second Rental (i.e. Property B) (Property A) Refi terms: 3.5%, 30-yr term, $585K Loan Amount ($295K plus $290K “cash-out”) Mortgage Payment: $2,626/mo Rental Income: $3,355/mo Expenses: $720/mo Monthly Cash Flow: $9/mo (effectively ~$0/mo) (Property B) Purchase Property B for $900K w/ $290K down at a 5% cap rate Loan Terms: 2.99%, 30-yr term, $610K Loan Amount Mortgage Payment: $2,568/mo Net Operating Income: $3,750/mo (i.e. 5% of $900K / 12-mo) Cash Flow: $1,182/mo (i.e. $156,024 over 11 years) Disposition: Sell Property B after 11 years for $1.246MM (assuming a 3% average annual appreciation rate) Sale Expenses: $62,300 (i.e. 5%) Net Sales Proceeds Before Taxes: $737,351

In Scenario 1, Property A is refinanced over 15 years, and the extra cash flow from the rent after paying the mortgage payment and the property expenses is used to accelerate the mortgage payoff in 11 years. In Scenario 2, Property A is refinanced over 30 years while taking out $290K of equity, making the total loan amount for Property A $585K (i.e. $295K + 290K). The “cash-out” amount of $290K is used as the down payment on the purchase of Property B. The new monthly payment for Property A is $2,626/mo, which when combined with the property expense of $720/mo and the rental income of $3,355/mo brings the monthly cash flow to $9/mo, which for simplicity, I’ll round to $0/mo. Note that the $290K "cash-out" amount was chosen specifically to ensure that the monthly debt service could still be supported by the rental income without creating a negative cash flow situation. Assuming Property B is purchased for $900K at a 5% capitalization rate (or cap rate), by definition, this corresponds to a net operating income (i.e. rent minus expenses) of $3,750/mo. Since the mortgage payment on Property B is $2,568/mo, the monthly cash flow from Property B is $1,182/mo or $156,024 over 11 years. Scenario 2 also assumes the sale of Property B in 11 years for $1.246MM, which represents an average annual appreciated rate of 3%. The before-tax sales proceeds from Property B after 11 years are $737,351, which includes real estate sales expenses of 5% or $62,300 and the loan pay-off of $446,349. However, keep in mind that my client also requires Property A to be paid off in 11 years. To achieve this, the principal loan balance of Property A 11 years from now (i.e. $437,023) also needs to be paid off using the $737,351 of sales proceeds from Property B, leaving a net profit of $300,328. Lastly, we cannot forget to account for the fact that Property B generated $156,024 in cash flow over 11 years. This means that while Property A is paid off in 11 years in both scenarios, Scenario 2 brings in an additional before-tax profit of $456,352 relative to Scenario 1.

Of course, Scenario 2 is not without risk. The question is, however, does this additional potential profit outweigh the risks? To answer this question, let’s look at the key assumptions of Scenario 2 and assess their risk. “Cash-Out” Refinance of Property A – While overleveraging a property can be very risky if/when the market corrects, leverage used properly is a key benefit with real estate investing. In Scenario 2 above, the “cash-out” refinance results in a loan-to-value (i.e. LTV) of 53% on Property A – well below the “high-risk” threshold. >5% Cap Rate – While most properties in Southern California on the market today will not qualify based on this metric, some properties will. The key is to identify and pursue only those properties that meet or exceed this criterion. 3% Average Annual Appreciation Rate of Property B – Opinions will differ on whether or not this assumption is reasonable, conservative, or aggressive. But consider that over the long haul (i.e. 10+ years), this assumption is consistent with the performance of Southern California residential real estate over the past several decades. It is also worth noting that my client’s property (i.e. Property A) has appreciated 4.9% annually on average over her last 20 years of ownership! Market Cycle Timing – While real estate cycles typically last 10 years, there is no guarantee that the market will not be at a low point in the cycle in 11 years, precisely when Scenario 2 calls for Property B to be sold. Rather, Property B may reach its target price considerably before 11 years or considerably after 11 years depending on market conditions. In summary, Scenario 2 may not be for everyone. It does, however, provide a perspective that may be worth considering. Not sure how to find a 5% cap property in Southern California? Not sure how to secure a “cash-out” refi? Not even sure how to start? Call me – I have resources that can absolutely assist you!