What do you do when you are lucky enough to have a property that has appreciated in value?
Although astute investors invest primarily for cash flow, recognizing that appreciation is the icing on the cake, any buy and hold investor will inevitably face the dilemna of what to do with the equity gained from the rental’s appreciation. This situation leaves many choices and is certainly a good “problem” to have.
What are your options? How do you access that equity?
Because real estate tends to increase in value over time, if you just sit on a property long enough, you will notice after a few years that it has increased in value (note: recognize that I am referring to residential properties, whose values are based on market comparisons, and not multifamilies, whose values are based upon capitalization of income; however, the same concepts apply). What a glorious pleasure to know that your house is now worth $60k more than it was six years ago, when you first got it. Now, what do you do? Here are your options:
Do Nothing: The property is now more valuable, you have grown equity and net worth and you debt paydown and cash flow continues.
Sell the house: Your property can give you a nice chunk of change when you sell, but then you would be subject to taxes, would lose out on many years of cash flow, and would need to find another investment, possibly in the same, higher-priced market.
Convert the equity to cash: Through either a Home Equity Line of Credit or Cash-Out Refinance, you can convert this equity to cash allowing you to deploy it to other places. While a HELOC is an option, it is essentially a second mortgage, and from my experience, lenders may not allow for a high percentage of the home’s value to be taken out against an investment property. In the case where you seek to convert your equity to cash, perhaps you consider a refinance.
Why should you consider tapping into that equity?
In a great market, it feels good to know that your wealth is greater due to the higher value of your properties. But that equity is unusable; unless it is converted to cash, it cannot create any more value for you.To support this statement, consider this: as the value your property increases, net operating income constant, the Return on Equity (ROE) decreases. Here is an example:
Your single family rental cash flows $400 per month. That is a Net Operating Income of $4800 per year.-Three years ago, it was worth $160,000 and your equity in the property was $40,000-Today, the property is worth $200,000 ($40,000 more) and your equity is about $40,000 more, $80,000.- Your Return on Equity (ROE) goes from 12% three years ago to 6% today; in other words, your wealth building is less productive over time.
The more you continue to put your money to productive use, the faster and greater your wealth building. This concept is called “velocity of money,” and many large corporations know how to do this well; so should you.
More Investment Capital: Pulling the cash out allows you to keep your cash-flowing asset while successfully pulling out cash to take advantage of other great real estate investment opportunities.- Take advantage of Improved Rates: Refinancing may allow you to take advantage of lower rates; which can improve your cash flow.- Tax Advantage: In case you did not know, when you refinance and cash out, the cash you received is not taxable, as it is considered a loan and not income. I hope this excites you!
Homeowners tend to “feel” wealthier when their home values increase, but what they are experiencing are the effects of inflation over time. Recognizing this, when you have cash that you can pull out, you tap into that equity (while it is still there) and can convert it to liquid cash that allows you to take advantage of other opportunities and generate better returns than you would on your idle equity.I recently executed a cash out refinance on my first home (which became my second rental), and was able to out nearly $30,000 while also lowering the mortgage payment.
I am not special; while this opportunity was circumstantial, “Luck is when preparation meets opportunity. “If you are a new investor, or even a seasoned one, prepare yourself for great opportunities such as these by getting educated on savvy wealth-building strategies. Subscribe to my blog to automatically receive my weekly articles in your inbox.
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Rodney Robinson II