“Don’t wait to buy real estate. Buy real estate and wait.” – Will Rogers
One thing I’ve learned being a real estate agent is that when it comes to our homes most of us want the best. Why shouldn’t we? Our homes are the places we build our memories, relax; our own private oasis’. However real estate can be much more than a place to build memories; for centuries it has been one of the greatest builders of wealth known to humanity. Yet with all the HGTV shows and hype that surrounds real estate there still lies the heavy debate of how to go about investing in it. The two trains of thought surrounding real estate investing are simply cash flow vs equity. Is it worth being house rich and cash poor?(I’ll explain this later) Or simply keep saving until you can buy a home in cash which you’ll have maximum equity and cash flow? But how long would that take? Is it even worth investing in real estate if you don’t achieve the maximum cash flow? In today’s blog I’m going to dive a little deeper into the debate of cash flow vs equity and how you can choose which approach might be right for you.
It’s All In The Numbers – Cashflow is defined as “the total amount of money being transferred into and out of a business, especially as affecting liquidity.” In layman’s terms, cashflow is the amount of money left over after all your expenses are paid. Many believe that your mortgage is your only expense when investing in real estate; however it’s important to also calculate for vacancy, maintenance costs, and capital expenditures. Capital expenditures are “big ticket items”, such as a new roof, furnace, septic, etc… For example, say you can rent a home for $1,200.00/mo however your mortgage is $600.00, and you allocate $400.00 towards your capital expenditures, vacancy, and maintenance costs. That means that you cashflow $200.00/mo for your unit. So the answer in all of this is that it’s important to run your numbers so you can make the maximum amount of money. The great thing about investing in real estate is that your costs and expenses aren’t fixed. What do I mean by that? I mean that if your taxes go up and effect your mortgage, which in turn decreases your cash flow, you could shop around for cheaper homeowners insurance which might offset the increase. Is your water or sewer bill cutting into your profits? Check the home for any slow leaks, or install more water conscious devices such as toilets, dishwashers, etc.. In real estate investing there are many challenges but there are also many answers to the challenges you will face.
House Rich But Cash Poor – Being house rich but cash poor means that you have more equity tied up in your home than actual liquid cash. What the heck does that mean? In the real estate world it means you have a ton of equity in your home; but your cash flow sucks. The next question is, is having alot of equity in your home a bad thing when investing? The answer is, certainly not. Many investors don’t realize that you can tap into that equity to leverage and expand your portfolio. So how do you do that? The best ways to extract equity from a home are a Home Equity Line of Credit (this is easy to do if you have equity in your primary residence) or the ever impressive cash out refinance. When applying for a Home Equity Line of Credit (HELOC) you would go to your local bank or financial institution. The bank would then appraise your home, see what you owe on it, and lend accordingly. For instance say your home is worth 300k but you only owe 190k on it so you have 110k worth of equity in your home! From there you could ask for a specific line of credit such as 25k-50k or the bank will lend up to a specific amount. This is a great way to have access to liquid cash to use as a downpayment on an investment property or even use to absorb some of your monthly expenses. Something to note about HELOC’s are that most are at variable interest rates and, as any line of credit, you need to pay back the money borrowed on you HELOC eventually. Most HELOC’s have payment plans of paying interest only for a certain number of years and then paying back the principal for the later half of the line of credit. Before agreeing to the terms of the HELOC it is always import to understand the terms of the line of credit and to make sure you do not over extend yourself. Another aspect to mention are that all banks have different rates and even introductory rates for HELOC’s; so it’s important to show around for the most competitive rates.
Another wonderful way to tap into your home equity is using what is known as a “cash out refi.” To apply for a cash out refinance simply go to your local bank or lender and they can walk you through the process. Basically the general gist of a cash out refinance is to pull the equity from your home, in return for a new loan on your home. So what does all this mean? In our previous example say you have a home worth 300k but you only owe 190k on it. So you have 110k in equity that you have in your home! Traditionally a bank will lend up to 80%; that means if you refinance your home you could potentially take up to 88k from your homes equity to anything you’d like with (80%x110k). This includes buying another investment property, putting that money towards your child’s college fund, or even purchasing a new car. The great thing about this cash out refi process is that you do not need to pay back the money that you take from your home’s equity. The next question is: what happens to your monthly mortgage when you do a cash out refi? In some instances your monthly mortgage might go up, however in an ideal situation your monthly mortgage would go down and you would be locked into a lower interest rate than you previously have; it’s imperative your mortgage professional runs the numbers beforehand.
Also noteworthy, are that cash out refinances do come in handy for those of us who used an FHA loan on our homes. With FHA loans most of us are required to have PMI or private mortgage insurance on our homes. However a great way to avoid this is to purchase a home using an FHA loan, create some equity in the home such as renovating a kitchen, bath, or new floors, and then eventually refinance into a conventional mortgage which could then drop the PMI from your monthly mortgage. This would ideally decrease your monthly mortgage. Eventually this pays off because when/if you go to ever rent out your home; your cash flow will increase as your monthly mortgage would decrease. Yet the best part about refinancing into a conventional mortgage from an FHA loan is that you then get your FHA loan back! So then you can pick another property and use your FHA loan again; which allows you to invest in real estate with a lower down payment as low as 3.5%.
Conclusion – So how do you determine which is right for you cashflow or equity? It really depends on your goals. In my opinion if you are trying to obtain a cushion or a basis of financial independence you need some sort of “passive” income stream to absorb the income coming in from a 9-5 job. In this instance I would say you need to get a few good cash flowing properties under your belt and want to focus on properties that will allow you to either pay them off fast; or properties that you can see a good amount of cash flow from. However with all that said using an equity approach is also extremely powerful and can also buy time/years of freedom from a 9-5 position. For instance say you have 1 rental property and can do a cash out refinance where you would receive 80k. If you already know that your expenses for 1 year total about 35k/yr, by just refinancing that one house you buy yourself almost 2 years of time. During that time you could focus on creating a new business, traveling, or just taking time for yourself and step away from a traditional “job” for a few years. There are powerful lessons to be learned using real estate to purchase your time. Cash flow vs equity is just one approach; it’s ultimately up to you to explore the many options and opportunities real estate investing can open up to you. What aspects of real estate investing interest you? Would you go with cash flow over equity or vice versa? Let us know your thoughts in the comments below!