Refinancing Your Primary Residence to Purchase Denver Investment Property

If you’re like many Denver homeowners who have owned their primary residence for a few years, then you’re probably sitting on a decent amount of equity that is often in the six-figure range. The Return on Equity module discussed calculating your return on equity and the opportunity costs of equity in your rental properties. This module will explore the opportunity costs of equity trapped in your primary residence.

My preference is to use real numbers, properties and scenarios to give you the most accurate picture possible. This module is based on a Real Estate Financial Plan™️ that I build for clients to help model retirement goals. For privacy reasons, all personal information is removed.

This post will cover:

• The clients’ goals and profile
• How to gather information to map out long term goals
• Three different options for using their primary residence to create a rental portfolio
• Four scenarios from the Real Estate Financial Planner™️ to model achieving goals of $5,000/mo and $10,000/mo.

Real Estate Investing Goals

• Medium-term goal: $5,000/mo to allow one spouse to no longer work.
• Long term goal: $10,000/mo when all the properties are paid off for retirement. This amount is in addition to other retirement funds, social security, etc.

Client Scenario

• Primary residence:
  • Own. Purchased it in 2016.
  • A 15-year mortgage with a $3,107 P&I monthly payment, with a remaining loan balance of $372,287
  • Current value at $645,000, based on comparative market analysis (CMA) from my team
  • The rental rate estimate is $3,000/mo. I asked a property manager for a rental estimate.

“I always like to go higher and as such would love to try $3195 and we can but for budgeting purposes and time of year (right now as we have seen a little shift in August), maybe plan for $2800-$3000 I think. Again, it is always useful to visit the home for a better feel.”

Annemarie Sunde of Legacy Property Management

• Personal info:
  • Husband, wife and two young children
  • Children recently got accepted into the desired elementary school! They want to stay in the current school district.
  • Both spouses work. The $5,000/mo real estate income would allow one spouse to stop working.
• Current real estate portfolio:
  • Purchased a cash flowing condo in Dec 2018.
• The monthly savings rate for real estate investing:
  • $1,000/mo from their job/business income (not including rental cash flow.)
• Current capital for real estate investing:
  • $55,000

My commentary:

• $272,713 – They have a lot of in their “real estate piggybank”, AKA equity, in their primary residence. Thank you Denver market for the gift of equity!!
• Their primary residence does NOT make a great rental. They can buy much better rental properties than a $645,000 home that rents for $3,000.
• House hacking is out of the question with a family.
• Nomading™️ isn’t ideal since they are raising a family and want to stay in the current school district. They can move once or twice within the current school district if it’ll move the needle on achieving their goals.

Real Estate Investing Options

Option #1: Move out of their primary, and convert it to a rental.

As I said above their primary residence does NOT make a great rental. They can buy much better rental properties than a $645,000 home that rents for $3,000. This option is crossed off the list.

Some people might say, “but the property will cash flow since they only have $370k left on the mortgage balance.” Yes, it will, but there is more to investing than just cash flow. They are getting a poor return on their equity and not optimizing it. They are in the accumulation phase of their Real Estate Financial Plan™️ and need to accumulate more! If they only need one or two more rentals to achieve their goal, this could make sense. They need more than that! Pulling out equity is the best way to accumulate more.

Option #2: Stay in their primary, and pull out equity to buy rentals.

Lonnie Glessner, Senior Loan Officer at Draper & Kramer Mortgage, did their loan on their recent rental property purchased. We asked Lonnie to run numbers for their current primary.

Hi Chris,
 
After running rates for them I would definitely recommend they refinance at 75% LTV for 2 reasons. First, it keeps their loan amount from being a High Balance loan and a cheaper loan at 75% LTV vs. 80% LTV. Assuming an appraised value of $645k, here are their 2 options on 30 year fixed rate loans—

80% LTV or $516,000 — rate is 4.375% with a P&I payment of $2576 (or they can pay a point and lower their rate to 3.875% with a P&I payment of $2,426)
75% LTV or $483,750 — rate is 3.875% with a P&I payment of $2,275 (or they can pay a points fee of just $875 and reduce their rate to 3.625% with a P&I Payment of $2,206)
 
Currently their P&I payment is $3107.

Their Heloc is for $154k at Prime + 1%. [Comment: As of 9/2/2109, the WSJ has prime at 5.25%] Knowing they like shorter-term loans they could do a 20 year fixed at $472,500 and still have a lower P&I payment than they do currently.

75% LTV or $483,750 — rate is 3.75% on a 20 year fixed with a P&I payment of $2868.

Lonnie Glessner, Senior Loan Officer at Draper & Kramer Mortgage

I agree with Lonnie’s comment regarding the 75% LTV at 30 years as the best option over the 80% refi and the HELOC. With current lending standards and rates, the 75% with rate buy down is the sweet spot. I’d avoid the HELOC, because it’s a higher rate and also variable. Since we’re pulling out a big chunk of money, let’s get everything fixed. Plus, certainty in my expenses helps me sleep at night. Clients call though.

Why 30 years instead of 20? Debt is cheap. Finance it. The rental properties that we find give you a greater return on investment than the interest rate of around 4%. Remember, we’re in the accumulation phase!

Option #2 results:

• Total cash: $166,463 for investing
  • 75% LTV refi: $111,463 ($483,750 refi amount – $372,287 current loan balance)
  • $55,000 from their current capital
• Total cash for real estate investing: $1,901/mo
  • $901/mo is the difference between their current payment and the new refi payment ($3,107 – $2,206) Let’s take the savings and apply it towards buying more real estate!
  • $1,000/mo current savings rate

Option #3: Sell their primary, buy a new one and buy rentals.

A cash-out refinance is a great way to pull out equity, but it’s limited to 75% for investment and 80% for primary. Selling a property will generally get you more equity. Let’s see how much equity my client will get by selling.

• $645,000 in sales price
• (38,700) for 6% selling costs
• (372,287) for loan payoff.
• = $234,013 cash proceeds

Since this was their primary residence for more than 2 of the last 5 years, the proceeds should be tax-free. Of course, they’ll want to check with their CPA. The capital gains free sale of your primary residence is one the best tax benefits from the IRS.

They still need a place to live. I had my clients look on the MLS to find an example house that is in their current school district and comfortable for raising a family. They sent me over a 5 bed / 4 bath house that is selling for $525,000. My inner frugal voice is cheering for the less expensive house.

Let’s say they buy this house with a 5% down conventional loan. The downpayment will be $26,250 and about $5,000 in closing costs. The current rate for a 30-year loan is 3.75%, which puts their payment at $2,310/mo for principal and interest.

$2,310 is less than their current payment of $3,107 P&I. They can afford it, and it frees up more cash flow for them on a monthly basis.

Option #3 results:

• Total cash: $257,763 for investing
  • $234,013 cash proceeds from the sale
  • ($31,250) for buying their new primary.
  • $55,000 from their current capital
• Total cash for real estate investing: $1,797/mo
  • $797/mo is the difference between their current payment and the new refi payment ($3,107 – $2,310). Let’s take the savings and apply it towards buying more real estate!
  • $1,000/mo current savings rate

Option #2 vs Option #3 Scenarios

This is the section of the blog that I’ve been excited to get to, because we’ll model and compare these two scenarios. Fortunately, I have access to the Real Estate Financial Planner™️ software which does long term real estate investment modeling.

The software can model every variable under the sun. To keep things simple and actionable for the clients, we’re going to compare the two options’ differences in starting cash and monthly real estate investing savings rate.

• Refinance results:
  • Starting cash: $166,463
  • Monthly savings rate: $1,901/mo
• Sell results:
  • Starting cash: $257,763
  • Monthly savings rate: $1,797/mo

To be conservative, the cash is parked in a savings account. I use Ally bank, and they are currently paying 1.9%.

Each model will buy the same rental property, a cash-flowing condo in Aurora. The client already owns one, and they are the ones we talk about on the podcast all the time. With the amount of cash on hand, we could explore multi-family as well which have a slightly lower cap rate than the condos.

Here are the assumptions that I’ll use:

• Purchase price: $200,000
• Downpayment: 25%
• Closing costs: $5,000
• Rent ready costs: $2,500 (usually from $0 to $4,000)
• Rent: $1,800 (most units rent for 1800-1850)
• Mortgage: 30 years at 4.875%
• Vacancy rate: 5%
• Appreciation rate: 4%
• Rent appreciation: 3% (I like to model it, so it keeps pace with inflation. Anything higher is a big fat cherry on top.)
• Taxes: $958/yr
• Insurance: $300/yr
• Property management: 10% of rent
• Repairs and maintenance: 5% of rent
• HOA: $299/mo
• Expenses and HOA appreciation rate: 3%

Don’t like or agree with my assumptions? Then copy this scenario to your Real Estate Financial Planner™️ account and change them. The links are at the bottom.

Scenario Details

The rule of thumb I use is to acquire properties until you’ve achieved the total gross rents needed to support your real estate income retirement. It’s usually best to acquire all the properties before turning to a debt paydown. Since we have two goals of $5k/mo in the near future and $10k/mo for long term retirement planning, we need to run different scenarios.

Having multiple goals makes modeling trickier. I didn’t discuss with my clients how their income looks after achieving the $5k/mo goal to retire one spouse. How much does that impact their monthly REI savings rate? It will impact their ability to buy new properties which will impact the timeline for achieving the $10k goal. Plus there are a few other variables in there!

My plan is to model four simple scenarios, review them with my client and then come back and update his real estate financial plan. Here are the four scenarios:

1. Refi Primary, buy 5 rentals
2. Sell Primary, move once, buy 5 rentals
3. Refi Primary, buy 10 rentals
4. Sell Primary, move once, buy 10 rentals

In the “Sell Primary, move once” scenarios, they are selling their primary house, buying a new one and only moving once. No Nomading™ or house hacking.

Each scenario takes the initial cash from the sale or refinance, the monthly savings rate, and rental property cash flow to buy properties as quickly as possible while never letting the account balance drop below $25,000. Once the scenario has acquired enough properties to achieve the desired income goal, a new rule kicks in to apply all the property cash flow and monthly savings rates toward debt paydown in a snowball method starting with the lowest balance.

For example, the first scenario of “Refi Primary, buy 5 rentals” would start off with $166,463 cash from the refinance and their cash savings. It would use as much cash as possible to buy rental properties. Once the account is below the amount needed to buy more, then they will let the account rebuild between their personal monthly savings rate of $1,901 and cash flow from their current rentals. Once the account has enough built up, they will buy the next property. It will repeat until a total of 5 properties are purchased, and then all the cash flow will go toward debt paydown.

Scenario Results for $5,000/mo

The graphs and my commentary are below. I was surprised at the result!

Again, I was surprised at the results! I expected the “Sell Primary, move once, buy 5 rentals” scenario to be the first one to achieve the $5,000/mo goal. I was wrong. It came in second place. Surprisingly (to me) the “Sell Primary, move once, buy 10 rentals” scenario achieved the goal first.

Important goal notes from the Real Estate Financial Planner™️ software:

1. It is using its Total True Cash Flow calculation to determine the monthly rental income which is rent – expenses – mortgage payment (if any) + depreciation/tax benefits
2. It’s not just calculating when it achieves $5k/mo but when it achieves the equivalent of $5k/mo in future inflated dollars. Remember, a dollar today is worth more than a dollar in the future. This is why I added the third column above of “Future Inflated dollars at the time of Goal Achievement” to show what dollar amount you need in the future to give you the same buying power in today’s dollars of $5k/mo. It’s assuming a 3% inflation rate.

Scenario Results for $10,000/mo

Now, let’s run the exact same scenarios, but see how long it takes to achieve the goal of $10k/mo.

The “Sell Primary, move once, buy 10 rentals” scenario is what I expected to achieve the goal first. I’m not surprised by these results. The two scenarios of buying 5 properties never achieves the goal. This is due in large part to how I set up the rules. As I said above, I don’t know what happens to their savings rate and income when they achieve the $5k/mo goal, and one spouse retires. Plus, there are other options that we can explore such as tapping into equity by refinancing or selling and utilizing a 1031 exchange to buy more properties.

Total True Cash Flow

Let’s take a look at the cash flow. Remember, this is the Total True Cash Flow which adds back in the depreciation tax benefits. The chart is in inflation-adjusted dollars. I prefer to look at charts in inflation-adjusted dollars, because I want to maintain my current buying power.

Why does the cash flow decrease on the right-hand side of the chart? That’s because the depreciation benefits are running out after 27.5 years.

Here’s the chart in raw dollars (or future inflated dollars).

Conclusion

It seems like staying in acquisition mode to get to 10 properties ASAP using the “Sell Primary, move once, buy 10 rentals” scenario is the best route for both achieving the $5k/mo and $10k/mo goal. Of course, we’re projecting out over many years, and it’s impossible to predict what the market will do, interest rates, and other variables. Personally, I’d start with the plan of getting a total of 10 properties, then adjust if needed depending on the market and personal goals of one spouse retiring early.

Selling their primary is the fastest way to get to 10 properties or $10k/mo by about two years for both the $5k/mo and $10k/mo goal. The right option depends on if they want to sell and move their family.

To run more detailed scenarios, I’ll discuss with my clients what their income looks like after achieving the $5k/mo goal to retire one spouse. How much does that impact their monthly REI savings rate? It will impact their ability to buy new properties which will impact the timeline for achieving the $10k goal. Plus there are a few other variables in there.

Part Two of this Plan!

I shared this plan with my clients and had a great meeting. Overall, they were excited to see it. After reviewing and discussing it, we have some changes to make which is no surprise. It takes at least a few meetings to get details fleshed out and to find the right path.

Check out part two for updates that include:

• A lower cap rate rental property to run a more conservative model.
• An increased monthly savings rate of $1,000/mo.
• Running scenarios that include cash-out refinances on their rental properties.

YouTube Video

Webinar recording – Watch it here or listen on the podcast.