Author’s note: This article was written when interest rates were at historical lows.
Since 2012 and the extraordinary year of 2020, most housing markets around the United States have experienced much appreciation. With historically low interest rates to be taken advantage of, it’s making more sense than ever to cash out on one’s residence through a refinance or home equity line of credit (HELOC).
If you’re like many folks who have owned a home for several years and built up some equity through principal pay-down and/or appreciation, you might wonder what to do with it.
Some would refinance at a lower rate, not pull out any equity capital, or do nothing. The value in the feeling of security that results from the idea of someday owning the house outright without a mortgage outweighs the advantages of using that equity to invest for a higher rate of return. And that’s perfectly fine.
For others, the possibility to arbitrage that equity capital into higher-yield investments is enticing.
For instance, you might pull the trigger and opt for a cash-out refinance at a 2.7% on the home purchased five years ago for $300,000 at a 4.5% interest rate now marketable at $500,000. You then get a check for $110,000 (to leave some equity in the house). Because the new loan’s interest rate is lower than before, your payments are slightly higher.
Now what?
You could buy that long-coveted Tesla Model S for cash and still have enough left over to remodel the kitchen. You’re happy. Your wife’s pleased. It’s a win-win.
Once the dopamine has worn off, you realize with a hint of guilt that the Tesla, although a fantastic vehicle, will be worth a fraction of what you paid in a few short years. But the $10,000 kitchen remodel has improved the equity position of your house in proportion to the cost of the remodel, so the remorse is somewhat mitigated.
Alternatively, you decide to put the entire amount into a major home renovation. But since your house is now the nicest in the neighborhood, the value has not risen in proportion to the $110,000 you put into the remodel. Although not bad, the neighborhood quality did not warrant that improvement. You likely won’t see a proportionate return on your renovations when you sell the house since the other homes in your neighborhood set a ceiling on the value.
A Better Idea
Let’s consider a third scenario.
You’ve read Robert Kiyosaki’s “Rich Dad, Poor Dad,” so you know how important it is to have your money work for you. You’ve just completed your refinance and have deposited the $110,000 in your bank account, and you’re chatting with your friend Patrick, a medical doctor, over a beer.
Patrick has been a successful MD for twelve years and has paid off his medical school debt. His income is much higher than his expenses, and he has been evaluating what to do with the surplus money he’s been accumulating. You inform him you’re in a similar position with your refinance funds.
A week passes by, and Patrick invites you for another beer. After some pleasantries, he tells you that he found an investment vehicle that would not only provide 16% annualized returns and have some significant tax advantages.
“It’s a self-storage fund.”
Over the next few days, you both do your research on passive commercial real estate investment and start to seek out some different companies that offer such investment opportunities. It turns out that it’s not a vast world.
You both share notes, pick a few companies that have an excellent online presence, and set up interview calls with the sponsors so that you can decide which ones offer the best fit for your goals. Since syndication investments are not liquid, you expect your investment capital to be tied up for several years, so it’s important to choose the right company to invest with.
Patrick narrows his list to three investment firms, one specializing only in multifamily apartment buildings and the other two in self-storage facilities. You choose one of his opportunities and then another from your list.
Your friend decides to invest half of his $200,000 in each of his first two picks, and he also opts to take control of his IRA and invest that entire $150,000 into the third company. You invest $50,000 into your two fund choices and have $10,000 left for that kitchen remodel.
A few months pass by, and you have started to receive your cash flow distributions. One of the self-storage investments is outperforming projections since it was underwritten conservatively, and self-storage tends to be weighted toward cash flow more than multifamily. The other had some initial issues with the property management, but the operator has since switched to a new management company, and cash flow is improving. Your 8% preferred return (similar to a dividend) is bolstered to 9.2% due to the first property’s superb performance despite the slight underperformance of the second property.
Now that your $100,000 is locked into two recession-resistant, inflation-hedged assets, you feel good about life. Not to mention that your monthly distributions of $767 are more than enough to cover the payment on your brand-new Tesla Model 3.
Two years go by, and both syndications are on track to achieve their goals. The first one increased in value enough to warrant a refinance, and the second took on a supplemental loan. This allowed them to return $84,000 of your principal while you still held the full equity position in the properties.
Now what? Should you finally buy that Model S?
Realizing that repetition of this type of investment will snowball your wealth, you decide to sink the entire $84,000 into another self-storage fund. Then you trade in the Model 3 for a Model S, with your ongoing returns combined with the returns from your new investment covering the monthly payments of $1,129 and then some. Life is good.
Another four years pass. Both syndicated properties are sold, and you get your remaining principal plus a proportional share of the profit, totaling $157,000 (including the $84,000 you have already reinvested). You decide to invest it into additional funds with the same operators.
You now have $157,000 invested into real estate along with the Tesla Model S that is being paid down by the cashflow distributions from your investments. Not bad.
How about Patrick? After six years, he is now invested in eight different syndications, and his net worth has gone from $350,000 to $1,025,000 since he has continually reinvested his syndication refinance and cash flow distributions into new syndication deals. Not only that, but he has legally been paying no income or capital gains tax on his investment income.
Conclusion
Refinancing your home and investing the proceeds may not be the right decision for you if the psychological benefit of having a significant degree of equity in your residence outweighs the advantage of being able to arbitrage that equity into financial gains. For many, the feeling of security in owning their home free and clear has high value.
But could you consider this? When one can now borrow money in the range of 3% and reinvest it into real estate for an average projected 15% annualized return, doesn’t it make the most sense to do just that and achieve a 12% net return? Only you can decide.
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Disclaimer: The opinions conveyed in this article are provided for educational purposes only and should not be interpreted as an offer to buy or sell securities or to make or contemplate any investment.