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Suggested pre-reading:
In my prior blog (see link above), I posited that an investor could achieve approximately 12.5% internal rate of return (IRR) by investing in a long-term rental (LTR) using prudent leverage. I added that an investor could improve their IRR by pulling out excess equity using a cash-out refinance strategy, possibly getting closer to 15% IRR. Expanding on that proposition, this blog will explore the question: Is a 15% return on investment reasonably achievable with a LTR as an active investor?
With a conventional deal, as time goes on, the equity starts to build up, and the ratio of equity to property value increases (i.e. the investor has more skin in the game). It makes sense, then, that as equity rises, leverage falls and becomes a drag on the IRR of the investment. In these situations, many active real estate investors pull out the excess equity from a rental property by refinancing the mortgage. So, what would the IRR look like if an investor pulled out some equity from the property using a cash-out refinance every 5 years and invested that cash to purchase another rental property with a similar ROI.
Before we get into details, I would caution against using the numbers too literally. Many key variables (e.g. interest rates) can change over time. It would be impractical to assume that these variables would stay the same over a 20-year period. Rather, the educational objective of this blog is to understand the concept that cash-out refinance helps reset the leverage and improves the overall IRR over time. I am using theoretical numbers to demonstrate this point. With that caveat, let’s do the math.
Years 1 – 5
Applying the same assumptions that I used in my first blog, the IRR for the first 5 years is 15.05%.
Years 6 – 10
At the end of year 5, the property that was initially worth $250K will be worth approximately $296K, assuming a 3.5% annual property appreciation. The investor should have accumulated approximately $112K in equity. The investor performs a cash-out refinance to reset the equity to 20% ($59,384) and uses the excess equity ($52,615) to purchase another rental property. Assuming that the cost to perform a refinance is 1% (included as closing cost in the calculator below), the IRR for years 6 through 10 would be approximately 17.4%.
Years 11 – 15
The investor repeats the refinance process at the end of year 10, earning an IRR of approximately 17.4% in years 11 through 15.
Years 16 – 20
The investor refinances again at the end of year 15 and ultimately sells the property at the end of year 20. The cost of selling the property is estimated at 7%. The IRR from years 16 through 20 will be ~ 13.4%
Overall ROI from Year 1 through Year 20 is 15.8%
In summary, the investor earned annual IRR of 15.05% from year 1 through year 5, 17.4% from year 6 through year 10, 17.4% from year 11 through year 15 and 13.4% from year 16 through year 20. The overall compound annual growth rate for all 20 years would be approximately 15.8%, in contrast to the ~12.5% IRR when investing in a LTR without refinancing.
A cash-out refinance resets the equity in the property back down to 20%, thereby optimizing the long-term performance of the rental property.
Taxes:
Cash that is pulled out using a cash-out refinance is not taxable, allowing for rapid growth. For this reason, a cash-out refinance is a better strategy to gain access to the cash compared to selling the property, which would be a taxable event (unless the investor performs a 1031 exchange).
Calculator:
Please note that these data were generated using the rental calculator available on https://www.calculator.net/rental-property-calculator
So, by using a cash-out refinance, you could go from ~12.5% to greater than 15% rate of return. Is the additional 2.5% annual rate of return worth the hassle of refinancing every 5 years?
Consider this: $60K invested for 30 years earning an annual compound interest of 10% (a 20-year historic S&P500 return) would yield approximately $1 Million, while the same money invested in a long-term rental without performing a refinance would earn approximately 12.5% return and yield ~ $2 Million. Optimizing the leverage using cash-out refinance would allow an investor to hit a return of approximately 15%. Plus, the initial $60K investment would be worth closer to ~4 Million after 30 years, which is about twice the final result compared to investing in a LTR without performing a refinance.
Will a cash-out refinance supercharge your long-term rental investment returns? In many cases, yes. But remember that leverage is a double-edged sword. Investors must remain vigilant to the risks associated with a leveraged investment and should consider maintaining a positive cashflow to mitigate the risks.
Above graph and image was generated using: https://www.investor.gov
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DISCLAIMER:
This post is meant for educational purposes only. The information provided via LokhandwalaRealEstate.com is not intended as individualized legal, accounting, tax planning, or investment advice. Lokhandwala Enterprises USA, LLC and its affiliates disclaim any liability, loss, or risk incurred as a direct or indirect consequence of using any information contained in this blog. Please contact us for a private consultation and/or consult your own network of licensed professionals before taking specific actions.
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