Updated: Mar 14, 2019
It is now almost the end of the seasoning period for my duplex in Philadelphia, PA. A seasoning period is the minimum amount of time required to use conventional cash-out financing; federal regulations dictate 6 months. Conventional cash out financing usually gives the buyer the best terms and lowest risk. There are ways to cash out finance earlier, but generally they require the property to be a Single Family Home (SFH) or a loan from a private lender.
I purchased this property originally as an all cash deal and did a rehab on the property to force appreciation so that the value of the asset after my repairs is higher than the cost of the purchase + renovation. There is a similar concept in cash-out refinancing a property. This occurs when the property has an existing mortgage and you simply pay off the balance on the old loan using the new loan. Any additional value left over after the minimum required equity (think down payment), can be taken out as cash. In the case of my property, I'll be financing it for the first time and pulling out as much equity as possible in the form of cash so that I can put that capital into new deals. Do note that a cash-out (re)finance is a loan; there will be a monthly payment that includes principal and interest that you'll need to take into account before deciding to use this type loan. Investors use it so that they can recoup their initial investment and put it back to work in an asset that will outperform the interest rate on the loan (e.g. in another property).
The overall process is pretty straightforward and simple. First, shop around locally and tap into your network to see which lender has worked best for others. Generally, a bank local to the area of the property will be your best bet. For Philadelphia, I've been working with Mike McKeown over at Allied Mortgage Group. They are local to the area and seem to provide the best rates. I also have others within my network who have used him successfully before.
A second step, which must be done carefully, is ensuring that the property is at least temporarily owned by you, the individual (unless you are at your personal loan limit of 10, but that is a topic for another time). If you purchased the property under an LLC, these conventional mortgages will not be available to you. The property needs to be owned by an individual to qualify for the type of conventional cash-out financing. Again, there are ways to do a cash-out finance under an LLC, but this will require a different type of loan that will not command such good terms.
The process is pretty simple afterwards. The lender will require an appraisal involving an inspection and evaluating comparables in the market. It doesn't hurt to send the comparables you originally used in your underwriting to the lender, as this shows that you‘ve been doing your homework and will get your target numbers top of mind.
The financing will then be dictated by the appraisal and the Loan to Value (LTV) for your home type. For Single Family Homes (SFH), you typically have to leave in 25% equity in the property (i.e. LTV of 75%). For small Multi Family Homes (MFH), you are generally required to leave in 30% equity (70% LTV). Keep this in mind when analyzing your cash flow after financing. The rest of the loan value will be available to you as a cash deposit.
Ideally the delta between the appraisal value and the purchase price + rehab cost + equity required to remain in the property (25%-30% depending on the property type) is greater than or equal to zero, meaning that you were able to get your original investment (or more) out of the property.
If there is additional equity that can be extracted beyond the original investment, you have a couple options depending on your goals and risk tolerance. Leaving more equity in the property increases cash flow since the mortgage payment will be smaller. Increased cash flow leads to less risk since you'll be able to profitably weather any rent drop storm that could come your way in a declining economy. Furthermore, leaving more equity in the property will lower your Debt to Service Coverage Ratio (DSCR), which can be important for getting lending in the future (especially in a declining economy).
At this point in my business and with the state of the economy, I prefer to leave the extra equity in the deal, creating more profit available on a monthly basis. If I were doing more deals per year or if the market was in a better state, I may take the cash so that I could sustain funding more deals. It all depends on your individual business strategy. Here is an example chart illustrating the various parts of the initial investment and the cash out loan:
In this hypothetical example, the initial investment includes the purchase price and rehab ($50k + $15k) and is shown in the first column. The After Repair Value is $100k. With a cash-out loan at 75% LTV, that allows for the borrower to pull out $75k (green + red section). After recouping the initial investment of $65k, there is an additional profit of $10k left over. As mentioned before, I prefer to leave any such profit in the property itself to increase cash flow.
Things to Watch Out For
It is key to watch out for a due-on-sale-clause.
"A due-on-sale clause is a clause in a loan or promissory note that stipulates that the full balance of the loan may be called due (repaid in full) upon sale or transfer of ownership of the property used to secure the note. The lender has the right, but not the obligation, to call the note due in such a circumstance."
If you are taking the loan out as an individual (as you'll be required to do) and transferring it back to the LLC after the financing has occurred, make sure that you don't trigger an effective "sale" of the property (since it is technically transferring owners) as that will result in requiring capital to cover the full value of the outstanding loan in addition to transfer fees and tax transfer costs that you really do not want to have. Some banks will work with you to avoid this, others will not. Make sure you know the situation before making any transfers!
Don't necessarily go with the first lender you meet. Shop around! Really do your homework and get the best terms. This will affect cash flow and is worth the time and effort. Once you find a good broker for your area, you are set for the rest of the properties that you will finance.