Many real estate investors believe the only way to grow a portfolio is with a large amount of cash. When an investor depletes their liquidity with one purchase, there is no opportunity for growth and diversification.
The concept of scaling is different from growing a portfolio. Scaling a portfolio means the strategic uses of equity and leverage to boost the purchasing power of an investor’s cash.
This article will explain the concepts and strategies of scaling and the proper use of leverage. These scaling concepts will benefit investors with the long-term hold objective or with a portfolio using a combination of short- and long-term holding periods for diversification and to recapitalize available cash.
Key Takeaways
- An important consideration to quicken the pace of accumulating equity is knowing whether the loan documents allow for pre-payment without penalty
- The essential factors an investor must consider are the net effects of an adjusted rate and higher leverage
- The quickest way to accumulate equity is to create forced appreciation through renovation
- Under the buy-and-hold objective, an investor will benefit from accumulated equity through loan paydown and market appreciation
- A savvy investor will diversify their portfolio to benefit from cash recapitalization and accumulated equity
Defined Terms
- Equity – the difference between market value and the balance due on a mortgage loan
- Equity Loans – leveraging equity by creating another loan against the property
- Liquidity – the ability to access cash within three days
- Market Appreciation – the increase in a property’s value by market conditions without any additional cash injection by the owner
- Refinance – the restructuring of the current mortgage into a new loan to access higher leverage and/or a lower interest rate
The Accumulation of Equity
Equity is defined as the property’s value not encumbered by the balance remaining due on the mortgage loan. In other words, equity is the difference between the market value and the loan balance. Generally, there are 4 ways to accumulate equity in an investment property.
1. Increase the Amount of the Loan Payment
The fastest way to build equity and reduce the loan balance is to remit extra money to the stated loan payment and direct the additional funds to the principal balance. A decrease in the principal balance loan will decrease the accrued interest and the cost of capital.
However, before implementing this strategy, the investor must confirm that the loan documents will allow for pre-payments without penalty.
There are instances where the terms of a permanent, long-term loan will preclude any pre-payment or impose a penalty during the early years of the term. Lenders require this clause to protect the expected interest earned on the loan.
2. A Larger Down Payment
A down payment larger than the maximum loan-to-value (LTV) ratio quoted by the lender will keep the investor ahead of the game. The larger the down payment (or the infused equity), the smaller the loan amount.
3. Improving the Property
This is where an investor can accumulate equity faster than paying down a mortgage over time. It is always the goal of an investor to renovate or upgrade a property to create value. This increased value translates into equity when the value created is greater than the cost of the renovations.
This strategy is for experienced investors who recognize a motivated seller in a market that will support the projected end value of the renovations.
4. Choose a Shorter Loan Term
Although a shorter loan term will mean higher payments, this strategy translates to lower interest, thus increasing equity.
It is important to note that, before an investor plans to exercise any of these strategies, a complete understanding of the loan documents must be known to ensure that the amount of the cash generated from the property will cover any projected increases in the loan payments.
How to Recognize Accumulated Equity
It must be understood that accumulated equity is not within a lender’s definition of “liquidity.” Equity can be converted into cash only when the accumulation exceeds the lender’s required LTV ratio. Typically, liquidity is defined as cash a borrower can access within three days.
For example, if a property’s market value is $100,000, the loan balance is $50,000, and the lender’s maximum LTV is 75%, then the amount of equity available for access is $25,000.
- $100,000 x .75 = $75,000, the maximum loan balance
- $100,000 – $75,000 = $25,000, the minimum equity amount
- $50,000 – $25,000 = $25,000, the amount available for an investor to access
From this example, $75,000 is the maximum loan amount the lender will allow against the property, and the borrower must maintain at least $25,000 of equity in the investment to meet the 75% LTV. Therefore, the amount of equity available for cash is $25,000.
Investors can use this financing strategy across several properties. As equity is “pulled out” from a property, the loan documents must be modified to reflect the higher leverage, or the entire loan must be refinanced.
There will be fees associated with either structure, and often a lender will require adjustments to the interest rate and term. Essential factors to consider are the property’s performance, the net effect of an adjusted rate, and higher leverage.
Creating Equity Through Renovations
The quickest way to accumulate equity is to create it. This is the basic premise of real estate investing—creating equity by renovating properties with a value-add opportunity. This premise holds regardless of the hold period.
Investors with a short-term, fix-and-flip objective will locate a distressed property where the created value can be realized at its maximum potential. The value (or equity) created will be higher than the costs of the scope of work.
Often, the property is placed on the market for sale before the renovations are complete. Under this scenario, the investor realizes all of the created equity because of the higher market value.
The result is a recapitalization of the investment amount, plus a profit. These funds can then be used for another opportunity or another use to improve the investor’s overall cash position.
Investors with a long-term, buy-and-hold objective have the same path during the acquisition and renovation as short-term investors. However, instead of selling the property, the investor refinances the acquisition loan with a long-term, permanent loan based on the increased market value.
The lender’s LTV will determine the investor’s required equity and whether any created equity is available for cash conversion.
Over the long-term hold, the investor will benefit from the net cash generated from the rent, market appreciation, and equity accumulation as the loan is paid down. However, this takes time.
A savvy investor will diversify the portfolio with both short- and long-term holding periods to recapitalize and benefit from accumulated equity.
The Ways to Access Equity
There are a few ways for an investor to access the increased equity in a property without having to sell it. Each must be considered against the investor’s objective and the property’s position. Besides an outright sale, there are three ways to render equity available for cash:
- a refinance or loan modification
- an equity line of credit, or
- an equity loan
These finance vehicles are discussed below.
1. Cash-Out Refinance or Loan Modification
When sufficient equity is accumulated in a property through either market appreciation, accelerated loan pay down, or both, the current loan can be refinanced for a higher amount or modified if the lender offers this choice.
A refinance is a new loan with associated fees. There will be fees with a modification, but not to the extent of a new loan.
Either choice will offer an investor the most flexibility for using the cash without tax consequences. The result is one mortgage against the property.
2. Equity Line of Credit
The acronym often used is HELOC, or home equity line of credit. HELOCs refer to the home of the owner, or the primary residence. This is not the proper definition an investor uses when referring to their investment properties.
An equity line of credit, like a HELOC, will make a portion of the equity available to the investor through a line of credit. The accessed cash can be used for renovations to the property, as a down payment on another property, or used for any other investment asset.
There are some equity credit lines that draw on a maximum amount of equity and a draw on credit. There may be a period to draw on credit, but there will always be a time period to repay the entire line.
The credit line is revolving and is appealing to many investors. There can be circumstances when a lender recognizes an investor’s access to an equity credit line as liquidity.
3. Equity Loan
Under this vehicle, the equity is borrowed under the structure of a loan, or a second mortgage. This method is simple, straightforward, and the easiest to understand.
An equity loan will result in two loans against the property. The current loan remains in place and unchanged. The equity loan, or the second mortgage, will be for a shorter term and at a higher interest rate. The equity in the property will accumulate under both mortgages as the loans are paid down, and market appreciation will not be lost.
When accessing accumulated equity, an important note is to realize that the loan terms advertised by traditional lenders for HELOCs and equity loans are targeted at those borrowing against their primary residences.
The terms and the loan structures will be very different for investors refinancing or tapping into the equity in an investment property. An investor must not prepare a proforma based on these advertised rates and loan ratios.
The Benefits of Leveraging Equity
Before an investor taps into either accumulated or created equity, the measurement of the property’s performance must be evaluated before agreeing to a higher levered position. Ideally, the net cash generated from the property must meet the required ratios of the lender for the equity loan to be approved.
If the property can support a refinance, an equity line, or a second mortgage, the benefits to the investor will outweigh the additional costs and the higher loan payments.
Personal debt will be easier to manage, and well-managed debt will improve an investor’s borrowing position for future loans. The investor will also benefit from the position of more buying power with access to cash without using or depleting personal funds.
The best way to scale an investment portfolio or maximize investment opportunities is to know how and when to leverage. The access to equity will not be the same plan or from the same financing vehicle for every property.
The market conditions, equity programs offered to investors, and the property’s stability will be essential factors to consider before securing another property or committing the funds to another use.
