One of our Facebook fans, Tony Margiotta, posed this question, which I’m happy to try my hand at answering here:
“Could you talk about refinancing an income property in order to purchase a second income property? I’m trying to understand the refinance process and how you can use it to your advantage in order to build a real estate portfolio. Thanks Frank!”
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The Good News
Your plan – to extract some of the equity from an investment property you already own and use that cash as down payment to purchase another – is fundamentally sound. In fact, that’s exactly what I did when I started investing back in the ‘70s, so to me at least, it seems like a brilliant idea.
Of course, you need to have enough equity in your current property. How much is enough? That will depend on the Loan-to-Value Ratio required by your lender. The refi loan has to be small enough to satisfy the LTV required on the current property, but big enough to give you sufficient cash to use as the down payment on the new property.
For example, let’s say your bank will loan 70% of the value of your strip shopping center, which is appraised at $1 million. So, you expect to obtain a $700,000 mortgage. Your current loan is $550,000, which would leave you with $150,000 to use as a down payment on another property.
Given the same 70% LTV, $150,000 would be a sufficient down payment for a $500,000 property, i.e. 70% of $500,000 = $350,000 mortgage plus $150,000 cash.
But Wait… Some Issues and Considerations
Unfortunately, it’s not the ’70s or even ’07 anymore, so while the plan is sound, the execution may present a few challenges. Best to be prepared, so here are some issues to consider:
- In the current lending environment, financing can be hard to find, and the terms may be more restrictive than what you experienced in the past. Notice that I used a 70% LTV in the example above. You might even encounter 60-65% today, while a few years ago it could have been 75-80%. In order to obtain the loan, you might also have to show a higher Debt Coverage Ratio than you would have in the past – perhaps 1.25 or higher, compared to the 1.20 that was common before.
- How long have you had the mortgage on the current property? Some lenders will not let you refinance if the mortgage isn’t “seasoned” for a year or even longer.
- How long have you owned the property? A track record of stable or growing NOIs over time will support your request for a new loan. You need to make a clear and effective presentation to the lender showing that the refi makes sense, especially in a tight lending environment.
- You need to run your numbers and not take anything for granted. For example, will your current property have a cash flow sufficient to cover the increased debt?
- Keep in mind that you’re adding more debt to the first property, so the return on the new property has to be strong enough to justify the diminution of the return on the first.
- Have you compared the overall return you would achieve from the two properties using the refi plan as opposed to the return you might get if you brought in some equity partners to help you buy the new property?
In a nutshell, refinancing an existing income property to purchase another is a time-honored and proven technique, but it in a challenging lending environment be certain you do your due diligence and run your numbers with care.
Of course I never miss an opportunity to promote my company’s software, so consider using that not only to analyze the deal and its variations, but also to build the presentations that will optimize your chances of obtaining the financing and/or the equity investors.
Frank Gallinelli
Thank you for the article Frank. I just purchased your book “What Every Real Estate Investor Needs to Know About Cash Flow” on Amazon.com and I’m anxiously waiting its arrival.
So using the example above, my original shopping center loan is $550,000. Is the original loan paid off when I refinanced and got the $700,000 loan? So now I own two properties and I have only one loan for $700,000? Or, do I have one loan on the original property for $700,000 and I also have a second loan for the new property. The second property mortgage is $350,000 in the example above.
It seems that I would have two mortgages: one for $700,000 and another for $350,000. That equals to $1,050,000 in mortgage debt. Monthly loan payments for both properties at a fixed 3.5% interest rate for 30-years would be $4,185 and $2,092. My total monthly mortgage payment would be $6,277. I’m sure I’m oversimplifying, but I just wanted to make sure I have a basic understanding.
So generally speaking, my total NOI from both properties combined would have to be more than the $6,277 monthly mortgage payments in order for it to be profitable. Am I starting to understand how this works? Sorry for the long comment…
Tony – Yes, you would pay off your original 550k loan with the 700k refi, which would leave you with 150K to use as the downpayment on another property. Assuming the same LTV on the new property, you could presumably get a 350k mortgage on that one.
I believe your monthly mortgage payments would be $3,143 and $1,572 for the two loans with the terms you describe. (An aside: I doubt you’ll find a 30-year loan for investment property, or quite so favorable a rate.)
The sum of your NOIs definitely needs to be greater than the sum of the loan payments. In fact, it would really need to be about 20-30% higher to qualify for the loans, because “just enough” is not good enough for loan underwriting. See my chapter on Debt Coverage Ratio for more on that. — Frank
investment property to purchase another is good concept .u wrote a good article
thanks
Frank, I just came across this blogpost. I have a question. I need to pay off a small mortgage of 35,000 due to a divorce. I have an investment condo (not living in it) paid off free and clear worth $110,000. Is there anyway to take a loan to pay off the other mortgage. My bank wouldn’t let me. Looking for options.
Jesse –
In general, you would expect to be able to get a $35k loan against a $110k property, but given the current state of financing, your bank could have any number of hurdles in place to make your quest difficult. Start by asking why they won’t loan against the property. Do they disagree with your valuation? Are there too many units in the complex that are sitting unsold? Are there issues with the condo management? Once you’ve identified the problem, if you can’t resolve it with your current bank then your next step is to shop the loan with other lenders. Be sure to ask other unit owners in the complex who holds their mortgages — good place to start.
Thanks for your reply Frank. I shopped around, because my larger bank had to abide by Freddie Mac and Fannie Mae rules. I found a credit union that will easily loan me the money.
Hi Frank,
Thanks for this nice article.
Actually I have planned same but not able to find any bank to loan on existing property. Last month I have bought an investment property with cash to get good deal and now I want to have loan on this and buy another one. Can you suggest some bank?
Thanks,
Niteen
Niteen — Financing, like politics, tends to be very much a local phenomenon, so I would start by talking to local banks. Since you’ve already purchased the property for cash, you should be in a position to make a strong case for your loan. Also, talk to a few of the more active agents in the area and ask who their favorite mortgage brokers are. An experienced m-b can often find financing on good terms for a well-qualified borrower.
Frank
70% LTV is still pretty common, that’s what I was doing on some duplexes in Indy.
It’s worth noting though, that in spite of the stringent lending now days, the combination of higher overall rents and lower overall interest rates on loans, that it becomes nearly impossible to not be able to profit, especially if you’ve been cash-flow positive this entire time already. I’ll take a 5% loan on a 20% ROI any day.