If you’ve been making regular payments on your personal residence, the equity you have built can be used to reinvest into rental properties, fund personal objectives, or complete renovations. Although home equity loans (HELOC’s) carry their own share of risk, responsible investments can still be made using these funds. Here are some pointers and strategies to apply when using equity from a primary residence to invest into a rental property.
1. Understanding equity and leverage
Equity is the difference between the current market value of a property, and the total amount of debt registered against it, including the mortgage. In other words, equity is the part of the home that you, the homeowner, truly own. If you were to sell your home and pay off your outstanding mortgage loan, the liquid cash you’d walk away with is your equity.
To calculate your equity, you need to know the current market value of your home. This will be considered your assets.
Next, you need to know the amount left to pay on your mortgage, which you can obtain through your bank or lending institution. This will be considered your liability.
Lastly, subtract your liability from your assets to find your equity amount.
In short: Equity = Assets – Liabilities.
Leverage in real estate simply means your capacity to borrow from your property’s worth, to help finance an investment property. Without leverage, high-capital properties such as multiplexes could not be purchased.
How to access your equity
Most investors choose to borrow against their homes using a mortgage or a line of credit. This is the safest and most affordable (in terms of interest rates) way to access equity.
Current HELOC rates in Montreal range between 4.2% and 4.5%.
How to choose an investment property
A safe real estate investment is one that generates a good, and predictable, rate of return.
There are two key points to look out for when scanning the market for promising opportunities:
1. Properties that are listed below market value.
Look for repossessed properties and properties listed below their municipal evaluation. Consider joining a mailing list for investors to receive handpicked deals in high-demand neighbourhoods. Lastly, always ask your broker to provide you with a comparative market analysis before putting in an offer on a property.
2. Properties that offer positive cash flow, or as close to positive cash flow as possible.
An investment brings ‘positive cash flow’ when the monthly income generated through rent is higher than the total carrying costs, including mortgage costs, bills, taxes, and other expenses.
Use a mortgage calculator to determine your carrying costs, while consulting with your broker about rental averages and vacancy rates.
Other financial considerations are: closing costs, interest rates, appreciation rates, ROI and net profitability. (You can calculate ROI on any rental investment using our free ROI Calculator.)
Avoiding risk when borrowing against your equity
Leverage can allow small scale investors to build their portfolios, but it comes with its own share of risk. If everything goes right, your equity can grow your wealth. In practice, however, many investors make mistakes and get burned. Here are some tips to avoid the pitfalls, when refinancing your home:
- Use an experienced real estate broker. Working with a real estate professional is free on the buying end, and a broker’s expertise will be immensely valuable to the unexperienced investor. A broker will help your determine current market value, calculate your financial projections, negotiate your offer, and guide you through the legal paperwork required to purchase an investment property.
- Think long term. Real estate investors should approach rental properties with a strategy that focuses on long term growth. Unless you are considering a real estate flip, you should give yourself enough time for returns to materialize. Generally speaking, that means having a time horizon of at least 5 years.
- Budget conservatively. When borrowing to invest, you need to have a clear understanding of your closing costs, monthly carrying costs, potential rental income and vacancy rates.Budget in a disciplined manner which accounts for unexpected issues such as repairs or rising interest rates. A classic mistake is to generate overly-optimistic financial projections, only to run short on cash and sell the investment at a loss.
Leveraging your equity is a powerful way of attaining growth as a real estate investor. When accomplished in a smart way, your equity can act as a stepping stone to a larger investment portfolio.