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Today we’re covering:

• Home equity and when to use it

• Multifamily investments and how to value them

• Performing market analysis

Leveraging Home Equity for Real Estate Investment: A Double-Edged Sword

Home equity - the difference between your property’s market value and the outstanding balance of all the debts on it - can be a powerful tool in a real estate investor's toolkit.

By borrowing against this equity through either a Home Equity Loan or a Home Equity Line of Credit (HELOC), investors can potentially fund new property purchases or address deferred capex and improve in their property.

When Leveraging Home Equity Works Well

Consider a positive scenario: An investor named Sam owns a home valued at $500,000 and has already paid off $300,000 of the mortgage.

This leaves Sam with $200,000 in home equity. Sam spots an opportunity in the market and decides to invest in a fixer upper.

Instead of taking out a traditional investment loan with a high-interest rate, Sam opts for a HELOC based on his home equity as a down payment. He is able to use a short-term high interest loan to fix up the property and then is able to refinance into long-term debt.

HELOC’s are great when interest rates are low as you can tap into built in equity without having to sell your asset.

When Leveraging Home Equity Goes Wrong

Home equity is great, but it’s also got a downside.

Consider Lisa, another investor. Lisa owns a home worth $400,000 and has $200,000 in home equity.

She decides to leverage this equity through a Home Equity Loan to invest in a property she believes to be a 'sure bet' for quick resale at a higher price, also known as flipping.

However, after purchasing the property, the real estate market experiences a downturn, and property values in the area plummet. On top of that, she discovers serious structural issues in the house that require expensive repairs.

Now, not only is Lisa unable to pay for her mortgage, but she also still has to service her Home Equity Loan (aka debt service). This is essentially 2 different loans, one from her mortgage for the rental and another for the HELOC.

In this case, Lisa's primary house is at risk of foreclosure if she defaults on her Home Equity Loan payments, and she's also underwater on her investment property.

The market downturn was beyond her control, but the decision to invest based on the assumption of a 'sure bet' and not conducting a thorough inspection led to a high-risk situation.

In both scenarios, it's clear that leveraging home equity can act as a stepping stone or a stumbling block.

It's essential to evaluate market conditions, conduct thorough due diligence on potential investments, consider the cost of borrowing, and ensure the ability to service the loan.

In today’s high environment of 4.02% (treasury rate aka risk free rate as of 7/7/23), a bank might lend at 6.02-7% HELOC. This means you must at least net a return of 9-10% for it to make sense.

Making well-informed and cautious decisions can help prevent the sword of home equity from cutting the wrong way.

Multifamily Investment

We have previously talked about the differences between single family and multifamily real estate.

Let's delve deeper into multifamily investment and how properties are valued using the Net Operating Income (NOI) and the capitalization rate (Cap Rate).

Multifamily Investment: Valuing Properties with NOI and Cap Rate

Instead of relying solely on comparable sales (comps), as with single-family residences, multifamily properties are often evaluated based on their income.

This is where concepts like Net Operating Income (NOI) and capitalization rate come into play.

Net Operating Income (NOI)

The NOI is essentially the annual income generated by the property after deducting all operating expenses.

Operating expenses include costs like maintenance, property management, utilities, insurance, and property taxes, but do not include mortgage payments or depreciation.

Let's consider an example.

Suppose you own an apartment building that brings in $500,000 per year in rental income. Your total operating expenses for the year - everything from property management fees to repairs - amount to $200,000. By subtracting your expenses from your income, you calculate your NOI: $500,000 - $200,000 = $300,000.

Capitalization Rate (Cap Rate)

The Cap Rate is a metric used to estimate the potential return on an investment, expressed as a percentage. It's calculated by dividing the NOI by the property's current market value.

For example, if the current market value of your apartment building is $3,000,000 and your NOI is $300,000, your Cap Rate would be $300,000/$3,000,000 = 0.10, or 10%.

How it all Comes Together

Understanding these calculations can be very helpful when comparing different investment opportunities. A higher Cap Rate typically indicates a higher potential return, but also a higher risk. Lower Cap Rates usually signify lower risk, but also lower potential returns.

Of course, these calculations are simplifications and it's essential to remember that many factors can affect the value of a multifamily property, including the location, the condition of the property, the quality of tenants, and changes in the broader real estate market.

Market dictates cap rate

The market and asset class you have dictate the cap rate. In Tier 1 markets like San Francisco, New York, Seattle, and Los Angeles, cap rates are lower as they usually signify less risk. In Tier 2 markets like Chicago, Austin, Denver, Washington DC, and San Diego, cap rates may be a smidge higher. Tier 3 encompuses all other major metros.

Product type also dictates cap rates. If it is a newer property, cap rates will be lower than a property that is 40-50 years old.

Real Estate Market Analysis: Picking Real Estate Markets

Real Estate Market Analysis: Factors to Consider

A real estate market analysis, sometimes referred to as a comparative market analysis (CMA), is a study of the current market values of properties, comparable to a potential investment property. It provides an estimate of a property's value based on similar properties, current market conditions, and a variety of other factors.

Here are the key factors to consider when picking real estate markets:

1. Geographical Location and Submarket Trends:

Firstly, identify the geographical area you're interested in. Market trends can vastly differ from one city to another, one neighborhood to another. Look at factors like property prices, rental rates, vacancy rates, and absorption rates in the targeted area.

2. Comparable Properties (Comps):

Once you've identified your area, find properties that are similar to the one you're considering in terms of size, condition, age, and so on. Look at the prices at which these properties have been selling.

Comps should ideally be in the same neighborhood, have been sold within the last 3-6 months, and be similar in terms of specifications and amenities.

3. Economic Indicators:

Consider broader economic indicators as well. What's the state of the economy? Is it a good time for people to invest in properties? Are people moving into or out of the area? Look at factors like job growth, unemployment rates, median income, and population growth in the area.

4. Property Specifics:

Specific attributes of the property can also have a significant effect on its value. These include the property’s age, its condition, any upgrades or special features it may have, and how well it has been maintained.

5. Regulatory and Zoning Changes:

Stay up-to-date with local legislation and zoning laws, as these can have a major impact on property values. For instance, changes in rental laws, building restrictions, or zoning that allows for commercial use can all dramatically affect a property's value.

6. Supply and Demand:

Analyze the balance of supply and demand in the area. High demand and low supply typically drive property prices up, and the opposite is also true.

7. Rental Income:

If you're planning on renting out the property, what is the potential rental income? Look at average rents for similar properties in the area.

A well-conducted real estate market analysis can give you a clear understanding of the property’s potential as an investment. However, it's always a good idea to consult with real estate professionals or use trusted real estate market analysis tools to get the most accurate information.

I hope you’ve enjoyed this edition of the newsletter. It was a bit meaty.

Do you like short and longer form content? I can send out several emails or even do some real life analysis of on-market properties.

Thank you for reading!

-Mo