Many rental property investors are leaving money on the table without even realizing it.
They purchased their property several years ago when interest rates were higher. Today, they’re still making a higher than necessary mortgage payment which eats away at their cash flow.
Not only that, many investors have a surprising amount of untapped equity in their property that could be put to much better use.
Here’s how real estate investors can benefit from doing a refinance on their rental property.
Why now might be a great time refinance
For most investors, profiting from today’s historically low interest rates is the #1 reason to refinance investment property. However, interest rates likely won’t stay this low in the long run.
The Fed has hinted at multiple rate hikes in 2022, so it may be better to get a low fixed-rate loan before it’s too late.
In addition to taking advantage of low mortgage interest rates, other benefits of refinancing a rental property include:
- Switch from a variable/adjustable rate mortgage to a fixed interest rate
- Lower the amount of interest paid over the loan term
- Increase monthly cash flow by lowering the total mortgage payment amount
- Change from a 30-year to a 15-year fixed-rate loan to build equity faster
- Cash-out refinance to turn accrued equity into cash to invest in additional rental property
Best ways to calculate your property market value
The first step in deciding if you should refinance your rental property is to determine the fair market value. Then, compare the property market value to your outstanding loan balance to determine how much equity you have.
Doing this will give you a better understanding of how you could benefit from refinancing, and whether or not a cash-out refinance makes sense.
When you apply for a refinance loan on your investment property the lender will order an appraisal to determine the market value. However, there are also several ways you can calculate the market value of your property on your own to get a feel for what your house is really worth.
Broker price opinion (sometimes called a broker opinion of value) is done by a licensed real estate broker. Sometimes the broker will charge a small fee for the work; other times they will waive the fee and hope you do business with them in the future.
One of the biggest advantages of getting a BPO is that the broker has his finger on the pulse of the marketplace and understands if market values are trending up or down. On the other hand, some brokers may inflate the value of your property as a motivation for you to sell or give them a ‘pocket listing’.
Many real estate investors will ask their broker for a price opinion, then do a ‘reality check’ by using additional methods to estimate their property value.
Zillow Zestimate is a model developed by Zillow to estimate the market value of a house. Zestimate uses public and user-submitted data and factors in variables such as specific facts about the property, the location, and current market conditions.
According to Zillow, one of the biggest advantages to using Zestimate to learn the value of your property is that the service is independent and unbiased. It’s a good starting point, but not a replacement for a professional property appraisal.
Realtor.com is the official website of the National Association of Realtors (NAR) and offers an online home valuation service called “Sell your home.” In order to receive an estimate, you’ll need to provide contact information and agree to receive emails, text messages, and phone calls from Realtor.com, real estate agents, and anyone else who is part of the organization’s network.
If you’re a new real estate investor and are in the process of putting a local real estate team together, this can be a good way to find active professionals to speak with.
Main steps for refinancing a rental property
Once you’ve determined what the value of your rental property should be, the next step is to apply for a loan to refinance:
1. Contact your current lender or mortgage broker
If you’re happy with your current lender, provide them with the first opportunity to refinance your existing loan. Having a trusted mortgage lender or broker on your team can make growing your real estate business that much easier.
That being said, do research other sources for loans as well, because not all lenders have access to the same programs for real estate investors. Be sure to get an estimated closing statement from each lender you speak with to see how much the cost to refinance varies from one source to the next.
2. Provide required documents and prepare for additional requests
There’s a lot of required paperwork when you buy a property, and even more when you refinance an investment property. In the next section we’ll take a closer look at the documents your lender will need.
But for now, be prepared to provide information when you apply and respond promptly to additional requests during the underwriting process so that your loan doesn’t get delayed.
3. Property inspection and appraisal
Your lender will order an appraisal to be done on your property to verify the value of the property. If the property is rented, be sure to let the tenants know in advance that you’ll need access to the inside of the house.
Also, if there’s any deferred maintenance that needs to be done, it’s a good idea to take care of the work before the appraisal is done so that you get the highest possible appraised value.
Some lenders may also require the property to be professionally inspected. Others will be satisfied with a copy of the most recent inspection report and receipts for any work done, especially if the house has been consistently rented.
4. Sign your loan documents
After you review your final closing statements and sign your loan docs, the lender will fund and close on the loan. The lender will ensure your existing loan is paid off, make sure any closing costs are paid for, and send any excess funds from the refinance to you.
What lenders look for when evaluating your refinance request
Refinancing your rental property will go faster and with fewer hiccups when you have your documents ready to go. Oftentimes lenders have stricter credit requirements for refinancing a rental property and look for an LTV (loan-to-value) ratio of at least 75%.
Refinance application documents
- Proof of personal income, including pay stubs or bank statements if self-employed
- W-2 forms to verify employment history and income
- Most recent tax returns for the last two years
- Statements for all investment (including rental income from other properties, if you own any) and retirement accounts
- Verification to run your credit score
Rental property requirements
- Copy of existing lease, rent roll, and proof of tenant deposit
- Proof of good corporate standing if property is held in an LLC
- Proof of homeowners insurance and title insurance
- Disclosure of any insurance claims made or potential lawsuits pending
- P&L showing financial performance of rental property over the past two years
How cash-out refinancing works
Professional real estate investors often use cash-out refinancing to pull accumulated equity out of one property to buy another, and also to lower the monthly mortgage payments.
Let’s use rental property investor Joe Smith as an example.
Five years ago, Joe purchased a single-family rental property for $150,000 in a market where property is appreciating 5% annually. He made a 20% down payment and his current mortgage interest rate is 6%.
Joe has the opportunity to refinance his current property at a 4% interest rate. He also has his eye on another single-family rental in a different state with a market value of $100,000.
Step 1: Determine existing equity
- Original property market value: $150,000
- Current property market value: $150,000 @ 5% annual appreciation over 5 years = $191,442
- Original mortgage balance: $120,000 ($150,000 purchase price – 20% down payment of $30,000)
- Current mortgage balance: $111,504 (reduction in principal balance over 5 years)
- Existing untapped equity: $191,442 - $111,504 = $79,938
Available cash-out funds: $191,442 @ 75% LTV = $143,582 new loan with $47,860 of equity used for down payment and remaining $32,078 of equity turned into cash.
Step 2: Calculate monthly mortgage payment before and after
- Monthly payment before cash-out refinance: $719 (30-year fixed rate at 6% interest on $120,000 original loan)
- New monthly payment after cash-out refinance: $685 (30-year fixed rate at 4% interest on $143,582 new loan)
Step 3: Decide if a cash-out refinance makes sense
Based on these calculations, Joe can:
- Pull out $32,078 in cash from his current property and use it for a down payment on another single-family rental
- Reduce the monthly mortgage payment on his current property from $719 per month to $685 per month
Joe decides that doing a cash-out refinance makes good business sense. In fact, if he contributes less than $8,000 more in additional capital, he can afford to make down payments on two single-family rental properties instead of just one.
Of course, our example with investor Joe is hypothetical and excludes any new loan fees or closing costs. You can explore your specific financing options with the Roofstock financing calculator.
Final thoughts on refinancing
To be fair, if you’re not planning on holding a rental property for much longer, it probably doesn’t make sense to refinance due to fees with the new loan.
In our example above, Joe could just as easily have sold his existing property and conducted a 1031 tax deferred exchange that would allow him to use all of his $79,938 for buying like-kind replacement property.
That’s the nice thing about investing in real estate. After a relatively short five-year holding period, rental property investors have good choices to make and a variety of options.