All About Refinancing Real Estate Investments In Toronto
We’ll talk all about refinancing: what is it, how it works as a real estate investment strategy, and tips on how to get the most out of refinancing for real estate investing.
What Is Refinancing?
Refinancing means you’re paying off your old mortgage and replacing it with a new mortgage.
There’s various reasons why people may do this including wanting to change the terms of their mortgage, debt consolidation, or tapping into their home equity to take out cash for something else.
Some are good ways to use the money and some not so good ways. We did another video where we dive into good vs bad debt so please check out this video here if you want to learn more about this.
Let’s focus on using refinancing for real estate investments and see what refinancing does.
Assume you have an investment property that’s a house. At the start of your investment, you put in 20% downpayment so your returns are magnified 5 fold. When your property increases in value, you gain equity. This means your loan to value ratio drops, so your returns decline over time.
You have unrealized gains in the property, but if you do nothing, those extra gains aren’t generating you more returns. If you sell the property to access these gains, then you’ll have to pay a bunch of taxes and fees so you’ll have less to reinvest.
This is where refinancing comes in. Refinancing allows you to tap into the equity gained so you can reinvest it and put it to better use.
A Financial Comparison: Do Nothing vs. Refinance
Most real estate investors would agree that refinancing to grow your portfolio is a good idea if you can generate better total returns, and I’ll illustrate the point by crunching some numbers. We’ll compare the “Do nothing” scenario with the “refinance & reinvest” scenario to compare total returns.
Here are my assumptions:
- 3% mortgage rates in the beginning
- 5% annual appreciation
- 3% annual rent growth
- 1% inflation
- 4.5% starting rental cap rate
In scenario 1, we buy a $1,000,000 house, and put in 20% down at $200,000. We also put in $100,000 of renovations to upgrade the property and after renovations, our house was appraised for $1,250,000. Let’s say something crazy like COVID hits, so interest rates drop to 1.5% quickly. Let’s also assume we’re on a variable rate mortgage so this helps increase our cash flows.
In 5 years, we gain a total of $131,000 in cash flow, $110,000 in equity pay down, $345,000 in market appreciation, and $150,000 forced appreciation. This generates a 5 year total return of $736,000 if we just keep the property without refinancing.
In scenario 2, we’ll refinance property right after renovations at 80% of the property’s new value, so that’s $1,000,000 in the new mortgage. It’s a bigger mortgage, so it changes up the total returns breakdown. In this new arrangement, we have a total of $84,000 in cash flow, $137,000 in equity pay down, $345,000 in market appreciation, and $150K forced appreciation totalling $716,000 in 5 years time plus we can take out extra money to reinvest.
With the $1,000,000 new mortgage, we pay back $800,000 in the old mortgage. There’s also a penalty fee because we canceled our old mortgage. Note that this penalty varies depending on whether you have a variable mortgage or a fixed mortgage. Typically, variable mortgage has a lower penalty equal to 3 months interest whereas a fixed mortgage is based on interest rate differentials – and we’ll dive into the differences a bit later.
The variable mortgage penalty at current 1.5% interest rates means the old mortgage will cost $3,000 to cancel. So after $3,000 to pay for the penalty, we will be able to buy another $840,000 house that requires $29,000 in closing costs and $168,000 in downpayment.
And the total returns for this second house over 5 years $379,000. This brings the total portfolio returns to $1.095,000 so al lot better than Scenario 1.
How To Maximize Refinancing Efforts
Based on this comparison, what should you note so that you can make the most out of the refinancing strategy?
1. Properties WIth Higher Cash Flows
Your monthly mortgage payments go up after refinancing. This means it’s a good idea to invest in properties with higher cash flows so you can comfortably make your mortgage payments even after factoring in higher mortgage payments post-refinancing.
2. Variable Mortgages vs. Fixed Rate Mortgages
Consider going with a variable rate mortgage since your penalty is capped at three months interest vs. a potentially much higher penalty on a fixed mortgage if there’s a big difference in rates.
In our example, because rates dropped from 3 percent to 1.5 percent – if we had a fixed mortgage, we’ll actually have a $60,000 penalty instead of just $3,000 if there’s 5 years left. At the end of the day, you have to know this – this high penalty for the fixed mortgage is because you agreed to be locked in a higher rates and the rates have dropped.
This means if you chose a fixed rate you’d be paying the extra $60,000 dollars if you held your mortgage for the entire term – the difference is that the extra interest would be paid over time, instead of paying it upfront when you break the contract.
By breaking the fixed rate mortgage – what you’re losing out on is the time value of money since the $60K is paid all upfront, and the higher penalty will eat into your cash out refinance amount, and will reduce the amount you can reinvest.
In our example, if we had a fixed rate mortgage, we’d have to pay out $60,000 from $200,000 which means we would only have $140,000 to reinvest and that means we’ll only be able to afford a condo with lower cash flows combined with a lower value asset, which translates to lower total returns.
3. Value Add Work
If you are thinking of using the refinancing strategy to grow your portfolio, it’s a good idea to take on value add work. This will give a big bump in your property’s new appraised value, which means a bigger cash out refinance amount to grow.
4. Property Appraisals
On the same lines with maximising the refinancing amount, it’s a good idea to be physically present when during appraisals. And when you’re with the appraiser, show them what exactly you’ve upgraded, how much your rents are, and the latest property price comparables. This allows appraisers to have all of the info if you’re looking to maximize your property’s appraised value.