Calculating Rental Property ROI with a HELOC?

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Joined: Sun Apr 14, 2019 9:13 am

Calculating Rental Property ROI with a HELOC?

Post by JessicaVSteele » Sun Apr 14, 2019 9:23 am

Hi everyone! I'm hoping that a clever, experienced real estate investor can help me. Maybe I'm just terrible at mathematics (likely :D ), but I'm struggling to figure out how to calculate ROI from a house purchased via my HELOC.

The numbers I'm giving below are just examples.

Let's say that I find a rental property which costs $50,000. Let's also assume that this would be the total cost of purchase, repair, etc.

Guesstimating with the 1% rule, let's suppose that this property can reliably provide $500/month rent. And for the sake of conservatism, let's guesstimate that the total expenses of the property (maintenance, water utility, property tax, insurance, management, and vacancy) will equal 50% of the monthly rent, or $250/month in expenses.

So, thus far, we would be earning $250/month, or $3,000/year. If we were to pay the $50,000 cost in cash, then our return would be 6%.

This cash-on-cash return is easy to determine, BUT...

Let's say I have a HELOC on my own house, and my mortgage is completely paid off. For ease of calculation, let's say my HELOC can go up to $100,000 so we can more than pay the $50,000 needed for the property.

However, my HELOC is a little weird. Unlike some HELOCs which have interest-only periods, my HELOC requires a minimum monthly payment of 1.5% of the loan. The variable interest rate on the loan is currently 4.5%.

So, if I were to draw 50,000 from the HELOC to pay for this rental property, my minimum payment for the first month would be $750, of which about $188 would be interest, and the remaining $562 would go towards the principal. Each month, these costs will be a little different, obviously, because the minimum payment will recalculate lower each month as the principal is paid down. (After 60-something months, for example, our minimum monthly payment will be only $384-ish on the remaining $25,360-ish balance.)

But obviously we already have a problem from the beginning.

Monthly rent: 500

- Monthly expenses: 250

- First Month Financing expenses: 750 (188 interest, 562 principal)

Net cash flow for the first month: -500

Unless I am just being a total idiot, this doesn't look good to me at first glance. At the beginning of this loan, anyway, I'm having to pay the $500 remaining principal out of my own pocket. So it is basically the equivalent of paying cash for the property (similar to a down payment, I suppose, which doesn't seem bad when you look at it that way).

But it will take a long while for this property to "break even": only when the balance of the loan falls to about 16,600 does the 250 rent income after expenses cover it fully. By that point, I will have paid $33,400 out of pocket (technically a little less, maybe 25k, since the rent would start to cover more of it eventually?), unless I'm mistaken... Then we wait a while longer for the remaining 16,600 to be paid off by the renters. Eventually, once the house has been paid off completely, the 250 after expenses goes to my pocket. That would be $3000/year, and I guess that would mean my annual return would be 8.9% at this point (3000/33400 = .089 = 8.9%).

While that 8.9% sounds all fine and whatnot, and suggests that using the HELOC in this way is eventually a better return than paying the entire 50,000 in cash, I'm really struggling to grasp whether this is a correct way of thinking about things.

After all, if I were to pay 50,000 in cash now, I would start getting the 6% return right away. But with the HELOC I essentially get zero return (or negative return, I guess?) for years before finally getting an 8.9% return. Or am I thinking about this incorrectly? Because the principal is still getting paid down, should I consider that my "return"? I have no idea. Sorry for being so bad at basic math.

Additionally, is there is a better way to use this HELOC to buy rental property? What would be the best method, assuming that I am looking at 50,000 properties which could generate 500 gross rent, or 250 after expenses? Should I use my 1.5% minimum payment HELOC towards this investment at all? Please help if you can, because my brain is threatening to give up now. :)

Lucky C
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Joined: Sat Apr 16, 2016 6:09 am

Re: Calculating Rental Property ROI with a HELOC?

Post by Lucky C » Sun Apr 21, 2019 5:57 am

You can't restart a comparison of investments midway through to make a long term comparison. You have to factor in all years. Would you rather hold Stock A that will have a 10% return in your 10th year of holding it or Stock B that will have a 5% return in your 10th year holding it? That's not enough info. What if I told you Stock A will return -10% years 1-9 whereas Stock B will return +5% years 1-9. Now you have enough info to determine Stock B is better.

So you have to compare years of losses then eventually +$3000/month vs. $3000/month right away. No question the HELOC is NOT the way to go looking at it that way, but is there an opportunity where you could be using your spare $50,000 cash is a way that nets you more than the 4.5% interest you'd be paying on the HELOC?

You have to compare the 4.5% interest on the HELOC vs. what you would be getting for the $50k cash if you had not taken out the HELOC. You can get about 2% interest just parking cash in some banks now, but that falls far short of the 4.5% cost of getting a loan of that amount, so it would make more sense to pay the cash to avoid 4.5% interest, since bank interest rates are lower than that.

What about investing the $50,000 you'd be getting as a HELOC in something else? Maybe you can get a > 4.5% return in the stock market, but that is no guarantee, especially with stock prices so historically high right now, and dividend payouts typically very low. You would just be adding risk with no guarantee of a payoff, plus the risk of the HELOC rate changing. Some people think they are clever playing the stock market when they could be getting a guaranteed 4-5% return with no risk just by paying off their mortgage. They are effectively making a leveraged gamble. If stocks go way up, they can make way more than they would have made otherwise, but if stocks go way down, they will lose way more than they could have lost if they hadn't done that (since it wasn't their money they were gambling - it was the banks!).

A HELOC makes sense if you can get a safe return on investment greater than the interest. For example, if your state had good solar panel incentives such that you could get a pretty much guaranteed 10-20% ROI on solar panels, it makes sense to get a HELOC to pay for them now rather than wait, especially since the incentives may go away. Other than "no-brainer" investments like energy efficiency improvements, insulation, etc. a HELOC is just like any loan where you are making the bankers rich by getting things you want sooner using other people's money.

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