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How should I use the equity in my home to invest in a pre-construction condo?

Andrew talk to Paul about investing in a pre-construction using a home equity line of credit (HELOC). What’s the strategy involved? How should he do this?

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Andrew la Fleur: Welcome to the Ask Andrew podcast. Real questions from real condo investors. You ask, I answer.

Hi and welcome back to the show. Thanks for listening to this podcast. I hope you’re enjoying these episodes. On today’s episode we have Paul and Paul is wondering about how to use the equity in his home to invest in pre-construction condos so we talked about that and strategies, specific strategies, around using your equity, using your home equity line of credit. In this case, to invest in pre-construction and how that looks like and what kind of things you need to think about and consider.

You will hear that conversation in just a moment. If you’d like to be on the show, if you have a question that you’d like to ask me, I’d be happy to chat with you so just go to Ask Andrew Podcast dot com and click the button Ask A Question. You can set up a time where we can chat and I can answer your questions about condo investing. Without further delay, here is my conversation with Paul.

Paul: Hello, Andrew. I’m interested in hearing more about some of the details around investing in a pre-construction condo. Sort of no money down. In my situation, financing a down payment through a secured line of credit and then obtaining a mortgage secured against our existing residential house. Just wanted to hear more about the details of that and particularly around that down payment. In your experience is it better to carry that down payment on a credit line, which is, say, prime plus one or to try and pay that off as we go?

Andrew la Fleur: Yeah. Great question. Yeah. You’re wondering about using a line of credit to invest in pre-construction and the mechanics of that, how it kind of works. Not to sound like a cop out sort of answer or anything but I guess it ultimately depends. It depends on the situation and a number of different factors on how you might want to do that or if you might want to do that. Can you tell me a little bit more about your specific situation? Are you using a line of credit right now and wondering what to do?

Paul: We have a line of credit secured against our residential house, which is appreciated quite a bit since we bought it.

Andrew la Fleur: Maybe start there and tell me about that. The house that you have …

Paul: Yeah. We have about 300 [crosstalk 00:02:38] Yeah. We bought it for $430,000. It was appraised recently at $720,000 over nine years. It’s kind of a crazy market where we are here. Took a secured line of credit against the house and made a down payment on a pre-construction condo that we’re still in the process of completing the down payment. Then also have been pre-approved for a mortgage for that condo.

I guess from a cash flow perspective, wondering in the long-term is it better to pay down that line of credit? Assuming that we would be cash flow neutral when we’re renting the place. Even if we were slightly paying more … So a cash flow negative if we were having to pay a bit more in interest costs but really is there a benefit to doing that and writing off the interest or trying to pay down that credit line?

In the long run we don’t need that equity that the credit line is tying up. We don’t need … Yeah. I don’t feel like we would need to pay it down from any sort of financial plan. Just wondering from your perspective, what are some things to think about?

Andrew la Fleur: What’s the move? Yeah. Generally speaking, I’ve written a lot about using HELOC line of credit, equity in your home, to invest. Generally speaking, I think it’s a great strategy. Generally speaking, I think that most people who have bought a house or any property two, three years ago or beyond …

Like if you’ve owned a property for any length of time in southern Ontario you probably have a tremendous amount of equity that you’re sitting on. Most people are just not utilizing that equity at all. It’s really just a waste of a very powerful resource to grow your wealth and to invest in real estate. In terms of your specific situation, talking about you’ve used a line of credit to buy a pre-construction condo so that condo is not finished yet?

Paul: No. It’s not finished.

Andrew la Fleur: You’re still making those payments, it’s under construction, it’s going to be finished approximately when?

Paul: I think they’re saying 2019.

Andrew la Fleur: Okay. About a year or so until it’s done and you start being able to rent that out. Yeah. If you can purchase a property as you’re alluding to and have basically 100% debt on it, no equity on it, you’re using a line of credit for the down payment and then you’re using a mortgage for the balance and you’ve put basically none of your own money into it, if you can find a property like that that when you rent it out it pays for itself or it comes very close to paying for itself, to me that’s an amazing opportunity.

That’s a no brainer. That’s fantastic to be able to find somewhere that carries itself with essentially no money down of your own, 100% debt. That’s very hard to find. If you’ve got something like that generally that’s a great thing. If you can hold a property like that over the long-term, if you could keep doing that over and over and over again and slowly growing your wealth and growing equity over time as that property appreciates, that’s a very good strategy.

Obviously it’s an aggressive strategy. Obviously it’s a risky strategy because you’ve got no equity in the property. If the market ever goes down you’re in a negative equity situation very quickly. But if you don’t sell the property then it’s not an issue. If you’re just renting it out continually and it’s continually paying for itself then that downside risk it poses no harm to you unless you actually sell at a loss, right?

Paul: Right.

Andrew la Fleur: That’s one of the mental traps that people fall into when it comes to this is thinking, “What if things go wrong?” Well, it only goes wrong if you sell at a loss.

Paul: That’s right. Capitalizing that loss.

Andrew la Fleur: Yeah. Generally speaking, it sort of depends on what your tolerance is for risk, what your tolerance is for how much debt versus equity you want to carry. Most people would say probably take a strategy of basically using that HELOC to pay for the down payment and then setting a goal to pay off that debt, which the HELOC debt is going to be at a higher interest rate most likely than your mortgage debt. You’d want to pay off that HELOC debt first before you pay off your mortgage debt, pay off the higher interest debt that’s costing you more first before you start thinking about paying off your mortgage debt, which is at a lower interest rate.

Yeah. That’s one way to look at it. A way a lot of people look at it is sort of, “Okay, let’s buy something pre-construction. We don’t have the cash upfront but we do have this line of credit we can access. It’s not going to be finished for three or four years. We’ll take the next three or four years as it’s being built and sort of slowly set aside money from our income to pay down that line of credit so that when the building is done, boom, we have equity in it right away.”

Hopefully, obviously hopefully, the property also has appreciated significantly from the time that you purchased it pre-construction to the time it’s actually finished and you’ve got additional equity there as well.

Paul: Right.

Andrew la Fleur: Does that make sense?

Paul: Yup. Yeah. Then you would potentially use the equity that’s being built in the condo to purchase another property? Is that your strategy that …

Andrew la Fleur: Yeah. It’s sort of a rinse and repeat idea. Again, it’s all about having a long-term strategy and understanding that real estate is a long-term game. You start thinking in decades. You’re not thinking in year to year. You’re not thinking one property at a time. You start thinking about building a portfolio of properties over decades. Yeah, it’s a rinse and repeat where you refinance these properties every three to seven years depending on how much the equity grows and you’re just continually reinvesting that equity into growing the portfolio and to adding more properties.

In terms of how much you leverage it’s going to depend on two main things. That is what your personal risk tolerance is for how much debt versus equity you want to have across your properties. The other thing is just what you can get approved for. Obviously with the banks. Just because you have a lot of equity in a property doesn’t necessarily mean you can get that out.

Paul: Right.

Andrew la Fleur: You still have to quality to pay for that debt with the bank. That is one mistake that a lot of people don’t realize. Some people, maybe they’re self-employed for example, they have a lower income but they do have a lot of equity in their properties. Without a decent or a high income, you’re not going to get approved for those lines of credits to pull that equity out.

In a lot of cases even if you have a lot of equity across these different properties over time, if you don’t show a strong income, if you don’t have a good balance sheet personally then you’re not going to be able to get access to that equity in some cases. That’s also something to think about and to talk obviously with your mortgage broker or your bank about and understanding what you can qualify for and how that works.

Now the good thing is when you have these incomes, these rental properties, is you’re getting income from the properties. You’re getting rental income from the properties. That is being added to your income.

Paul: All right. So that counts as income for those calculations?

Andrew la Fleur: Yeah. That rental income is added to your income so it allows you to qualify for more … Once you have that income in place, once the property is being rented out, and it’s not a paper pre-construction purchase anymore, it’s a real property and you’re getting real income from that and you can show the lease and everything to the bank, then that allows you to potentially take on more leverage moving forward.

Paul: Would that be net income for the property or just the revenue from the rent?

Andrew la Fleur: Well, it depends. Generally speaking, yeah, we’re talking about net income. It depends on the lender and the bank that you’re talking to, how they’re going to calculate that and how they’re going to add that to your income. Some banks will only take half of the rent or some banks will take all of the rent.

Paul: Oh, okay.

Andrew la Fleur: You want to be working with the banks who are investor-friendly in that sense. Some banks are the opposite of investor-friendly and they’re backwards in their thinking. They’re taking half of your rent or something like that in some cases instead of actually looking at your real estate portfolio as assets.

They’re looking at it as almost their liabilities and they’re punishing you for having these income-producing properties, which is completely asinine for those of us who understand real estate investing. Not every bank is like that so it depends from time to time.

Right now Scotiabank, CIBC, for example, tend to be very on the ball and forward-thinking with understanding investment properties and working with investors who have multiple properties. Bank policies, mortgage policies change from time to time so it depends on when you need the mortgage and what banks are playing ball or not at the time.

Paul: Okay. That’s good. I think that’s good advice. Yeah. The property that we have we purchased it below the market price for similar properties that are already being rented.

Andrew la Fleur: Amazing.

Paul: Yeah. In Kitchener. It’s a bit of a booming market.

Andrew la Fleur: Yeah. What are the details on the unit? What did you pay for it? What do you think it might rent out for?

Paul: Yeah. We got a one bedroom, one bathroom. I think it’s 600 square feet, including a balcony. It’s the Charlie West development, which overlooks Victoria Park in Kitchener. It’s in the Innovation District where Google and a bunch of other high tech companies are.

Andrew la Fleur: Yup.

Paul: Close to transit. It seems like a good … Right on the new rapid transit LRT line. We got it for $384,000 including parking and a storage unit. Current rental is probably around $1400, anticipating for that, $1450 a month. We bought it for $385,000 and there is some resale condos that are maybe one or two years old in the similar area by the same developer that are above $400,000 right now.

Andrew la Fleur: Above $400,000. Nice. You’ve certainly got some equity there. In terms of the … Looking at those numbers, $384,000 purchase price, renting it for $1400 to $1450, so you’re definitely not going to be able to have positive cash flow on that with 100% financing. You’re probably … Even at 20% equity, 80% mortgage on something like that, you’re still probably going to be short on that from a cash flow basis.

Paul: Let me just double check my numbers here because I think I’m off by $100,000. I think we bought it for $284,000 and current ones are selling for $350,000. Yeah. That sounds more right.

Andrew la Fleur: Yeah. There you go. That sounds better. That sounds better.

Paul: Yeah. I was off by $100,000.

Andrew la Fleur: Yeah. That’s a good time to be wrong, to be off by $100,000. Yeah. That sounds great. That sounds a lot better. Yeah. If you’re talking about you bought it for $284,000 that’s an incredible one bedroom with parking, $284,000. Incredible price. Yeah, if you can rent that out for $1450 then with 20% down that would be cash flow positive. With 0% down, probably not but as you said you’re maybe a couple hundred bucks a month, rough numbers, just back of the napkin here, you’re probably a couple hundred bucks a month negative cash flow.

Again, you might have a scenario where you can refinance it as soon as the property is done and pull some equity out of that and there’s different ways you could reinvest that equity. You could pay off that line of credit that’s been sitting there that you used in the first place. Yeah, if you bought it for $284,000 and it’s worth $50,000 or $80,000 or $100,000 more you could basically refinance it and pull some equity out immediately as soon as its done and as soon as you start renting it out.

Paul: Right. Okay. We haven’t even written the mortgage yet. It’s just been approved. At the time of completion, we could have it appraised and then even at that time rewrite the mortgage. Okay.

Andrew la Fleur: Yeah. That’s what some people do. Again, talk to your mortgage broker for specific strategies around that. What some people will do … Often, pre-construction condo by the tie it’s built it’s gone up so much in value and you want to access that potentially right away. What you can even do is just close on the property, get your mortgage on the first day, and basically have an open mortgage and then refinance it immediately on the second day.

Paul: Okay.

Andrew la Fleur: In the old days you used to be able to do both on the day of closing, like finance it and refinance it all in one shot, but that’s become harder to do. Most banks now you’re looking at closing on it and then basically having an open mortgage and then the very next day refinancing it.

Paul: Okay.

Andrew la Fleur: There’s some fees involved with that but it’s pretty nominal compared to the amount of equity that you’re going to be pulling in.

Paul: Then immediately pay off that line of credit or look for another opportunity? Yeah. Okay.

Andrew la Fleur: Yeah. Exactly. Depending on what you want to do with that cash and what your overall debt and equity situation is and looking at your principle residence and taking into different factors that are for your situation.

Paul: Provided there’s a lease signed on the property that’s closing. Yeah.

Andrew la Fleur: Yeah. Yeah. Generally speaking, you’re going to get your keys and you’re going to get occupancy of the unit before your closing takes place so that’s another nice thing about buying pre-construction is it gives you some flexibility in that respect where you can actually go to the bank when you’re getting your mortgage and say, “I need a mortgage on this property that I don’t technically own yet but it’s already rented out and I already have a lease in place and the income is already there.”

Paul: Yup. Yup.

Andrew la Fleur: That’s a unique thing about an advantage in a way of the pre-construction condo process where you have occupancy before you have final closing is you’ve actually got income coming in on the asset before you even own the asset. The bank looks at that and says, “Oh, wow. Okay. Here’s your personal income. Oh, you also have income coming in from this property, rental income, even though you don’t even own the property yet. We’re going to add that to the equation and do the numbers that way.” It helps you out in that respect.

Paul: Okay. That’s great. That’s really helpful, Andrew. I appreciate the answers there and the time.

Andrew la Fleur: Sure. Yeah. No problem. Yeah. Are you looking at adding more units? Are you wanting to close on this one before you get to the next one?

Paul: Yeah. I think that’s where we’re at now. This is our entry into the market and kind of wanted to see how this goes and learn a few things. Yeah, I think we close on this one and then look for our next one.

Andrew la Fleur: Yeah. It sounds like the first one … It sounds like you’ve done very well already. You’re doing exactly what you want to do. If you got it for $284,000 that’s perfect. You’ll have some major equity in that as soon as you close on it. That’s great.

Paul: Yeah. I see a similar unit down the road right now selling for $360,000. It’s already below market. Renting for $1400. I think our numbers are good here.

Andrew la Fleur: Yeah. Yeah. If you’ve got a property like that in an area like that, transit, the LRT and everything is coming in there, downtown Kitchener, a lot of jobs and everything coming in as you mentioned, that’s a great long-term hold on something like that if it pays for itself.

Paul: Yeah.

Andrew la Fleur: That’s a great unit.

Paul: Yeah. I think it was a good entry point anyway for us.

Andrew la Fleur: Excellent. Great.

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