How Cash Out Refinances Can Help You Build Wealth & Diversify Income Streams

If you were to ask any financial advisor for their golden rules when investing, there’s a good chance almost all of them would include diversification near the top of their lists. Diversification is the most effective means of managing risk. By spreading out investments over a variety of assets you’re less likely to have your investment portfolio wiped out due to one negative event. As the timeless adage goes, don’t put all your eggs in one basket. But how can executing cash out refinance transactions help in diversifying your investment portfolio even further, and how can it be utilized to effectively mitigate your risk?

For those frequent readers of our physician-owned real estate journal, you may remember an article from one of our pervious editions, which talked about how the practice drives the real estate investment. This is vital to remember as we talk about the risks associated with these owner-occupied investments. As long as the practice continues to lease the space and can keep up with the rent payments, the real estate risk is minimal. This remains true even for highly leveraged properties, as the rents are set high enough to cover the loan payments and then some in these cases. The moment this changes, and the practice is unable or unwilling to pay the rent on the property, the real estate risk grows substantially. If the world turned upside down, and your practice was unable to pay the rents, the property would substantially decline in value. That is to say, a vacant building is worth a fraction of the value of a fully leased property.
 
The question therefore becomes, are you better off having a lot of equity locked in that property or are you better off using that equity – through a cash out refinance – and investing it in assets that aren’t tied to the practice’s wellbeing? When pondering this question, it’s important to recognize that if the practice is unable to pay the rents, it’s likely the practice is struggling. and it’s the practice that was likely your primary source of income. Then, if these events were to unfold, not only would you lose this income, but you would also lose a substantial amount of your net worth stored as equity in the property. In these situations, the bank would either repossess the property or you’d sell the property at a substantially reduced value.

A cash out refinance event would allow the group to distribute cash to the partners from the equity that’s accumulated over the years, while still enabling the partners to retain ownership in an investment that’s likely yielding a very attractive return. More than that, the cash out refinance would actually enhance the return on investment that’s being generated by the property itself. This means the equity you do have stored in the property starts working even harder for you. And, as we highlighted earlier, taking on this additional debt is usually a fairly low risk proposition assuming the practice continues to use this space and is able to pay the rents. Moreover, in instances where there are no personal guarantees on the debt, the risk is mitigated even further.

This debt financed distribution (cash out refi) is also typically a tax deferred transaction, which allows the group to kick the tax can down the road so to speak and build additional wealth on the money that’s been stripped out. To use a back of the napkin calculation, if you’re able to reinvest that money at a better return than you’re receiving on your new real estate loan, there’s a strong chance that you’re going to be accumulating more wealth than you would have done if the equity had remained stored in the property. Moreover, if you’ve invested that money in various different assets such as stocks, other real estate properties, savings accounts to name just a few, you’ve amassed a good number of additional wealth generating assets that aren’t tied to the practice’s success and protected yourself from one negative event potentially derailing your retirement plans.