How to Use the Smith Manoeuvre as a Powerful Wealth Strategy in Launching your Real Estate Empire
You’ve exhausted all of your savings…
You want to buy more properties, but your short on cash and the thought of looking for joint venture partners makes you feel queasy.
I had this exact same feeling more than 8 years ago. The thought of going to a real estate investment group to attract joint venture partners made me incredibly uncomfortable.
As much as I REALLY wanted to buy the next rental property, I felt uneasy introducing a complete stranger into my real estate business. It felt like an arranged marriage with a possibility of divorce.
What if I attracted an arrogant partner who is more hassle than it’s worth? What if the partner decides to break our joint venture agreement early, or worse, what if the partner is super cheap and leaves me paying for all of the repairs?
You have to be incredibly picky with whom you choose as a joint venture partner.
Fortunately, if partnerships aren’t right for you, I’m excited to say there are other options to building your wealth when short on cash.
All you have to do is figure if this strategy is right for you.
And the best thing is — you don’t have to ask anyone else for money.
You’re about to learn the Smith Manoeuvre, a powerful financial strategy that gradually restructures the largest non-deductible debt of your life (mortgage) into a deductible investment loan and use it to invest in real estate and help you accelerate your income and your wealth.
And if you have many, many years left in your investment journey, then the Smith Manoeuvre might be right for you, especially if you have a house that has a very small mortgage.
Smith Manoeuvre: A Power Financial Strategy Explained Simply
Every dollar you pay into the mortgage principle can be re-borrowed to invest it;
The re-borrowed money can be deployed to buy rental properties;
The rental properties pay you rental income;
The rental income pays off all expenses including the interest paid on the borrowed money and the profit is called cash flow;
Unlike the interest on your home mortgage, the interest on the re-borrowed money, that you used to invest in the rental property, can be written off your income to create tax savings;
The cash flow and tax savings can be used to accelerate your mortgage pay down, which in time can be borrowed again for another purchase;
The beauty of the Smith Manoeuvre is that you were already paying interest on your home mortgage to start.
By paying down your mortgage and re-borrowing it for an investment purchase, you end up paying the same amount of interest (maybe a little more because of interest rate differences between your mortgage and line of credit), but now that interest is tax deductible.
The added bonus is to find rental properties that will generate enough cash flow to pay the interest on the line of credit and have some left over for further acceleration of your mortgage pay down.
You are learning how other real estate investors are winning in the real estate investment game.
The Anatomy of a Smith Manoeuvre
To set this up, you need a re-advanceable mortgage.
A re-advanceable mortgage has two parts: 1) a mortgage; and, 2) a secured line of credit commonly called a home equity line of credit (HELOC).
Every time you make a principle payment into the mortgage, your line of credit increases accordingly.
Sometimes these products are marketed under different names, here’s a sample from the large lenders:
- Scotiabank calls it a STEP mortgage
- National Bank calls it an All-in-One
- Royal Bank calls it Homeline.
Helpful Tips in Obtaining a Re-Advanceable Mortgage:
- You need a good credit score to qualify;
- You need to have a healthy debt ratio to qualify for more and more re-advanceable mortgages (please check with your lender).
- A small number of banks will let you pay your line of credit interest from the line of credit itself (capitalized interest), if this is something you want to do, please check with your lender.
- Some lenders will charge for extra fees like appraisal costs and legal fees. You can negotiate this with some lenders.
- Check how the interest is calculated on the line of credit, compounded semi-annually is better than compounded monthly (less interest payments).
- Check that the bank automatically grows your line of credit when you pay down your principle. I made that mistake where I had to follow up with the bank every single time to increase my line of credit — it wasn’t done automatically.
- Home equity lines of credits (HELOC) are typically higher than your mortgage interest rate. Mine are +0.25% to +0.5% higher than my mortgage interest rate.
Here is the magic formula for calculating how much Equity you can re-borrow:
If you have at least 15% of the value of your home in a mortgage, you can borrow up to 80% loan to value in your HELOC.
Appraised home price* — 20% of the initial purchase price — mortgage balance
= $ you can reinvest
* if you don’t have an appraisal, you can estimate your home price based on comparables through your real estate agent
Without a mortgage on your home, you can borrow up to 65% loan to value.
A Simple Example of How to Calculate the Equity:
In 2005, you bought your home for $300K. You put in a down payment of $60K. Over the years, your mortgage dwindles down to $100K. And your house grows to $400K (based on a recent appraisal and/or recent comparables).
Set up a re-advanceable mortgage with your bank and you can re-borrow up to $240K to invest into real estate ($400K — $60K — $100K).
That’s a good chunk of money to invest in real estate (equivalent to cash).
A Simple Example of how Investing your Equity Generates Infinite Wealth (without costing you money to service the loan)
You buy a duplex for $400K, using $80K as a down payment borrowed from your equity (HELOC), and the rest lent as a mortgage.
The duplex generates $2800 in monthly rental income and cash flows around $500 after paying for all expenses including mortgage, property manager, property taxes, insurance and monthly wear and tear (assuming 3% interest and a 30 year amortization).
The cash flow also services the monthly HELOC payment of $200 (at 3.5%).
The rental property generates you more and more wealth because of mortgage pay down, cash flow, and appreciation.
After 5 years, the tenants have paid down approx. $35K in principle payments and $18K in rental cash flow. Plus your rental property probably has appreciated nicely.
And none of the interest payments came out of your pocket.
In fact, you grew your wealth by +$53K (assuming no appreciation) simply by reinvesting your equity and having the rental income service the HELOC.
Your return on investment is infinite. (+53K/0 = infinite).
10 Great Things about the Smith Manoeuvre for Investing in Real Estate:
- You can do this without exhausting your cash reserves.
- You can invest in more real estate without liquidating your wealth building assets (i.e., existing rental properties).
- While paying off your home mortgage, you can still invest (without dipping into your cash savings).
- You can reinvest that lazy equity into rental properties that generates more income and wealth even while you are sleeping
- The rental income pays for the interest payment (HELOC), which means it is not coming out of your wallet.
- In Canada, the interest paid on an investment loan is a tax write off.
- Any tax returns you receive can be used to accelerate mortgage pay down.
- You have the power to pay off your HELOC as fast as you want without early payment penalties.
- Any principle you pay down on your mortgage gets translated to an additional limit on your line of credit.
- This is 100% legal in Canada. In the USA it’s not an issue since mortgages on your principle place of residence are already tax deductible.
6 NOT So Great Things About the Smith Manoeuvre for Investing in Real Estate:
- New real estate and semi-new real estate investors should avoid this strategy until they understand the business of rental properties and can execute it like a business. There is increased risk involved every time you borrow even for good debt.
- You need a healthy appetite for risk taking (i.e., you’re comfortable with borrowing money to invest).
- You need to accept that your mortgage is never paid down, at least not while you continue to use your home equity to buy more rental properties.
- You need to be ok with paying the mortgage payment plus a HELOC interest payment. If you invest wisely, your rental property will generate enough cash flow to more than cover the HELOC payment.
- You need to be comfortable knowing that you are borrowing against your own home (even if it is for rental property investing).
- This is a strategy that involves more risk as you are using borrowed money to reinvest. Do it with caution. If your principle place of residence drops in value, you need a back up plan (e.g., having cash to pay back the loan in the event the bank asks for it).
5 Ways to Protect Yourself with these Risk Management Strategies
- Don’t over extend yourself leveraging up to the maximum (borrowing up to the maximum) — make sure you have a comfortable buffer left in your HELOC.
- Consider getting a long-term fixed rate mortgage if you are worried about fluctuations in interest rates and don’t want to worry about how to offset any repercussions.
- Accelerate pay down of the HELOC with your rental income to decrease financial risk and for peace of mind even if it means a smaller return on investment.
- Conduct your regular due diligence before purchasing a property and crunch out the numbers to make sure your rental property cash flows well, even after all expenses (including the HELOC).
- Stress test your numbers to make sure your rental property cash flows well, even with lower rents, higher property taxes, and higher HELOC payments.
5 Common Strategies Where the HELOC is Used for Real Estate Investing:
- Buy and hold strategy: This is a simple wealth building strategy where you borrow equity (HELOC) to invest in rental properties. The rental income services the interest loan and helps pay down your mortgage.
- Buy, fix, and refinance strategy: This is an advanced strategy where an investor buys a discounted rental property using borrowed equity, ‘fixes’ it (i.e., renovates), gets it appraised at a much higher value and refinances the property to get most of the borrowed equity back out. Then rinse and repeat to buy other rental properties.
- Buy, fix, and flip: This is an advanced strategy for generating income (not wealth). The investor buys a discounted property, renovates it, and sells it back on the market at a much higher price for a nice profit and to pay back the borrowed money.
- Become the bank to real estate investors: This is an advanced strategy where a real estate investor lends out borrowed equity to finance homes (for other real estate investors) for a short period of time for a much higher interest rate and secured against that home.
- Become the bank to yourself: This is an advanced strategy where an investor uses only borrowed equity to finance rental properties initially, and re-mortgages it at a later date to get that equity back out. Typically this strategy is used when a seller needs to close fast and you can help the seller out by buying it immediately without the nuances of a bank.
Are you Ready for the Smith Manoeuvre for Real Estate investing?
It took more than four years of real estate investing and holding 5 rental properties before I felt comfortable using the Smith Manoeuvre.
This is a very powerful strategy, when used right. It requires you to be extremely diligent with your finances and in choosing the right rental property that cash flows well.
If you have several years under your belt investing in real estate as a business, have a lot of equity to deploy plus years to go in your investment journey before you really need the money (because real estate is illiquid), this might be the right option for you.
Instead of getting the queasy feeling thinking you have to attract joint venture partners to buy more real estate, you can actually look forward to deploying equity from your home to generate more wealth; all because you’ve done the work to pay down your mortgage diligently.
Not only will you accelerate your mortgage pay down even more with rental cash flow, but also, you will generate a nice nest egg to set aside for retirement, for your kids’ education, or for many dream vacations.
Figure out if this is right for you, and if so, take action to accelerate your journey to Financial Nirvana.
Now you’ve got a roadmap to get you started — all you need to do is follow it.
Your new life of freedom and possibility awaits.
Originally published at financialnirvanamama.com on March 24, 2016.