Rookie Reply: Rental Arbitrage 101 and How to Invest Your Home Equity

Ashley:
Okay, let’s get your questions answered. I’m Ashley Care and I’m here with Tony j Robinson.

Tony :
And welcome to the Real Estate Rookie Podcast, where every week, three times a week, we bring you the inspiration, motivation, and stories you need to hear to kickstart your investing journey. Today we’re diving into the BiggerPockets forms to get your Ricky questions answered. Now guys, the forum are the absolute best place for you to quickly get all of your real estate investing questions answered by tons of experts. So today we’re going to discuss the ins and outs of short-term rental arbitrage, and if it’s still a good option for today, how to pull out equity from your primary residence, then reinvest that back into a real estate deal, and then what steps to take when you’re buying a tenant occupied property so you can set yourself up for success.

Ashley:
Tony, I thought I would be very courteous today and we could start out in the short term and vacation rental forum. So is there a question that sticks out to you that you’d like to answer?

Tony :
There is, there’s a question about short-term rental arbitrage. So this person says, is short-term rental arbitrage still a good opportunity for those that are doing it or who have already started it? Is arbitrage still something worth pursuing? Is the opportunity still there for new people? So I guess first Ashley, maybe we should just explain what arbitrage is and then I know you have an arbitrage deal. We actually just ended three of our arbitrage units yesterday. We actually literally just sold all the furniture and got rid of ’em yesterday. So I can talk a little bit about our experience, but first just to describe what arbitrage is. So in a traditional short-term rental setup, you go out and you purchase a property, right? You have maybe a mortgage, your name is on the deed, you are the owner of this property, and then you rent this property out to folks to guess who come and say at your listing with arbitrage as opposed to going out and buying a property. You go to a landlord and you rent that landlord’s property, but instead of moving in yourself, you rent that, you sublease it onto your Airbnb, vrbo, et cetera, and then you get to collect the difference between what your guests are paying you, what your lease amount is in any other operational expenses. So management wise, very much the same thing. It’s just the acquisition and the initial setup that differs slightly. So Ash, what’s your experience been on the arbitrage

Ashley:
Side? Yeah, and I think too the tax benefits too, you’re not really getting to do the depreciation. I actually prefer to own the property because you’re going to have control of it. You’ll get those tax benefits and you don’t have to worry about somebody ending your lease. But I do have two units. There are two apartments and a 40 unit apartment complex. I do manage the units, so I feel like that gives me a little bit more control of what’s going on in the property. And I’ll never, I shouldn’t say never, but I won’t as the property manager, I won’t say that short-term rentals won’t be allowed in that property at any time. So I had first one, I think I started it in 2019, maybe even 2018. So we’ve had one for a while, and then the other one we just started in, I think 2022 maybe so just two years ago.
But yeah, so we rent them out. One is primarily a midterm rental where we get people who stay 30 days or more. And the other one is a short-term rental. And I have to say this year for the short-term rental one, it’s a two bedroom, one bath. It has been probably our worst performing year for that one compared to when we started it in 2018. And for the one that we do medium term rental, that one is a one bedroom, one bathroom. And in the last two years that’s pretty much performed the same each year. We do really great in the summer where we get, last year we had a construction worker in there for the summer. This year we have a grandparents that want to visit their grandkids for the summer. So definitely one thing that’s helped us is having the flexibility of with that midterm rental is having the option to short term rent it out when we do have 30 or 60 days where there’s nobody coming in to the property. But I think that the reason it really works for us is because I do manage the property and I think that definitely is a huge benefit to actually doing the strategy. But I’ve never done it where I’m actually signing a lease with just a landlord that I don’t really know and going and winging it. So maybe you can talk more about that, Tony, as far as not having any kind of relationship with the building and doing arbitrage or with the owner. Yeah,

Tony :
So you’re definitely in a unique, and I think it’s to your advantage, I think that you manage all of the other listings because you can really control the experience of both sides for us. So we actually did know the landlord. He was a buddy of ours and he had three units going up for rent in Dallas, and it was within a 12 unit apartment building that he owned. And he reached out to us and said, Hey, would you guys have any interest in doing the arbitrage thing? And we’d never done it before. It always kind of just been something in our back pocket and we said, Hey, this is a great low risk way for us to try it out. So we jumped in three units all at one time. We set ’em all up last summer. And the biggest challenge, and I think we’ll maybe recap the pros and cons after we both kind of share our experiences, but some of the biggest challenges for us was that we didn’t control the entire experience for the guests.
And there were some issues that were outside of our control that continued to impact our guest stay. So I’ll give you a few examples. There was some bad storming in Dallas a few months ago, and a tree fell onto the property and ended up busting out the windows for two of our units. And the property management company, I don’t know if just because there was so much damage in that city, but it took them a long time to get this window replaced. So we had to keep letting guests know, Hey, you’re booking in, but there’s a window in the living room that’s busted. And some people didn’t want to come, some people tried to cancel. We had an issue where there’s communal laundry, so the washer and dryer, there’s one on each floor and the washer and dryers kept breaking, and guests would book our space knowing that there was laundry facilities on site.
They go to use it and it’s not working. It doesn’t make sense for us to pay to fix the properties, laundry, laundry services. There was a homeless guy who broke in and slept in the hallway. There were some neighbors who really enjoyed smoking marijuana and guests would get there and there’d be marijuana smell walked through the hall. So we had I think a lot of challenges with just sharing a space where we couldn’t control the entire experience for the guest. And I think that’s what really was a challenge for us, was trying to make sure that we could still get a good review and charge enough to make it worthwhile for us.

Ashley:
And I think that really just showcases even more the opportunity that I had to have control of those things where if a guest sent a message to my short-term rental manager and said, Hey, there’s somebody sleeping in the hall, that she could easily contact me and I could get it taken care of so that there isn’t that bad review of you. So I think cutting out the middleman of the actual property manager of the property is a huge advantage. The first time I ever heard of this strategy was actually on a BiggerPockets podcast, and it must’ve been around 2017, 2018. If I started my first one then, because this is what made me want to do it, was this guy who had rented a duplex in Nashville and I think it was like a three bedroom duplex and he just filled the thing with bunk beds and he marketed to bachelor and bachelorette parties.
And I remember him talking about how he was in one weekend, he was making his mom’s rent to rent out that unit and was just cashflowing this great amount from doing this rental arbitrage. And I think the story goes as the owner of the property, as soon as the people upstairs moved out, he actually started doing the same thing in the upstairs unit of that property because it was doing so well. So I think maybe in that situation it could be different where maybe if it’s a single family house you’re doing it or a duplex where there’s not shared common areas with other residents or things like that, maybe it could work out better. But I think Tony did a great point as to understanding, even though he knew the owner, the owner could not be the one managing it. Maybe it is a property manager and the owner’s not even aware that these things are happening and going on too in the property.

Tony :
I do agree with you, Ashley, and I think because you can also arbitrage, I think for a lot of people when we think about rental arbitrage, we kind of default to apartment units, but you can also arbitrage with single family homes. And I know a lot of folks who almost exclusively focus on the single family home. I know some people who do luxury rental arbitrage where they’ll go out and they’ll get a $10,000 a month lease somewhere and then do arbitrage with something of that size. So there is really no limit on the size of the scope of the property, but being able to control the experience I think is big. Now, just to recap, we touched on these differences a little bit, but I think the pros of rental arbitrage, because there definitely are some, I think the pros are that you can get started with very, very little capital out of pocket.
So if you are cash strapped, I think being able to go sign a lease somewhere, maybe you’re putting down first and last, you put all the furniture on a 18 month interest free credit card, and you can get into one of these units for a couple thousand bucks and then start cash flowing to pay back the debt and kind of cycle it all over again. So those are the benefits is that very little cash to get started. The downside to the things that we’ve talked about so far, you have limited control over the actual property itself. So a certain issues arise, you’ll have to go through maybe an owner or a landlord or a property manager who may not be as incentivized as you are to get some of these things corrected. And then the other cons are that you don’t get, I think potentially some of the biggest benefits that come along with investing in real estate, which is the appreciation and the tax benefits. So pluses and minuses to each, but you got to make the decision for, I guess what makes the most sense for you.

Ashley:
Okay, so we’re going to take a short break, but when we come back, I actually want to touch on this topic with one more thing and I want to find out what Tony did to decide to actually exit out of rental arbitrage or maybe something he wished he would’ve done to further protect himself. So stay tuned, check out our show sponsors and we’ll be right back. Okay, welcome back. So we are going to be getting into a question about how you can pull equity out of your primary residence. But first, Tony, I want to know is there anything you wish you would’ve done differently going into this short-term rental arbitrage? And were you on a 12 month lease or were you month to month? How was this all kind of set up for you and how were you able to exit out of it?

Tony :
Yeah, so I’ll tell you how we set it up and then I’ll tell you what I would do differently. So the way we set it up, it was one year lease for all three units, but because it was my first time doing arbitrage and it was a city I literally knew nothing about, I’d never owned any type of real estate or done anything in the city of Dallas. And literally the week that we were going to sign this lease, Dallas started talking about potentially banning short-term rentals. So there was a lot of kind of uncertainty.

Ashley:
I remember you guys flew there, didn’t you? And went to city hall? Yeah,

Tony :
Yeah, we did fly out there to try and get some insight and that gave us a little bit more confidence to move forward. But we told the owners, we said, Hey, we’re willing to kind of test this out, but it will be great you guys could work with us on limiting our downside. So we negotiated a base rent, which was several hundred dollars below what they were asking. So I think on one of the units, the rent was supposed to be 1500 bucks a month, but we negotiated a base rent of a thousand bucks per month. So no matter what happens, they would get a thousand bucks per month. Now that additional 500 that was left over, they would only be paid that out if we had at least $500 in profit for that unit. So I had limited downside because I was able to decrease the monthly rents a thousand bucks if for whatever reason it didn’t work out and they had the upside because, okay, cool, we know we’re going to get this much, and then if Tony does well, then we’ll be able to kind of scale it up to what we know market rents are.
So that’s what we did to kind of reduce some of our risk going into this. Now, what I would do differently would, if I were to do arbitrage again, I would really focus on buildings that I think were a little bit newer. This was an older building. They had done a lot of cosmetic updates to kind of make it look nice from the outside, but as we ran the building, we started to notice that there was probably some things underneath the hood that weren’t been updated as of late. So I think for me, if I could go into a place where they just got their certificate of occupancy and they’re looking to lease this out, now I know that I’m walking into hopefully a more well oiled machine, and I actually have a friend, we’ve interviewed him on the podcast, Rafa Lozo, who that’s a big part of his strategy. He just looks for buildings that are being completed and before they’re even done, he’ll reach out to the builder and say, Hey, look, I’ll lease these out for you. Give me four units. And that’s been his strategy to get higher quality arbitrage units in his portfolio.

Ashley:
And let’s take a look at that. As far as the landlords side of renting out, and I know that he talked about this too when we had him on the podcast, was how he keeps the units in nicer condition than somebody was that was living there full time. And our unit that we’ve had since 2018, I’ve had turnovers people move in and out of that building and ours is the nicest even for people that have lived there for a year, two years because we are constantly cleaning and any little damage that happens, it’s being repaired, it’s being reported, it’s being taken care of because we want it nice for our gusts. And that apartment is still beautiful four years later, or no, six years later, oh my God, we’ve had it a long time.

Tony :
Even for us, we negotiated in our lease as well that we would take care of any maintenance that was below a certain dollar amount. I think it was like 200 bucks, anything below 200 bucks within the four walls of the unit. That was our responsibility we would take care of. So we replaced and fixed a lot of little things that the average tenant is going to ask the landlord to replace.

Ashley:
Okay, so let’s go back into the forums and find our next question.

Tony :
All right, so Ash, what about you? What do you got sick out to you here?

Ashley:
I’m in the starting out section of this question, and here’s one, how can I use the equity in my primary residence to get started? I have over 500,000 in equity with my primary residence and feel like I should be using it to get into real estate investing, but have no idea how to get started. How can I use that equity to buy a rental property? Thank you. Well, you’re in a great position. This is a great dilemma to have as to figure out how to tap into your equity. So I think the first thing is that I would want to know to kind of give this a valid response is what is the current interest rate on your mortgage that you currently have? If you actually have a really high rate, then maybe we would talk about actually doing a cash out refinance where you would get a completely new mortgage and it would be a higher mortgage amount than what you owe so that you would be able to take that cash out.
But if you have a great interest rate already, then maybe that’s where we decide, okay, you’re keeping your current mortgage, and then we look at different loan products or types that will take a second lien position so that way you can keep that great interest rate on that debt you already have on the property and then continue into something like a line of credit where you can use that line of credit to go and put down a cash offer on a property. And I think in this situation, a burr where you’re buying the property and then you’re rehabbing the property, then you’re going to rent it out, and then you’re going to refinance it because it’s now it’s worth more than what you purchased it for. You added that value by rehabbing it, you increased the rents because now it’s a better rental property and it’s going to appraise for more. So then you can pull that, do that cash out, refinance again, and pull your money back out. Then you go and you pay off your line of credit, and now your line of credit is whole again, and now you have a mortgage on that investment property. Then that’s where the last R comes in for the burr is now you can repeat that process with that 500,000 or those funds that you have from your line of credit. Yeah,

Tony :
Ash, I couldn’t agree with you more. I like the idea more so of using a HELOC in a short term situation as opposed to just taking that keylock and plopping it down as a 20% down payment on a turnkey property. Because if you do it that way, now you have the mortgage, the principal interest, taxes and insurance on this investment property that you just purchased, and you have to pay back the line of credit over that time as well, right? But if you do the burr strategy, you can deploy the capital from the line of credit, use it, pay it back, deploy it, pay it back, deploy it, pay it. So it becomes a way to scale a little bit more quickly and efficiently because you’re not just plopping that capital into one specific

Ashley:
Deal. And you definitely could do it the first way Tony stated, I do prefer the borrow way better, but you could say you’re taking a hundred thousand dollars and you’re going to use that for your down payment, and now you have a mortgage if your property can cashflow and it can pay your mortgage on your investment property, plus it can make your line of credit payment, which is usually interest only. So you have to make sure you have an additional funds or you ask for your line of credit to be amortized over so many years with the principal included so that you can make principal and interest payments on the line of credit, and then you’re still cashflowing on the property. So maybe that would still work. I have seen it where people do the line of credit for the down payment and they just take all the cashflow from the property, they take the extra money from their W2 job and they just throw it at the line of credit. And the advantage to that is that they’re investing today and they know that, say it’s 50,000 they’re using from a line of credit, they know within six months they’ll be able to save 50,000 and pay off that line of credit a little bit each month, and in six months they’ll have it paid off, and that makes sense for them.

Tony :
So there’s always different ways to kind of attack the whole, how do I tap into my equity piece? So I think a lot of it does come down to your unique situation. But again, going to Ashley’s initial point, I think the interest rate of your current property should play a really big factor in whether or not you actually do a refinance, because who knows if in our lifetime we’ll ever see a 2.99 interest rate ever again, right? So protect that if you can,

Ashley:
Unless the only thing I would say is if you owe, okay, maybe it says you have 500,000 in equity. Let’s say your house is worth 600,000 and you, or not even that, let’s say your house is five 60, so you only have debt of 60,000 on your property and maybe at that point where it’s such a small percentage of your actual mortgage, or maybe you don’t have a lot of time left on the mortgage either because if you reset it, so now it’s amortized over 30 more years that it might not be that bad. So I think you really got to sit down, take a piece of paper, take a pencil and write out, okay, if I did, this is what my current mortgage payment is, this is what my interest rate is, this is what my monthly payment is, this is how much I’m paying an interest over the next 10 years.
And then if you did a line of credit, what would you be paying? And then if you went and actually refinanced all of it and got a brand new mortgage over the next 10 years, what would those payments be? And how much would you be paying an interest compared to principal? And where would you be at financially at year 10 for both of those situations? There are so many scenarios and different ways to kind of, what’s the word I’m looking for, to put out your money, to deploy your money or deploy your resources that literally writing on pen and paper, the different scenarios and seeing where you’ll be at today, where you’ll be at five years, will you be at 10 years down the road, can really help you kind of decide which is the best path for you to.

Tony :
Alright, so in our next question we’re going to discuss how to best handle the transition when buying a tenant occupied property. But first a quick word from today’s show sponsors. Alright, so we’re back guys. We love talking about real estate. We love answering questions like this with you all, and we’d love it if you hit that follow button on your podcast app, wherever it is that you’re listening. Alright, so final question, Ash, what do you got? What are you seeing in the forms right now?

Ashley:
Okay, so I’m in the tenant screening discussion since I gave you the first one, short-term rental, and I thought we could talk about one that I know more about. So this question says, hi everyone. I am currently planned to close on a rental property, congratulations in southern Indiana and will inherit a long-term tenant. This tenant has lived in the home for 10 years and pays a very low amount in their monthly rent. I have a few specific questions and would greatly appreciate any advice or insights you can offer. Okay, so then the question goes into what’s the best way to introduce myself to the current tenants and inform them about the change in property ownership? Are there any common pitfalls I should avoid during this process? Understanding the lease agreements, which there is no lease agreement currently in place, and the tenant is paying about $400 lower than current market rent.
We have three offers for them, and I’d like to present this information the best way possible. How should I go about, this is an email with all this information, the best way to start. Then my next question is what are some crucial state laws regarding tenants rights and landlord responsibilities that I should be aware of? Are there any good resources or websites where I can learn more about these laws? I’m eager to ensure smooth transition for the tenants into manage this property responsibly. Any tips, personal experience or resources you can share would be incredibly helpful.

Tony :
We’ve got lots to unpack there, right?

Ashley:
Yeah, but this is great. I think a great question. So the property is in Indiana, let’s kind of tackle the state specific laws. Tony, did you read up on Indiana state law for tenant landlord laws last night?

Tony :
I did not. I have not.

Ashley:
Okay. Well that is why we have resources. So the first resource I want to give out is the BiggerPockets lease agreements. So if you’re a pro member, you get these lease agreements for free and they are state specific so you’re able to know what, and it’s actually not even just lease agreements, there’s landlord forms, different things that a avail.co, so a avail.co. They have a great resource on their website where you can actually click on your state. So I think you go to the resources, you click on the state and it gives you a brief overview of what the laws are for each of those states and what you need to know of. So great overview, but also you should be taking a landlord class in your state because it is so informational and it’s usually free or like 10 bucks. The last kind of suggestion I would have for this is that the attorney, if you use an attorney, and I don’t know about Indiana specifically, but if you didn’t use an attorney to close on the property, I would find an attorney that deals with evictions or deals with landlord laws and just have a conversation with them to have them in your back pocket for questions so that when it comes time when a tenant doesn’t pay, you already have an attorney you can go through to help you through the eviction process.
But more importantly, having an attorney, and you know what, say to them upfront, I would love to be able to just ask questions. Is there someone on your team that would be best where maybe you’re not bothering the head attorney but speaking to a paralegal or an admin and you’re just billed for the time of that phone call or the email, whatever that may be. And so that you can ask questions. There are a ton of times where I am just asking, there will be this random thing that comes up that I’ve never experienced before where I just shoot my attorney’s office an email and say, could you please give me some guidance on this? And I think the money isn’t going to be that much to literally just send an email and get a response back, but finding an attorney and having that conversation where they’re open to being available to you for different questions like that will be very, very, very useful.

Tony :
Yeah. So the crux of what you’re saying here, Ashley, I think the premise is that make sure you go to a trusted true source to get whatever information from a legal standpoint and maybe don’t rely on a random web search or even chat GBT at this point because you want to make sure that you really get this information dialed in. So if we look at the tenant communication part of this question, again, there was a lot to unpack there as well, but basically the question is how should this person introduce themselves and maybe go about increasing the rent because it’s currently $400 below market value. So guys, we had Dion McNeely back on episode 369, and in that episode he talked about the binder method. So if you want a full breakdown for what he did, go back and listen to that episode. But basically his process was when he bought a property with inherited tenants, he would give them the actual numbers and data for what rents look like for a comparable listing in that market for a comparable property in that market for rent.
So he’d say, Hey, here’s what you’re paying right now. Here are whatever, four or five other properties that are currently for rent that are similar to this unit and here’s what they’re charging. You’re paying a thousand bucks per month, all of these other units are at 2000 bucks a month. Now I’m not going to take you all the way up to 2000, but I’m going to take you to 1750, right? So we can get you kind of close. And he said that the majority of people opted to stay because when they saw that all of their alternatives were double the price, they were actually still saving on that rent amount. So I think that’s one option as what are your thoughts on that whole binder method and maybe have you found another way or an alternative way to maybe get rent up to where they should be?

Ashley:
Yeah, I’ve done the same thing where I show other units in the area that are available or I saw just recently listed or rented out, and I’ll do the address of the property and that it’s comparable by saying it’s two bedrooms, one bath, the square footage and how much it rents for. Because when you think about the rent, so say there’s a hundred dollars, $50 difference in the rent, it still costs a lot of money to move, plus a lot of time changing your address, just doing paperwork gets me overwhelmed. So I think there’s, the inconvenience of having to move is a big factor too, that showing you’re not only going to have to pay the same amount if you move or maybe even more money, but you’re also going to have to pay to move. Even if you’re going to move yourself, that’s probably maybe a day, two days you have to take off work, you have to go to the post office, change your address, all these different things.
So I think that that is a great tool to do that. And I’ve never had anybody object to the rental increase. I recently didn’t increase at a property and I did get a little pushback from the tenant, but you just stick to your guns and say, okay, well if you’re not going to renew, please let us know. And she eventually just signed the lease and renewed. So it was fine. But I think that’s a great strategy. But as far as introducing yourself, that really depends on how you want to, because that first impression really sets your standards and your expectation of the relationship between you two. So I think meeting face-to-face is great if you, first of all, some people don’t even want people to know that they’re the actual landlord of the property. But I do think having some communication from the seller is always beneficial.
So if you can actually have the seller give the tenants your information, that is really useful because I’ve had people thinking they were getting scammed because I’m like, here’s the new property management, these are the new owners of the property, things like that. And they think it’s a scam. I have to say, please contact the previous landlord. There was a sale and it was something that that owner didn’t want anybody to know the property was selling. So we couldn’t even do an estoppel agreement before the property actually sold to find out information on the tenant. So just real quick, an estoppel agreement is before you close on a property, it’s given to the tenants to basically verify what the seller of the property is saying is true and that it agrees with the lease agreement. And if there is no lease agreement, an estoppel is wonderful because you’re really taking the landlord’s word for what he’s saying is going on.
So that’s including what the rent is the last time they paid rent, any maintenance issues in the property, who owns the appliances, who pays what, utilities, things like that. So if you have the opportunity to stop agreement before you actually close is also a great way to introduce yourself. You can include a letter with, here’s how you sign up for your portal, things like that. I think specifically in this question she asked, is email okay to do this? I think email is perfectly fine. Just make sure that they actually get the email that it doesn’t go to their spam, that it doesn’t, that they don’t look at and be like, yeah, I have no idea who this is. I’m not going to sign up for some portal to pay my rent. So you might need to do some, send a letter, send an email if you can have the previous owner contact them to let them know it’s change of hands and to expect some something. So I think there’s a couple different ways you can do it. No wrong way, really.

Tony :
And for those of you that are wondering how it’s spelled, it is E-S-T-O-P-P-E-L. I remember the first time I heard estoppel, I was like, what word are you saying? And actually, I got to add this in there, but estoppels, the word Es stop. I didn’t know that either. And es stop means to bar or preclude from doing something. So there you go. Estoppel agreement. A little history lesson for today.

Ashley:
So basically it’s stopping the seller from lying about what’s in

Tony :
The listing basically.

Ashley:
Interesting. I learned something new every day on this show. Okay, well, if you want to get involved in the community, all these real estate investors who are submitting questions, go to biggerpockets.com/forums. Thank you guys so much for joining us for this week’s rookie reply. If you guys have a question, please submit it in the forums. Make sure you check out the Real Estate Rookie Facebook group. If you like the show, please follow us in your favorite podcast platform and make sure to like this video on YouTube. I’m Ashley. And he’s Tony. And we’ll see you guys next time on the Real Estate Rookie podcast.

Tony :
This BiggerPockets podcast is produced by Daniel ti, edited by Exodus Media Copywriting by Calico Content.

Ashley:
I’m Ashley. He’s Tony, and you have been listening to Real Estate

Tony :
Rookie. And if you want your questions answered on the show, go to biggerpockets.com/reply.