When it comes to equity and ownership in real estate it’s important to know how investors make money. And if you’ve followed our articles, then you know real estate investors can make money in four different ways.
- Cash Flow
- Appreciation
- Tax Benefits
- Principal Paydown / Amortization
Of the four, appreciation and amortization are sources of equity growth. This article will focus on how to get the most out of real estate ownership by increasing your equity and putting that equity to work for you.
What is Equity in Real Estate?
To start, let’s define equity. In the simplest terms, equity is the difference between how much your property is worth and how much you owe. It is common to hear people talking about home equity based on their home’s value in relation to the remaining balance on their mortgage loan. The more their home’s mortgage is paid off, the more equity the homeowner has in that property.
To calculate the owner’s equity in a real estate property, you can take the fair market value of the property (the price it would sell for in the current real estate market) and subtract the remaining balance owed (mortgage loan and any liens/debts). What’s left over is the owner’s equity in the property.
For example, if a home is valued at $500,000 and has a remaining mortgage loan balance of $200,000 then the homeowner’s equity would be $300,000.
With different financing options, ownership percentages, preferred equity, and equity sharing for joint ventures, it can get more complicated. But, for this guide, we are going to focus more on how to grow your ownership equity in a home or real estate investment and how to put that equity to work for you to make more money.
Assess Fair Market Value for Your Investments
If you’re going to own resident occupied real estate then you should know how to assess fair market value of your property. The two most common ways are the comparison or “comp” model and the other is a rental income model.
The “comp” model is used for valuing residential properties (single-family homes, duplexes, triplexes, and quads). In the “comp” model, appraisers search for properties within a short distance from the subject property. Those properties should have similar fit and finish, build year, school district, etc. to determine the property’s value. Ideally, those properties should also have sold within the last three months.
If they meet enough criteria, they are considered comparable to the subject property. Appraisers look at the prices the comparable properties sold for. They divide those numbers by their square footage to come up with a price per square foot range. Then they multiply that range by the square footage of the subject property.
That will be the range you can expect to receive for the subject property. The downside of the “comp” model is that it limits your ability to force appreciation. Short of adding square footage to the property, there is very little that can be done to increase the property value.
The income model is used for larger resident occupied real estate (multifamily) and commercial properties. It recognizes that these properties are businesses that make money. And just like any business, the more money it brings in the more it is worth.
The equation the income model uses is:
Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)
In the above formula, NOI is the annual revenue derived from the investment minus all reasonable and necessary expenditures (not counting the principal and interest payments).
The Cap Rate is the annual rate of return one would expect to receive from their investment if they owned it outright (without debt).
How Do You Build Equity
There are a number of ways to build equity in a property. Among those ways are:
- Purchase the property below market value
- Applying a large initial down payment
- Increasing the amount or the frequency of mortgage payments (debt service)
- Improving the property
Purchase Property Below Market Value
Finding properties that are below market value may sound impossible, but it’s not. Extensive research, strong negotiation skills, and deep resources can all be helpful. Typically these sellers are desperately looking to offload their property.
Oftentimes the property has one or more problems that they cannot fix. If you can’t fix it either, then you probably shouldn’t buy the property. These problems can be structural, environmental, managerial, or tenant based problems. But if you’re experienced in solving such problems, then you could be well on your way to finding a good deal.
Spending less money to acquire a property, relative to the current market appraisal of the property, allows you to build real estate equity.
Larger Initial Down Payments
When you buy a property, it’s common to finance that purchase. The terms of financing will require you to submit an initial down payment. With residential real estate, that down payment can be very low.
However, to avoid private mortgage insurance (PMI) 20% of the value of the property will need to be placed as a down payment. In this scenario, your loan-to-value (LTV) will be 80%.
For larger multifamily real estate, 80% LTV would be considered on the higher side of leverage. Multifamily owners have a whole host of lending products available to them. Many of those mortgage lenders will loan at an LTV range of 55% – 75%.
Whatever amount you put down represents your private real estate equity in the property. The more money you put down, the larger your owner’s equity in the property. Having higher equity allows for a lower debt service payment and potentially more cash flow.
The amount you decide to put down is known as the initial capital contribution.
Increasing Mortgage Payments
Once you’ve purchased the property and taken over operations, rental checks will start coming in. That rental property income should cover all expenses with money left over. One of the expenses it will cover is the debt service or monthly mortgage payment. Part of that monthly payment includes payment toward the principal balance. This amortization builds equity over time.
The money that is left over is your cash flow. You can do with it what you want to. Some people may choose to roll that money into the debt service and pay down the debt with extra payments. This is one way in which an investor can build real estate equity faster.
Because of prepayment penalties, this is often more viable with residential mortgages than it is with larger multifamily properties.
Improving the Property
Increasing mortgage payments and putting down a larger initial capital contribution are both ways to increase private equity real estate ownership. However, one requires a higher initial capital injection while the other reduces investor cash flow. That’s why improving the property is my favorite way to grow equity.
As we discussed earlier, commercial multifamily real estate investors can force appreciation through strategic improvements based on the income method of valuation.
It all starts with a rent survey. 70% of your future renters already live within a five-mile radius of your property. So it’s important to know your competitor’s properties. What are their rents? Which amenities do they offer? What is the fit and finish of their interiors and exteriors?
If you find similar grade properties that command higher rents, it’s important to understand why they’re getting more money. Maybe they have upgraded appliance packages or modernized flooring. There is a myriad of enhancements that can justify higher rents.
Understanding which upgrades command higher rents and which ones do not is critical. Armed with that information allows you to craft a capital improvement plan that returns multiple dollars in the form of cash flow and appreciation for every dollar of capital that is injected.
That is how you force appreciation. That is how you increase equity.
Why is Equity Important in Real Estate?
There are multiple ways to make money in real estate. When done right, the investment property should produce both current and ongoing cash flow (yield) and equity growth as the property value increases.
The goal is to have your initial capital investment grow in the form of equity. And multifamily apartments have a long history of superior returns.
Equity Offers a Convenient Way to Borrow Money
It’s true that private equity can offer a convenient way to borrow money and real estate professionals will utilize this fact to grow wealth. However, using your properties as an ATM is not always a good idea. For that reason, I consider it an advanced strategy that is best used by professionals. I’ll discuss my reasoning below.
As equity in a property builds up, the loan-to-value (LTV) declines. But that equity just sits there as lazy equity. So it can be tempting to refinance the property, ratchet the LTV back up, and pull out lazy equity in the form of cash.
But what you do with that money may or may not warrant the extra risk that you’re taking.
You can use it to buy more assets and increase your wealth. You can use it to pay off high interest debt or you can buy liabilities. Unfortunately, too many people use their equity to buy boats, cars, or finance vacations just to name a few.
I know it’s tempting, but you’re actually losing wealth when you do that. In certain circumstances, using it to pay off high interest debt can be wise. This is especially true when that debt comes at a higher interest rate than the rate of return you’d make by investing it.
However, without reformed spending habits, the benefit that is extracted from your real estate or home equity may only be temporary.
I prefer to use that equity to buy more real estate assets. It’s a way in which one investment property can become two. And two properties can become four over time. In the right hands, securing debt to harvest equity can be a smart investment strategy to build your wealth.
Common Uses for Real Estate Equity
There are a myriad of ways to spend private real estate equity. Some of those ways are better than others and they generally fall into one of three categories:
- Finance more assets
- Finance more liabilities
- Pay off debt
Financing Emergency Expenses
We all know that stuff happens. Life can get complicated and messy. Unfortunately, when stuff happens, it’s often expensive too.
So it can be tempting to tap your real estate equity to finance emergency expenses. Instead of using equity for these expenses, you’d be wise to have a robust emergency fund. Many financial experts recommend holding an amount equal to 3-6 months worth of your salary in liquid reserves.
An emergency fund should finance your rainy day needs. If you don’t have an emergency fund or if it’s not adequate then you could consider tapping your real estate equity. But if you do, you’re making yourself poorer and not richer.
Home Improvements and Maintenance
Owning your own home has long been considered the American dream. But homes are expensive, in addition to the monthly payments on your mortgage you also have to factor in property taxes. And over time houses need maintenance and improvements. Sometimes they need to be modified to accommodate special needs.
Ideally, one saves for those expenses. However, if need be, using equity from real estate may or may not be preferable to financing those improvements.
Consolidation of Debt
Credit cards allow one to live above their means. If that becomes a habit, that debt can spiral out of control. It’s easy for credit card debt to become an albatross around your neck.
In worst case scenarios, the high interest rates that are charged on credit card debt, can make it nearly impossible to cover the monthly payments.
So if the interest rates that are charged on that debt is higher than the rate of return from real estate, an argument can be made to deploy that real estate equity to pay off the credit cards.
If one decides to do that, they should consider switching to paying cash for their expenses and forgoing credit cards as much as possible.
Can You Lose Equity in Real Estate?
Multifamily real estate has a long history of escalating values over time. And with one of the best risk-adjusted returns available to investors, it can be a low risk investment. Nevertheless, all investments have risk and you can lose equity.
It even has superior performance record in times of recession (including during the COVID-19 pandemic).
That doesn’t mean it hasn’t had periods of short-term downward fluctuation in value. For that reason, it’s important to invest in apartments for the long-term.
Increasing Your Loan Amount
As we discussed earlier, refinancing a property is a way to exchange debt for lazy equity. In the right circumstance, tapping that equity and redeploying it into another real estate asset can enhance your cash flow and increase your wealth over time.
In the wrong circumstance, it can result in an overleveraged original property and harvested equity that was spent unwisely.
37th Parallel Professional Real Estate Equity Investments
37th Parallel Properties is a private real estate acquisition and asset management firm that offers high quality apartment investments for accredited investors.
We’ve been in business since 2008 and have a 100% track record for making our multifamily investors money.
Multifamily investments are all we do and our private real estate income and equity investment funds have a track record that speaks for itself.
Our private real estate investment fund owns and manages multi-family real estate properties in some of the best real estate investment locations throughout the United States. If you’d like to learn more about the 37th Parallel advantage and how to get started, simply click the link below.
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