Real estate investors love equity. Equity can grow all by itself and increase your net worth when property appreciates and can also provide a source of funds for adding value to an existing house or acquiring more rental property.
In this article we’ll discuss how to measure and increase equity in real estate, how to put it to work, and how to avoid losing equity in a rental property.
What Is equity in real estate?
Equity is the difference between the value of a house less any debts owed on the property.
Rental property investors who purchase wisely and use leverage conservatively can usually keep and grow equity throughout their holding period. Sometimes equity can be negative. This occurs when people make poor or emotional buying decisions, or when too much leverage is used.
Factors that can affect the value of your property include the type of loan used to finance the house, interest rates, down payment, demand for the property, and normal real estate market cycles.
How to calculate equity in a property
Let’s say an investor purchases a house with a fair market value of $150,000 from a motivated seller who agrees to sell for $140,000.
He finances the purchase with a 30-year mortgage at 5% interest and puts 20% down. The property has an annual appreciation rate of 3% during the investor’s 5-year holding period. At the end of the five years the investor sells the property at current market value of $173,891.
In this example, equity is created in a few different ways:
- $10,000 in immediate equity for buying the house below fair market value
- $28,000 down payment also becomes immediate equity
- $33,891 increase in value through appreciation becomes equity
- The amount of the mortgage payment applied toward principal also incrementally increases the investor’s equity each month until the time the property is sold
What is return on equity?
ROE – or return on equity – is expressed as a percentage and measures the return on a real estate property compared to the equity in the property.
For example, let’s say our investor purchased a $150,000 property at market value with a down payment of 20% and financed the rest. If the property generates a net annual cash flow of $3,600 the return on equity for the first year of ownership would be:
- ROE = Net cash flow / Total equity
- $3,600 Net cash flow / $30,000 equity from down payment = 12%
ROE can also be measured over multiple years. After five years of annual rent increases, property appreciation, and paying off the principal with monthly mortgage payments our investors return on equity would look something like this:
- $4,200 Net cash flow (reflecting annual rent increases) / $55,000 (combination of appreciation and principal reduction) = 7.6%
The reason the ROE is lower than in the first year is because equity grew faster than the annual rent increases. That’s not necessarily bad, because now the investor has accrued equity of $55,000 to reinvest while still holding onto his first cash flowing rental property.
How to build up your equity
The median sales price of houses in the U.S. has been steadily trending upward since 1960, according to the Federal Reserve Bank of St. Louis, with only one 2-year correction between 2007 and 2009 where median prices declined by about 20% then quickly recovered.
So, one way real estate investors can build equity is to do nothing by simply buying and holding for the long term. But most rental property owners like to give equity growth a boost, because the quicker equity grows that faster funds become available to buy more property.
There are several strategies that real estate investors use to build equity:Buy property with a low LTV (loan to value) using a bigger down payment.
Putting more money down is almost like having money in the bank. Plus, the increase in cash flow generated by a lower mortgage payment will help boost overall returns on the investment.Use net cash flow to pay off the mortgage faster.
One good use for all of that extra cash flow is to use as much of it as possible to make extra payments toward the principal. Before doing this, be sure to verify with your lender that the loan you have allows this type of prepayment.Make an extra monthly mortgage payment (or overpay).
If you’re unable to divert all of your extra cash flow to paying down the principal, another good equity building technique is to pay a little more every month. Even an extra $50 per month can quickly add up by reducing the loan’s principal balance and growing equity faster.Buy and hold over the long term.
As the Federal Reserve notes, housing values appreciate over the long term. While there can be short-term down cycles, the longer investors hold the greater the odds are that equity will increase.Add value.
Everything from a fresh coat of paint, upgraded appliances, improving curb appeal with better landscaping, and adding some extra space can help to incrementally increase rental income and add to the value of your house.
Why having equity is important for investors
Many real estate investors think of equity as ‘free money’ that’s a byproduct of their investing strategy and normal real estate market cycles. Having equity in a property is important for several reasons:
- Borrowing against equity in a house is a type of secured loan, presenting a lower risk to lenders and a lower interest rate to borrowers
- Equity can be turned into cash and used to pay for emergency repairs or routine improvements that add value and increase rents
- When one property accrues enough equity, investors can tap into the equity and use the funds as a down payment for another single-family rental
Ways to use untapped equity
You’ve probably heard the phrase “house rich, cash poor”. That’s another way of describing someone who has a lot of equity in their house but hasn’t yet tapped into their equity and turned it into cash.
One of the challenges of tapping into equity is that real estate isn’t highly liquid. Unlike owning stocks that you can buy and sell online in almost real time, selling a home often takes 30 days or longer and comes with sales commissions and transaction fees totaling around 7%.
Accessing equity can create a dilemma for real estate investors who want to tap into their accrued equity without having to sell their property. Fortunately, there are several ways to turn equity into cash without having to sell:
Home equity loan
A home equity loan is similar to taking out a second mortgage on a house. Banks normally allow borrowers to take out a home equity loan equal to about 80% of the property’s equity.
Earlier in this article we discussed a real estate investor who had accrued $33,891 in equity over his five-year holding period.
Based on this 80% guideline, the investor would be able to take out a lump sum loan of up to $27,112 ($33,891 x 80%) and then pay back the loan in monthly installments plus interest.
Home equity line of credit
Also known as a HELOC, this equity line of credit is tied to the equity in a house and follows the same 80% guideline as the home equity loan. Unlike an equity loan, a HELOC doesn’t have to be used in full or right away.
Similar to the way a credit card works, a home equity line of credit may be reused. This allows a real estate investor to have immediate access to funds for emergency repairs, adding value through upgrading and rehabbing, or to move base and purchase a property priced below market value.
Investors using a cash-out refinance can refinance their existing loan for more than the current mortgage balance (but not more than the property’s appraised value) and receive the extra amount of equity back in cash.
Lenders generally follow the 80% guideline when making a cash-out refinance loan too. Although a cash-out refinance would raise the LTV (loan to value) back to 20%, if interest rates are lower than on the original loan mortgage payments would also be lower.
This could potentially increase the cash flow from the property while freeing up some of the equity for other investment uses.
Can you lose equity in a property?
Although real estate investors do everything they can to increase equity, there are also several ways equity can be reduced or even completely lost. Some of these factors are controllable, some unfortunately are not:
- Taking out a HELOC (home equity line of credit) will temporarily reduce the amount of equity in a property until the credit line is repaid
- Doing a cash-out refinancing reduces the amount of equity to the minimum allowed by the lender (usually no less than 20% LTV)
- Allowing the property to deteriorate by deferring maintenance for too long of a time or neglecting to conduct inspections of the exterior and interior of the house while it is occupied by a tenant
- Real estate markets are cyclical, so if market values begin trending downward over a long period of time property values and equity will also go down, although investors can help to mitigate this risk with a low loan-to-value ratio
Final Thoughts on Equity in Real Estate
Building equity doesn’t happen overnight.
Rental property investors buying and holding for the long term often think of equity as the ‘gift that keeps on giving’ because equity appears to grow all by itself. That’s because the longer a property is held, the faster equity grows, especially toward the end of the loan term when most of the mortgage payment goes toward principal instead of interest.
Key factors that contribute to building equity in real estate include:
- Size of down payment - the bigger the better as far as equity is concerned.
- Loan term – a shorter term means the principal balance gets paid off faster.
- Property improvements – can add value and justify higher incremental rents.
- On time mortgage payments – to avoid interest and penalties that may be added to the loan balance or make new property more expensive to finance.
- Housing prices rising – above the rate of inflation in the rental property markets invested in.