A Hidden Secret to Wealth

How important is equity in calculating a property’s return on investment (ROI)? Should you invest in an appreciating market or a market with stable, slow growth??

What Is Equity in a Property?

Equity is the value of the property less the amount owing on the property. If you were to sell the property, it is the amount of money you would get out of the property after expenses to close the sale. The equity formula can be written in different ways.

Equity = Sold price - debts owing - expenses to sell

or?

Equity = Market value - debts owing?

or?

Equity = Appraised value - debts owing?

How Does Equity Increase?

The goal of increasing the equity is to increase your ROI. There are different ways to add to the equity over shorter and longer time frames. Here are a few ways.

On the buy:

When you purchase a property at a discount, there may be equity built in. For instance, you buy a house for $500K and its appraised value is $550K. Though the banks will give you a mortgage based on your purchase price, you know that the property’s equity is increased with the extra $50K equity in the buy. This is of value for net worth valuation, and future refinance or sale of the property.

Down Payment:

The capital you put in as a down payment to purchase a property is equity. If you buy the $500K property as a rental and put in twenty percent, the $100K ($500K x 20% = $100K) will also add to the equity in the property.

Mortgage Paydown:?

Each mortgage payment will have a larger portion go toward the interest at the beginning and a small portion go toward the principal amount. With each payment, more goes toward the principle and less toward the interest. The amount of principal paid is increasing the equity in the property.

Value Add:?

Whether for one door, or a multifamily, getting a property with room for improvement is a great way to add equity. If you purchase a property for $400K, you may add $50K in improvements bringing the value up to $525K. Your investment is $450K and now there is an extra $75K in equity. If the property was a rental property prior to purchase, with the improvements, the rents may be increased due to the desirability of the space.?

Market Appreciation:?

Some markets have higher appreciation year over year. One area may have no appreciation increase for years and be considered a stable or flat market. You will still be making money in the areas listed above like mortgage paydown, forced appreciation via value add and on the buy, but there is no bonus or passive equity (aka passive appreciation).?

Different markets will have different appreciation. If you have a $500K property and the appreciation in the area is 2% per year, after 5 years your property would be valued at $552,040.40 with all other things being equal. The same property in an area where the appreciation increases by 5% per year, will increase in value to $638,140.78 over 5 years. As you can see, appreciation with hidden compound interest greatly impacts wealth.?

What are the risks:?

Here are a few of the things to consider to achieve more equity.

Purchasing a property at a discount isn’t a risk. It makes sense if you know your numbers and house values, and have the opportunity for a discounted property rather than full price.?

With the capital in, the downpayment can be increased to bring up cash flow on a property and have more initial equity in the property. The numbers need to make sense for your cash-on-cash investment and what works for cash flow. The mortgage paydown can be increased through shorter amortization and/or extra payments; this is a strategy that may not make sense if you want to focus on the best return on investment using leverage (the bank’s money).

Value add has a little more risk. You may add $50k of renos and the property’s value may only go up by $40K making it seem like a loss in equity in the beginning, even though rent increases may be mitigating or creating a better return than not putting in the value add.?

Market appreciation is often considered bonus money and many suggest not to rely on it. That is certainly true for a flat market as the prices may fluctuate down over a few years.?

A risk factor in an uprising market is a sudden drop. This isn’t a problem unless it is something you were banking on, especially if you were planning to sell or refinance during this time. Many come across this problem, in the case of purchasing resales and committing to a future price, only to arrive at that future date and the price is much lower, creating a negative equity situation.?

Where should you buy?

A rising market is great for ROI. The greater the yearly appreciation rate in an area, the higher your ROI. Do your homework, know your numbers, know the risks, and talk to other professionals in real estate investing. From my experience, I will always say, buy in an area that has appreciation.

To get your complimentary copy of the ebook (The Secret to Wealth by Huong Luu & Brian Tracey) click here .