After discussing what the “I and the “D” stand for in the IDEAL GROWER system, today I like to spend a little bit of time on the “E”, which stands for Equity.
Often time this term gets confused or mistaken with value.
The concept of equity ownership emerged in England during the late middle ages as the demands of commercial activity challenged its traditional system of property. New contractual forms of property, such as land uses, enabled trade in property independently of its legal title, with disputes increasingly decided in courts of equity that supplemented rules with notions of fairness. It became common for an asset to have an owner in equity, who had a contractual interest in it, and a separate owner at law, who held its legal title indefinitely or until the contract was fulfilled.
In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of an asset. For example, if someone owns a car worth $15,000 and owes $5,000 on the loan used to buy the car, then the difference of $10,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business entity.
Selling equity in a business is an essential method for acquiring cash needed to start up and expand operations. Stocks are typically used. By buying stocks in a business the buyer owns a part of the business. That part is the equity. In a large company like Apply owning a couple of shares of stock gives the owner a microscopically small part of ownership in the whole company.
The value of that stock is mainly determined by the market. If a company has great sales, makes profits and it is reasonable to expect that the business will keep thriving, the value of the stocks is increased because more and more people want to have stocks and bid up the price. Conversely of a company isn’t doing well, more and more people are selling stocks and the value for each stock is falling.
Besides trading stocks (or you could say – parts of ownership in equity) the valuation also has to do with the level of debt a company has accumulated. As shown in the definition, that debt is counted against the value to determine the actual equity.
When liabilities attached to an asset exceed its value, the difference is called a deficit and the asset is informally said to be “underwater” or “upside-down.”
What does that mean for us as real estate investors and IDEAL GROWERs?
When we are looking for a new property to buy we would ideally like to find what’s called “a great deal”. Part of the definition of a great deal is the difference between the purchase price and the equity of the property.
Imagine you find a property that is offered for sale at $100K and you have secured qualification for financing. You lender requires you to the an appraisal to make sure the property is worth the purchase price.
The appraiser is acting in a similar role like the stock market on Wall Street. He or she goes to visit the property and then conducts a market analysis to compare the property to a number of similar properties in the neighborhood that have recently sold. The idea is that your property should be worth about the same as similar properties within a few miles radius.
You will get in increase in value for certain features, like new floors, new kitchen, etc. and downgrades for old windows, etc. In the end the appraiser will issue a report detailing what he or she found about your property and what the comparative market analysis has shown. That will lead to a final amount of value.
Please be aware that this approach applies to residential real estate up to 4 units and not to commercial real estate, apartment complexes, etc. The IDEAL GROWER is focusing on residential real estate up to 4-plex.
In our example, let’s say the appraiser determined in the analysis that the house you plan to buy is worth $107K
If you are applying the most common form of financing in residential investing, you would have 25% down payment and 75% mortgage. For our $100K property that means you put $25000 down and the bank will give you $75000.
Your equity on first glance would be $25000. But because your appraisal says that the property is worth $107K, your actual equity is $25000 + $7000 = $32000. A lot of people would call that a great deal.
Keep in mind that this only applies at the time of purchase. If the market changes a new appraisal a year later could lead to other numbers. It’s basically a snapshot. In my experience that’s what applied for most things in real estate investing. In future articles I will expand on it and explain what that means for you, i.e. when it comes to credit card use, buying consumables, how to file your taxes, etc.
The second and equally important part of equity in the IDEAL GROWER system is found after you purchased the property.
For your purchase to continue to be a great deal, you don’t just want to have an appraisal at or above the asking/sales price, but you also want to have rental income that provides what I call “instant positive cash flow”. Instant in this case means you are making more money from rent from day 1 after the purchase has closed than you have to pay for your mortgage, property taxes, insurance, reserves for repair, vacancy, etc. My rule is to aim for instant positive cashflow between $100 – $200/month for properties purchased between $80K – $180K.
When your tenant pays you rent, part of it will be used to cover your mortgage payment. That mortgage has an interest and a principle portion. The principle is what actually pays back the bank and returns equity from the bank to you. You start out with you having 25% and the bank holding 75%. Each month you pay a tiny fraction of that 75% returns to you until the mortgage is totally paid off.
The positive cash flow mentioned earlier is money that you can use to pay extra principle into your mortgage each month. As you now know from the first part of this article, every time you reduce the debt on the property your equity increases by that same amount.
Overall it is important to understand what equity is and how it works. In a future article we will take a closer look at strategies that allow you to benefit from the equity in the properties you own. The IDEAL GROWER is keenly focused on increasing equity.