Equity, equity, equity. You’ve probably heard this term many times in discussions about why real estate is the ultimate investment strategy, thrown along with other terms like positive cash-flow and appreciation. But…what exactly does it mean? In different kinds of investments, equity will mean different things. As a real estate investor, real estate equity is what you’re concerned with. So, without further ado, here’s what you need to know about equity in real estate.
Related: The Ultimate Guide to Getting Started in Real Estate
What is equity?
Investopedia generally defines equity for all kinds of investments as this, “the value of an asset less the value of all liabilities on that asset”. For the math junkies out there, here’s what equity would look like in the form of an equation: Equity = Assets – Liabilities. But as previously mentioned, the definition of equity will differ depending on the investment or asset.
What is real estate equity?
Now we’re talking. Equity in real estate is essentially the difference between the market value of your property (asset) and the amount left on the mortgage (liability). As an investor, you’re bound to know what mortgage is. If you aren’t familiar with market value, then check this out.
In a way, equity in real estate is another way of showing how much of a property that you financially own in relation to mortgage payments. Here’s an example of equity. Let’s say the fair market value of a property is $300,000 and $100,000 is left on the mortgage. Since equity is essentially the difference between these two values, the equity would be $200,000 in this example.
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What is net real estate equity?
While the previous example is helpful, it depicts equity in its most simple form. For a more accurate illustration of equity, we need to consider the costs of selling the property. This gives us net equity.
Here’s an example. If the market value of a property is $150,000, and there is $30,000 left on the mortgage, and $10,000 is used for closing costs, then the net real estate equity is $110,000.
Why is real estate equity important?
Equity is among the important features of real estate, such as cash flow and appreciation. There is a difference in its importance, however. While cash flow is a priority for renting, equity is important for selling. As mentioned earlier, the more equity an investor has, the more the investor owns of the property. The more equity a property has, the more easily it could be sold. Also, real estate equity is an asset, so it could be used for other purposes. Equity is often used in purchases, like buying a new car or property.
In what ways can real estate equity increase?
Since equity is primarily based on mortgage payments and fair market value, anything that boosts these two factors will also improve a property’s equity.
- Paying Mortgage: Every time you pay mortgage, equity will build up, it’s as simple as that. The same applies to interest that you pay on insurance.
- Fair Market Value Appreciation: As nearby properties appreciate for higher selling prices; you might be able to have your mortgage financed at a higher value. This will, in turn, increase equity.
- Improving the Property: Improving the property through additions or renovations will increase the property’s fair market value.
In what ways can real estate equity decrease?
Same rules apply with decreasing equity. So, anything that decreases mortgage payments and market value may reduce equity.
- Changing up the present mortgage: Altering the current mortgage plan may decrease your property’s equity. Accepting a new loan or refinancing the present one may result in equity reduction. This may be situational, so be sure to contact an advisor to see if this may apply to your property.
- Fair Market Value Depreciation: If nearby properties begin to sell for less, your property’s equity will downtick as well.
- Property Deterioration: If a property is not taken care of and falls out of condition, its equity will fall along with it.
What’s the difference between real estate equity and appreciation?
Both equity and appreciation deal with value, but they are different. Real estate equity, as already mentioned, is the fair market value of a property deducted by the remaining mortgage. Appreciation, on the other hand, is an increase in value primarily due to time. Equity is mainly determined by only the mortgage and value of a property. Appreciation is due to multiple factors, including land, resources, economy, and real estate market. Equity is completely based on financial aspects, while appreciation includes some physical influences.
Related: Is it OK to Invest in Real Estate Just for Appreciation?
What should I invest for, positive cash flow or real estate equity?
As mentioned previously, equity can be a very important feature in real estate. However, the prime reason to invest in real estate is and will always be cash flow. Cash flow is a liquid asset, and thus is much more usable than equity, since equity can only be used once a property is sold. Cash flow is the more immediate gain as well, and tends to be more consistent. Equity fluctuates from time to time, because it is heavily dependent on market value. Also, gaining cash flow is more controllable, since the investor’s decisions will impact cash flow immediately, rather than equity. Nonetheless, equity is still a very important part of real estate.
To sum up,
Equity is an important part of real estate, especially if you are interested in selling the property. Like other assets, it can improve or diminish depending on the factors that influence it. While it is not as influential and immediately profitable as cash flow, it is still worth taking care of. Seek out advice from your mortgage lender and real estate advisor to learn more about the equity of your properties.
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