The Ultimate Guide to Managing Equity in Real Estate Investing

This content is for informational purposes only and is not investment advice. You should not construe any such information or other material as legal, tax, investment, financial, or other advice. Learn more.

Equity is the value of your ownership in a property.

If you buy a house with a 20% down payment and get a loan for 80% of the purchase price, you would own 20% of the house. As a result, your equity reflects 20% of the current value of the house. If you buy a million-dollar house, that would mean you have $200K of equity.

It reflects ownership of a valuable asset and in many ways resembles an unrealized gain.

Because of this, there are a number of tools you should familiarize yourself with in order to access and use equity. The best investors have a clear understanding of how to always take advantage of unused equity to increase their velocity of money and control more property.

Let's dive into the world of real estate equity.


How to Access Equity

In general, it's not easy to access equity.

You can't go to a bank and withdraw your equity in cash. You have to use tools to either collateralize or realize your equity if you want to turn it into real dollars. There are a few tools to learn about but luckily they're very straightforward and getting a good mortgage professional on your team will help significantly.

1. Sell the Property

The easiest way to access almost all of your equity immediately is to sell your property.

This in a way realizes your unrealized gains.

You take the sale price minus any selling costs and subtract the total debt on the property. This leaves you with your equity in cash, ready for another deal. Don't forget about taxes though since this is likely considered taxable income.

And don't underestimate selling costs.

Budget for realtor commissions, advertising, cleaning, closing costs, and everything else. Having a good real estate agent on your team is imperative and they'll be able to give you a better expectation of how much you can expect to pay in selling costs.

2. Cash-Out Refinance

As real estate investors, many of us are trying to buy and hold more property.

So selling and owning less property might not align with our strategies. In this case, you can still access your equity without selling by instead collateralizing it with a loan.

The downsides of refinancing are abundant but the benefits are clear.

Pros

  • Keep the existing property
  • Access equity without paying taxes on it
  • Avoid selling costs

Cons

  • Can't access 100% of equity, typically limited to 80% LTV or so
  • Debt increases
  • Mortgage payment might increase

As a result of doing a cash-out refinance, you are getting a larger loan than you previously had in order to take cash out of the property.

This means a higher loan balance and in combination with possibly higher interest rates, a much larger mortgage payment. But the fact that you could access a significant amount of capital without having to pay taxes on it immediately and while keeping your previous property, makes this appealing to many investors.

You get to continue building equity through debt paydown and appreciation on your initial property while acquiring another to multiply your results.

3. HELOC

A home equity line of credit (HELOC) is a tool similar to a refinance, with a few minor differences.

Instead of immediately being given a loan for the total amount, this tool acts like a credit card. Typically, your line of credit allows you to draw amounts and pay interest-only on only the amount used. Compared to a refinance which would charge interest AND principal on the entire total amount of your loan amount immediately.

This makes HELOCs a powerful alternative for certain scenarios and might be worth talking to your lender about.

Pros

  • Only pay for the amount of credit used
  • Draw period is usually interest-only payments
  • Keep the existing property
  • Access equity without paying taxes on it
  • Avoid selling costs

Cons

  • Debt increases
  • Usually variable interest rate
  • Usually higher interest rate than mortgage
  • Also can't usually access 100% of equity, depending on lender

I recently used a HELOC after getting a mortgage on a property. My mortgage had a 2.6% interest rate. After renovating it, I built up over $200K in equity that I wanted to access for another deal. By the time I could refinance, mortgage rates were closer to 4% which made a full refinance less appealing since the bulk of my debt is already secured at a lower rate.

A HELOC allowed me to access more equity than I could through a refinance (through a local lender) AND allowed me to keep my low-interest rate mortgage. Plus I get the benefits of interest-only payments which is great for my cashflow.


Building Equity

There's no point in learning about how to access equity if you are unable to build equity, so let's cover that.

We already covered how equity is your ownership in a property. Your equity comes down do the value of the property minus the amount of debt against it.

So if you want to build equity, there 2 levers you can pull:

  1. Decrease the amount of debt on the property
  2. Increase the value of the property

Building Equity Through Debt Paydown

Debt paydown directly increases your equity by reducing the balance of your loan against the property.

Typically, every mortgage payment is broken down into an amount that covers interest and some amount of principal that is paid off. That amount of principal reduces the total balance of the loan, resulting in equity with each payment.

Debt paydown is one of the 4 types of returns in real estate investing. It means even if your mortgage is a few thousand dollars a month, some portion of that actually just decreases your debt and as a result, increases your equity and overall net worth.

This is what most people talk about when they say buying can be better than renting. Paying rent doesn't build equity, paying a mortgage does.

Building Equity Through Property Value

While debt paydown happens over time as you make mortgage payments, property values can also appreciate over time.

Market Appreciation

Recently, real estate has appreciated in value significantly.

A lot of investors typically claim that homes appreciate something in the ballpark of 3% a year on average. If we use that number on a $500K property, that would result in the value of the property going up by $15,000. And that equity is all yours.

If you happened to buy this property with 20% down or $100K, you might see a 15% return from this market appreciation alone.

And don't forget to combine that with the additional equity you built from the debt paydown in your mortgage payments.

But this is the lazy approach. Waiting on appreciation can be slow and risky if that's your only strategy. So let's try to speed up the process...

Forced Appreciation

Forced appreciation is an increase in property value that you directly created.

Let's say you buy a property for $500K, and make it a better property so that it later appraises for $700K. You could renovate it to an improved condition, quality, size, or better overall use. All things that could potentially make it more desirable and increase the value of the property.

In this example, you will have created $200K in equity by making it a better property.

Compare that to the 3% appreciation we got from the national average, forced appreciation has the potential to deliver much, much higher returns in equity.

It should go without saying that this strategy of building equity is certainly riskier.

When you dive into the world of renovations, contractors, and future appraisals, you are at the mercy of many other people. Contractors can go over budget, costing you more than the equity you get out of the renovation. Markets can drive future appraisals down (believe it or not, housing pricing actually can go down). And of course, the renovations you make can potentially have no impact on the value of the property.

For example, if you add a pool to a property in a cold-weather climate, you might actually just increase maintenance costs and add extra liability which could make the property less desirable and sell for less than you acquired it for. Despite putting thousands, if not more, into it.


Wrapping Up

Equity is one of the buzzwords you hear getting thrown around in real estate a lot.

But fear not, there's really not that much to it.

Take the value of a property, subtract its debt obligations from that amount. And boom. That's your equity.

If you want to use your equity, chat with your mortgage officer or real estate agent about the best strategy for you. Bring up the costs and benefits of selling, refinancing, or getting a HELOC. And it would be wise to do your homework so you can come to them with the right questions.

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