By Mike Jacobson
Pete noticed something was different at the dinner table. It was set with a nice tablecloth, china and complete with candlelight. As he sat down he asked his wife, “what’s for dinner?”
“Equity”, she replied.
It seems that Pete may have said one too many times, “I’d rather have equity than eat.” He also understood how important equity is when it comes to generating passive income. He would forego spending on non-essential items so that he could continue to acquire appreciating assets.
Peter Fortunato is one of my favorite real estate teachers and a master at creative deal structuring. So when he says something like the quote above it makes me stop and think.
Equity is a key part of why real estate is the IDEAL investment. To summarize, the five reasons real estate is an IDEAL investment are Income, Depreciation, Equity, Amortization and Leverage. You can read about the others in an article HERE.
We put income first. It is important to us to have income-producing properties, which provide cash flow while we own them.
Why is equity important?
Income producing real estate provides cash flow at time of purchase and over the life of the property. Creating equity grows your nest egg and net worth.
We have found the real power of multi-family properties is this growth of equity over time. As you will see below, we can even “force” the growth of equity in multi-family properties.
The equity can be used to generate additional passive income or used as collateral to obtain additional cash or assets.
How can equity be created? There are endless possibilities, but here are three that have been proven and time-tested.
The first is using inflation over time. If you have owned your own home for at least several years then you have likely seen the value appreciate. Some areas have seen price increases of 5-10 percent annually in recent times, but 3-4 percent is a more normal sustained rate. During this time the mortgage gets paid down a little bit. So a house you paid $200,000 for several years ago may now be worth $250,000, giving you an additional $50,000 in equity.
A second way is to renovate a distressed single family residence. This requires more work but creates equity in a shorter period of time. It could be for a flip as has been glamorized on TV in recent years, or it can be for a rental. As a rental you could combine the use of inflation over time with the renovation, creating even more equity. Holding for a longer period of time also qualifies for more favorable tax benefits than flipping.
A third way is investing in a multi-family property. This can combine the methods above and scale it for greater equity. Since multi-family properties are valued based on their net income the equity can be increased by making improvements, raising rents and reducing expenses through property management. By doing this through a partnership known as a syndication, investors are able to participate monetarily without spending their time managing the project.
These techniques utilize some of the basic building blocks for creating equity with real estate. Purchasing and holding for long-term appreciation is similar to purchasing stocks for the same purpose. However, you can have more control over the investment with real estate and force the appreciation with effective property management.
It was on our first single-family rental that we realized the potential real estate for quickly growing our equity. We purchased the house for $80,000 using funds from a private lender. It required a light rehab with cosmetic updates for under $10,000. A tenant moved in paying $925 per month. The house was now worth about $120,000. We refinanced with a loan for $90,000 and paid off the private lender, leaving us with a cash flow of about $200 per month. We had just created $30,000 in equity.
We sold the house several years later for $175,000. Although the rents were increased slightly during this time, it can be seen that the gains due to equity growth far exceeded what we received in rental cash flow.
How can we take this lesson and scale it? Multi-family investments are like houses but add zeros to the cash flows and equity gains. They also provide more opportunity to drive appreciation.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.