Equity in Real Estate is Dead Money — and This Case Study Proves It
Equity in real estate is dead money. Before I go any further, I can read minds… I know what you’re thinking: “What are you talking about, Jeff? My net worth is huge!”
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I see it all the time as a mortgage broker. In my area of the country, where million dollar values are common, I just laugh when I see someone with credit card and auto loan debt, a small mortgage, and several hundred thousand dollars of equity in their house. Most have some money in the bank (maybe 4 months' worth of expenses on average), but for the most part, they are clueless as to how to create wealth using debt.
"I have a great rate!" they say. "I don't want to refinance because I like my low mortgage payment. I don't want an ARM loan because it's risky. I'm doing just fine right now saving $1,000 per month from my rental property that's completely paid off. My student loans are a tax write off." Yada, yada, yadaâ¦ the list goes on and on.
There are two things to pull from the above scenario.
One, as Robert Kiyosaki has said a million times: “Savers are losers.” Not a loser, as in “you suck,” but a loser as in the value of your money is going in the wrong direction even though you continue to save. As the government in the US continues to print money, the dollar is devalued. Real inflation grows, and your money is worth less and less, month after month, and year after year.
The cost of goods and services rises over time because the purchasing power of the dollar has gone down. Just ask your parents about how much real estate used to cost back when they were kids (even the Millennial generation can ask their parents how much it cost to buy a home back in the 1990s).
Two, equity in a house, whether it be your primary residence or a rental, is dead money. That is to say that it’s like putting money under the mattress of your bed and leaving it there for as long as you have a your house.
Sure, the money is liquid now and you could spend it freely, but it’s not being used to its full potential. When the money is re-invested in your asset of choice, the money starts to work hard for you and earns a rate of return. If you add the compounding interest effect of money, it grows exponentially.
Let’s look at a hypothetical example. (And I emphasize hypothetical… I know there are one hundred and one variables and the stars have to align just perfectly, but you get the idea).
The Case Study
Equity Steve has 5 rental properties. Each rental property is valued at $100,000. Each rental property has no mortgage. (There are still expenses for the property like taxes and insurance that will never go away, so the mortgage is only a piece of the puzzle.)
For the sake of argument, let’s say Equity Steve receives a monthly cash flow (minus any expenses and maintenance that he pays) of $1,000 per month per property. Or $5,000/month in positive cash flow in total. He keeps a 6 month reserve of $1,000 per property in the bank, which equates to $30,000 total for anything that needs to be covered in an emergency. His net worth is $530,000 because we’re going to assume he has no other debt.
|Number of Properties Owned||5|
|Monthly Rental Income Per Property Minus Mortgage Payment||$1,000 – $0 = $1,000|
|Monthly Rental Income Total Minus Mortgage Payment||$5,000 – $0 = $5,000|
|Cash in Savings||$30,000|
What happens if Equity Steve changes his name to Wealth Steve and refinances each of his 5 properties and pulls out ½ the equity on each property or a total of $250,000?
Wealth Steve then uses the equity to buy 4 more $100,000 properties, putting $50,000 down on each and obtaining $50,000 mortgages on each. He adds the additional $50,000 to his savings to cover any related expenses. Each of the new properties still brings in the $1,000 per month in rent. Surprisingly, the monthly mortgage payment on a $50,000 mortgage at 4% is only $250 per month (it’s actually only $238.71, but I’ve rounded up to make the math easier).
|Number of Properties Owned||9|
|Monthly Rental Income Per Property Minus Mortgage Payment||$1,000 – $250 = $750|
|Monthly Rental Income Total Minus Total Mortgage Payment||$9,000 – $2,250 = $6,750|
|Cash in Savings||$80,000|
Taking it one step further, what happens if Wealth Steve changes his name to Accelerated Wealth Steve and refinances each of his 5 original properties and pulls out ¾ of the equity on each property or a total of $375,000?
Accelerated Wealth Steve then uses the equity to buy 11 more $100,000 properties, putting $25,000 down on each and obtaining $75,000 mortgages on each. He adds the remaining $100,000 to his savings to cover any related expenses. Each of the new properties still brings in the $1,000 per month in rent. The monthly mortgage payment on a $75,000 mortgage at 4% is $375 per month (it’s actually only $358.06, but I’ve again rounded up to make the math easier).
|Accelerated Wealth Steve|
|Number of Properties Owned||16|
|Monthly Rental Income Per Property Minus Mortgage Payment||$1,000 – $375 = $625|
|Monthly Rental Income Total Minus Total Mortgage Payment||$16,000 – $6000 = $10,000|
|Cash in Savings||$130,000|
Look, I get it. There are a ton of hypotheticals in these illustrations (like getting 16 mortgages, qualifying, interest rates, etc.), but that’s not the point. The point is that equity is dead money.
The above scenarios have three takeaways that I want you to focus on as investors. Accelerated Wealth Steve has the advantage because of:
- Decreased Risk: With more property (or more doors), his risk is spread out. By leveraging the equity, he’s got less money involved in each deal.
- Increased Liquidity: By leveraging equity, he has more cash on hand to account for emergencies or unexpected expenses.
- Increased Rate of Return: By leveraging equity, he has a higher monthly cash flow and less useless equity tied up in each property. This in turn means he’s got a higher rate of return on the investment
In the end, by leveraging other people’s money and decreasing equity to get your money working for you, you win!
How do you creatively use equity to accelerate wealth building?
Leave your comments below!