You can’t fake equity

The difference between those who are professionals in real estate investing and those who aren’t is equity. Pure and simple equity. Are you purchasing properties at 70% minus repairs so that equity is built in to every single deal you make? If so, you’re on the right track. If not, brace yourself for nothing exciting to happen in your business at all. (Unless you find business plateaus, losing money, and sometimes bankruptcy exciting. Then, prepare yourself for excitement like you’ve never seen before.)

Equity is king, and you can’t ignore it or fake it, although there are certainly plenty of gurus who try. One way they attempt to fudge the numbers is by teaching that you can accurately assess the value of the property based on the cap rate alone. Cap rate is simply a ratio gauging the profitability of a property (Capitalization Rate = Annual Net Operating Income / Current Market Value), so when it’s in the spotlight, the possibility exists that you could buy a property for more than its actually worth based on the profit potential expressed by the cap rate.

The problem is that you can’t use cap rate as a means to measure single family performance from a rental standpoint. It’s a terrible metric for single family investments unless you have more than about 500 of them. However, there are uneducated real estate investors who will jump on a deal because they see the potential to make a 10% rate of return on the property. And that’s all fine and dandy until they go to sell the house and realize that they bought it for more than it’s worth based on the cap rate, so their only option is to take a loss on the sell.

Another way to fake equity is to settle for small margins. If you’re buying at 85% or 90%, you’re essentially buying retail. Think about it. When you sell a house, it’ll cost around 10% in realtor fees, title costs, transfer costs, etc. If you sell to a retail buyer, they’ll get an inspection period and they’ll want concessions of some sort, so whatever small margin you still have after typical closing costs will get eaten up by things like granite counter tops, upgraded flooring or upgraded appliances. You cannot build a business on small margins because at best, all you’re doing is breaking even, and at worst, your small margins will actually end up costing you money.

But what if you’re in a hot market like DFW, Denver or a few markets in California where properties are appreciating even during short term rehabs? The investors gain equity simply because the value increased during the short time they held the property. Surely that’s not fake equity, is it? Think again. The problem is, this strategy works until it doesn’t. What happens when the market decides not to appreciate? What happens when the trend stalls and you were counting on that appreciation to gain equity? What happens when the market crashes like it did in 2008 and you’re stuck holding multiple properties that you can’t unload? You’ll either end up bringing a lot of checks to closings or, if you can’t afford that, you’ll end up with multiple foreclosures.

You can’t fake it by justifying your deals based on the expectation of equity or the promise of equity or the potential for equity. The only way to guarantee equity is to insist upon it on the front end.