Be Careful of Dead Equity!!

Be Careful of Dead Equity!!

Rental Property Investor · San Diego, CA · Member since 2014 · 1k+ posts · 2k+ votes

What prevents us all from becoming super wealthy?  Plain and simple it is the return you get from your net worth.  So, for an experiment take your net worth.  That means, if you were to sell everything today and paid off all your loans etc...  What would you be left with?

A few years ago I figured out that if I were to do this, I would have about $2,500,000.00 in Equity or Net Worth.  I thought that was something else at 49 years old.  Then I calculated my ROE or Return On Equity.  I figured out that our passive income from all this RE was at $72,000 a year.  To figure out my ROE, I took that passive income and divided it by my $2,500,000 in equity or Net Worth.  Guess what?  It wasn't very impressive.  My Return on Equity or my return on Net Worth was almost 3%.

Wow!! That was a real eye opener.  That was pathetic.  What that told me was that I had too much dead equity sitting in pricey California single family rental properties.  So, what I did was learned and read and learned and read and attended seminars etc...  What I learned was people with dead equity and were successful RE investors took that equity and did one of 2 things.  The first was they refinanced that equity out (tax free) or the route I took, which was the incredible tool called the 1031 exchange.  

All I did was started to trade this pricey San Diego Re in for undervalue apartment complexes in Ohio.  Right now our passive income has risen to $120,000.00 a year and our ROE is now up to about 5%.  Again, this is tax deferred and the Net Worth is still the same.  The difference was, increasing the front doors from 12 to 78.  That is including 2 personal residences that don't give us any passive income.  Those personal residences have loans and take money out of our pocket each month.

Remember, If you keep the proper leveraged debt 30-50% on each property you keep a level of safety and ROE. Let me know what your ROE is currently and what you plan to do about it.

Happy and prosperous New Year to all here at BP!!!

Swanny

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Member since 2016 · 13k+ posts · 12k+ votes
9y

My opinion has always been that equity in a property is a liability not a asset. The most troubling issue I have with novice/inexperienced investors is they have absolutely no concept of the value of cash, the opportunity value to generate more cash.

Novice investors state that paying down a mortgage increases cash flow, they keep their rents below market, they do not apply annual rent increases. They do not understand that all of those things depreciate a investment. They have no concept that  when a property appreciates their returns are dwindling away. Clearly no concept of the value of cash. These I refer to as hobby investors, regardless of their net worth, as they never see beyond the money coming in.

The biggest hurdle novice investors face is looking beyond the money they are making. They never see the money they are not making. By doing that most overlook the unlimited amount of income they do not even know they are losing. That's right, it is not that they are not making it they are actually losing it and 9 times out of 10 it is because they have no concept of the value of cash. Having equity in a property is reducing cash flow and throwing income away. Appreciation is a double edged sword that money hoarders never benefit from.

Investors holding dead equity are looking at a diminishing dream. A someday thing. Thanks but no thanks I'll take the cash, every dime I can generate, before I die.

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  • Investor · Cleveland, OH · Member since 2015 · 6k+ posts · 2k+ votes
    9y

    @Jack B., I don't know why ANYONE should need to justify "trading for cash flow". Cheers...

  • Investor · Pueblo West, CO · Member since 2014 · 310 posts · 213 votes
    9y

    Trading for cash flow seems like a reasonable approach when someone wants to quit their day job and live off of the income.

  • Developer · San Diego, CA · Member since 2015 · 1k+ posts · 1k+ votes
    9y

    @Peter Tverdov I like how you included risk modeling along with the ROI calculation. Investments are always about alternatives, and most people don't care to make their comparisons based on *risk adjusted* returns.

    Is anyone else trying to apply CAPM or other risk modeling to their REI decisions? Perhaps this is a different thread.

  • Member since 2016 · 13k+ posts · 12k+ votes
    9y

    My opinion has always been that equity in a property is a liability not a asset. The most troubling issue I have with novice/inexperienced investors is they have absolutely no concept of the value of cash, the opportunity value to generate more cash.

    Novice investors state that paying down a mortgage increases cash flow, they keep their rents below market, they do not apply annual rent increases. They do not understand that all of those things depreciate a investment. They have no concept that  when a property appreciates their returns are dwindling away. Clearly no concept of the value of cash. These I refer to as hobby investors, regardless of their net worth, as they never see beyond the money coming in.

    The biggest hurdle novice investors face is looking beyond the money they are making. They never see the money they are not making. By doing that most overlook the unlimited amount of income they do not even know they are losing. That's right, it is not that they are not making it they are actually losing it and 9 times out of 10 it is because they have no concept of the value of cash. Having equity in a property is reducing cash flow and throwing income away. Appreciation is a double edged sword that money hoarders never benefit from.

    Investors holding dead equity are looking at a diminishing dream. A someday thing. Thanks but no thanks I'll take the cash, every dime I can generate, before I die.

  • Investor · Willow Spring, NC · Member since 2009 · 5k+ posts · 3k+ votes
    9y

    It's always fun in a roaring real estate bull market! Prices never go down. And 2008 is a distant memory. Leverage cuts both ways.

    Equity in a property is not a liability to me, but rather I consider it 'near cash'. With a commercial LOC, I can have a $0 balance with the opportunity to use up to 75% (usually) of appraised value if the opportunity arises. Set it up ahead of when you anticipate needing it, on a portfolio basis, and you can have 'safety' and 'future leverage' in the same investment vehicle.

  • Multifamily Lending · Dallas, TX · Member since 2014 · 55 posts · 21 votes
    9y
    Would note there are rumblings of 1031 possibly going away next year... Wonder the impact on strategies and prices/cap rates of properties. Less inclination to sell so less inventory on the market yet and less people overpaying to find a home for 1031 money... maybe a wash?
  • Rental Property Investor · Monterey, CA · Member since 2014 · 23 posts · 11 votes
    9y
    As I read this thread ( very interesting info) I'm curious about the 1031 exchange that is discussed. It is my understanding that the exchange has to be for a property "of like kind". Seems like a SFR was placed into the 1031 and used to buy an Apartment building in Ohio. Would someone explain please?
  • Rental Property Investor · Scottsdale, AZ · Member since 2012 · 314 posts · 146 votes
    9y

    Unfortunately, there's no such thing as a 'free and clear' property since property taxes are a perpetual lien on everybody's real estate and many have HOAs as another perpetual lien. 

  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    9y

    @Chris Martin  I hear ya.. most of those loan products though have call provisions.. were the lender can unilaterally call the loan... one must be careful to read the fine print.

    and I see all these newer investor running out getting helocs on their resi's and I know most of those have call provisions in them.

    I bailed out a lot of smaller investors from 08 to 2010 when the banks called their helocs and they where mid stream in a project counting on that money to finish only to not have it avalaible.

    We of course had these monster LOCs for our lending business. but we negotiated 24 to 36 month wind downs... and that was one thing that kept us from going under in 08 when 5 of my 6 banks called our loans due and would not extend..

  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    9y

    @Mark Braun, 1031 fits into the scenario because it is exactly the way to move between property classes to capture cash flow and slumps in the market sector or geographically.  "like kind" really means "...any property purchased with the intent of holding for productive use in business, trade, or for investment...".  So any type of investment property can be exchanged for any other type of investment property.  Unhappy with your sfrs?  Sell and exchange for duplexes.  Scared of residential?  Sell and exchange into commercial.  

    There's a lot of bright people trying to figure out the impact of 1031 going away.   I don't think the true long term implications have been figured out yet.  The creativity of the human mind springs eternal!  Folks will find ways to make money with or without 1031.  I'll be sad of course :)

    The 1031 Investor5137 Reviews
  • Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    9y
    Michael Swan I'm not arguing with your basic concept. And yes if you do covert high end property equity into low end markets you should do large apartment complexes. And yes if you are able to improve NOI that's the right model. But all that takes time and effort and not easy with full time work. But as the end game for retirement income it's a good model I think. One risk is cap rate compression can affect your valuation. We are at the top of the cycle and rising interest rates will affect cap rates and valuations
  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    9y

    @Dave Foster  from my understanding the 1031 was first called the starker exchange and was coined for the Starker family an Oregon logging concern that wanted to exchange timber or timber lands.  Many timber companies swap lands all the time.

    And the only 1031's I have done has been on standing timber.. talk about nirvana and no competition LOL...

    @Michael Swan sounds like you have a plan... what most west coast folks just need to be cognizant of is mid west rentals are NOT west coast.. and one can get sucked into thinking a 10 cap is as easy to run as your 4 cap .. and many have broken their picks and come home with their tails between their legs.. one must be very careful picking MF in those markets... of course there are great properties but there are areas an properties that are simply almost impossible to make work and they are constantly changing hands once the owner figures out rents are near impossble to collect on a consisitant basis or that CAP EX murders them..

  • Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    9y

    the OP would be wise to spend an afternoon and search on BP for the numerous "appreciation vs cash flow" threads. Lots of ink (sic) has been spilled on this subject, and he is missing/disregarding significant information in his analysis. 

  • Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    9y

    @Amit M. Im with you on the appreciation. As all of us Bay Area investors, I have seen significant growth in my equity. However even my $1M valued townhouse if fully paid off would only throw out about $2500/month of income. Obviously not enough if I needed that income for a significant portion of my expenses. So at some point you need to convert a 3% return into a 10% return where the cash flow is meaningful relative to expenses. How do you propose one does that? One way is the higher cap apartment complex model. Open to other ideas also.

  • Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
    9y

    @Brent Coombs Its a valid question. If you want to quit your day job you need cash flow now. IF you are working and building wealth, you care about building net worth. There is a difference. Like the difference between buying a growth stock and a bond.

  • Real Estate Lender and Broker · Dallas, TX · Member since 2013 · 966 posts · 500 votes
    9y
    Originally posted by :

      from my understanding the 1031 was first called the starker exchange and was coined for the Starker family an Oregon logging concern that wanted to exchange timber or timber lands.  Many timber companies swap lands all the time.

    And the only 1031's I have done has been on standing timber.. talk about nirvana and no competition LOL...

    Jay,

    I believe the Starker exchange was for a non-simultaneous exchange.  The 1031 has been around since 1921.  The Starker case happened in 1979.  Starker took the IRS to court and won the right to do the deferred exchange.  Most exchanges today are Starker exchanges.

    Mark

  • Jay HinrichsBusiness Member
    Real Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
    9y

    @Mark Creason  thanks mark I knew it had something to do with our timber industry here.. !!  I have a hard time seeing the 1031 going away.. but then again.. I was no prepared for 1986 tax reform either LOL

  • Sherman Oaks, CA · Member since 2013 · 3k+ posts · 2k+ votes
    9y

    Moving dead California equity to East Cleveland ignores some rei principles like discounted future cash flow, basic location fundamentals, rent growth, appreciation, redev opps etc... Could it work out better than moving dead equity to another Cali asset? Historically speaking, that is not likely. What did those Ohio assets sell and rent for 20 years ago? There is a reason you can find high cap multis all over the mid west. Not to say this is wrong but someone should point this part out too. 

  • Specialist · Honolulu, HI · Member since 2014 · 1k+ posts · 1k+ votes
    9y
    Originally posted by @JD Martin:

    Agree with @Account Closed . I am fond of saying leaving equity sitting in homes is like having employees sitting around, not doing any work. That said, the opposite of dead equity is 100% leverage, which is a dangerous place to be sitting without massive cash reserves. My personal preference is about 50/50, although in reality we sit at around 20-25% (I lean towards the financially conservative side of things). That allows some properties to maintain all their equity as a partial hedge against economic difficulties, while allowing others to help grow the business along with income generation. Also, the overall trend of the specific market needs to be considered. A property that will generate cash flow may stall or deflate when it comes to appreciation, and it could be a coup in a low-interest environment to harvest that equity at a high point and utilize those funds to expand your portfolio. 

    People say this all the time and I still can't wrap my head around it. If you have a $100k property with say a $800 PITI mortgage payment, if the property is 2% or 98% leveraged, where is this "partial hedge against economic difficulties"? You will still be making that same payment month after month, if its a rental the rents will be quite stable in the near term, so I am not seeing the benefit or even existence of this added 'security'.

  • Specialist · Honolulu, HI · Member since 2014 · 1k+ posts · 1k+ votes
    9y
    Originally posted by @Amy Greger:

    @Jack B.

    The 3 properties we're selling we've owned for 8-9 years. I wanted to cash in on the appreciation, and the Seattle market is getting too expensive for new investment properties. For the Midwest properties, they are over 10% CAP and cash on cash ROI between 15-26%.

    A cap rate of over 10%, just speaks to the low desirability of the property and of the submarket. May (likely) also mean higher risk. If people (including investors) are willing to pay $100k for a $10,000 NOI in the Midwest, and $300,000 for the same $10,000 NOI in San Francisco, there is a good reason for that.

  • Investor · Willow Spring, NC · Member since 2009 · 5k+ posts · 3k+ votes
    9y

    I don't think it's been mentioned, but I'd also start with a well defined DSCR number/goal and make sure you stick to it. I am all for leverage, when used properly. DSCR of 1.5 may be too conservative, but that's where I'd start if going for a cash flow play. And I'd go MF, not SFR, even if it is a turnaround. But I have a bias because I've done that in central NC.

    My 2 cents.

    What would suck would be for you to trade future west-coast capital appreciation for mid-west or east-coast phantom cash flow. No one can predict the future, but you should be able to weed out "current" bad deals with in-person site visits and proper due diligence. Amazing the posts on BP about people not visiting sites and letting the turn-key guys spend their money.

    Personally, "dead equity" as a phrase... I don't like it. Maybe because of our commercial LOC facility that allows 'tapping' it if necessary, so it isn't dead. But that equity is like a good, reliable truck. It is there when you need it and it can bail you out if all hell breaks loose.

  • Rental Property Investor · San Diego, CA · Member since 2014 · 1k+ posts · 2k+ votes
    9y

    Well since I last checked, you guys @Chris Martin and @Brent Coombs and @Adam Christopher Zaleski and @Justin R. and @Thomas S. have been contributing nicely to this Dead Equity issue.  That's why BP if used properly spurs many different aspects to RE investment.  I seem to remember reading in an excellent book called the secrets of the Millionaire Mind by Harv Eker. One of the ways that rich people think and act different from the middle class is exactly what we have done and continually do on this forum and all others.  We are consistently learning and growing.  Middle class and the poor, think they already know.  I truly believe, when you quit learning, you start to die.  You all bring up good points.  

    Yes. I am a little worried about future 1031 exchanges not an option possibly.  Of course, they won't be able to take away the six I have already completed in 2015 and 2016. Next, I feel some of what Jay is speaking of when he talks about Midwest is more difficult to collect etc..  Right now my PM and I have worked extremely hard to maintain consistent collections of rent and late fees etc.  If you don't budget in Cap Ex, of course Muphy's law will hit you right between the eyes.  At the moment we have 3 vacancies out of all our front doors.  I am all over my PM if we don't maintain 95% or better occupancy.  

    Remember, I have 2 teaching jobs, working about 60 hours a week and just love every bit of this!!  I also think that Harv Eker in that book said that rich people focus on opportunities and poor people focus on obstacles.  Every 3 hours I press A button on my phone and another craigslist ad goes to the top of the list to rent out one of my vacancies.  I am texting, emailing, calling my PM to make sure he has signs up, flyers in neighboring retail establishments, $100 referral for tenants that refer new tenants, bonuses for my PM to lease out vacancies within one month, PM splits all late fees, bonuses for raising rents at lease end, $25.00 pet rent per month per pet etc...  We just purchased a 21 unit with investors too and come to find the previous owner was being dishonest etc.. Upon purchase 5 tenants moved rather quickly.  Many middle class or poor minded people would start to feel sorry for themselves and just play the victim.  No Way!!  We proceeded to rent them out for $80.00 more rent per month in Dec no less.  Not a good time for people to move. Plus a few wanted to pay $25.00 more pet rent.  An incentive for them to sign an 18 month lease at much higher rental rate than existing tenants was we gave them one free month rent to be used in Nov or Dec of 2017.  I choose to look at all obstacles as opportunities to succeed. I also am attempting to grow bigger than my problems.  Am I fearful yes!! But, that fear fuels my determination and persistence to be bigger than my problems.  I believe Albert Einstein once said, you can't solve big problems with the same thinking that got you into those problems. When I began to change the way I looked at things, the things I looked at changed right before my eyes.  I now want bigger and bigger problems.  That way I know I am growing!!   At one time I wanted to be comfortable.  Hogwash!! I want to be uncomfortable to grow way beyond what I could ever or anyone could have ever expected of me.

    I had a 6th grade teacher that sat down with my mom and told her, maybe Michael should do something with his hands, possibly become a gardener or something.  Guess what Mrs. Gates, I have a four year degree, a masters, and more than you will ever know.  Those statements that teacher made way back in 1976, predicated my path I have traveled.   I am much bigger than the problems that have been many many opportunities to succeed.  (Sorry to rant guys)

    Swanny

  • Specialist · Honolulu, HI · Member since 2014 · 1k+ posts · 1k+ votes
    9y
    Originally posted by @Thomas S.:

    My opinion has always been that equity in a property is a liability not a asset. The most troubling issue I have with novice/inexperienced investors is they have absolutely no concept of the value of cash, the opportunity value to generate more cash.

    Novice investors state that paying down a mortgage increases cash flow, they keep their rents below market, they do not apply annual rent increases. They do not understand that all of those things depreciate a investment. They have no concept that  when a property appreciates their returns are dwindling away. Clearly no concept of the value of cash. These I refer to as hobby investors, regardless of their net worth, as they never see beyond the money coming in.

    The biggest hurdle novice investors face is looking beyond the money they are making. They never see the money they are not making. By doing that most overlook the unlimited amount of income they do not even know they are losing. That's right, it is not that they are not making it they are actually losing it and 9 times out of 10 it is because they have no concept of the value of cash. Having equity in a property is reducing cash flow and throwing income away. Appreciation is a double edged sword that money hoarders never benefit from.

    Investors holding dead equity are looking at a diminishing dream. A someday thing. Thanks but no thanks I'll take the cash, every dime I can generate, before I die.

     Come on Greg, you know better than to make such an absurd statement. When a property appreciates, your IRR goes up. Also, rental income tends to follow appreciation, so your return on cash ALSO goes up. Last I checked, both of those are "returns" metrics.

  • Rental Property Investor · Monterey, CA · Member since 2014 · 23 posts · 11 votes
    9y

    @dave foster 

    Thanks Dave. I need to further educate myself on this product. I wait to see what happens after the New Year in case it goes away. 

  • Rental Property Investor · San Diego, CA · Member since 2014 · 1k+ posts · 2k+ votes
    9y

    Hi @Audrey Y. and @Thomas S. 

    Those are the people I am buying these apartment complexes from. They fail to increase rents, due to not having debt on the property. I especially love to buy from the owners that live on site and are totally done. That's when I swoop in to save the day for them. Then 18 months to 2 years later, maybe 3 years if it takes that long I refinance or 1031 exchange. Just curious, anyone out here have true Multi-Family (5 units or more in one complex). Single family (1 to 4 units on the same parcel of land) is a different beast altogether. Single family is valued based on comps. Not so with true Multifamily. NOI is King!! The lenders value my apartments by the total gross income minus your operating income, NOT including debt service and NOT including Cap Soooooo, anybody that has contributed here own any true Multi-Family and can relate to my particular situation? Has anyone taken the path I am taking now? Or are you speaking hypothetically?

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