“Equity” is a word that is used a lot but in my opinion, there are a lot of people who might not understand how it can be very misleading.
Having read the responses of the board veterans, I really can’t offer any insight over & above what they have said already.
I wanted to relay a story that I think might offer another way to view “Equity.”
Two years ago, I was in the office and a woman who was a new investor, was talking to the receptionist about an REO deal she had. I overheard her say, “I got a great deal!. I got $100,000 equity on a house I bought for $300,000.”
My head spun around so fast, that I thought I would get whiplash. I said to the woman, “You didn’t close on that deal, did you?” She said she had and I shook my head and said, “You don’t have $100,000 in equity.”
She became irritated with me and said to me, “Oh really? And how exactly do you figure that? I bought it for $300,000 and its ARV is $400,000.”
I asked if she was going to rehab the house and sell it and she said she was.
I took out some paper and said, “Let me break it down for you and ask some questions.” She folded her arms and nodded, ok.
“Are you going to use a Realtor to sell it? She said, Yes.
“Ok thats 6%. On $400,000 that will be $24,000.”
“You said you already closed so, your closing costs were at least 2%, right?” She nodded, yes.
“Then thats $6,000 on a $300,000 house. But wait, you are going to sell it for $400,000. You will have to pay closing closts as the seller at the increased price. Even at 2%, thats going to be $8,000.”
“Are you going to put in carpet and have it painted? What is the square footage?” She said, yes and it was 4,000 sq feet.
“Even if you put in cheaper carpet, it will cost you around $5,000 and if you hire painters, it will be at least $5,000 to paint it.”
“Are you going to make any upgrades, repairs or improvements?” She said, yes.
“Well on a $400,000 house, you won’t be buying fixtures and such at Home Depot because a house like that will get quality materials. Considering you are going to hire the work out, you will be lucky to come in under $5,000 and that’s IF nothing unsuspected comes up.”
“Did you pay cash or get a mortgage?” She said she got a mortgage and her payments were $2,200 a month. “What is the average Days On Market?” She said around 60.
I said, “Alright, lets figure 45 days from purchase to complete the rehab and get it on the market. Add another 60 days for listed on MLS time and another three to four weeks for a buyers contract to close. So if everything goes as planned, you are looking at about five months of holding at $2,200 per month. Thats $11,000 at best, in holding costs and that doesn’t include any utilities, trash dumpster, etc.”
She looked on with a blank face as I said, “Assuming you will have the property for five months and the taxes are close to 3%, that would be another $5,000 you would face for property taxes.”
I pulled out the calculator and added it up.
$24,000 for Realtor fee’s
$14,000 + for Closing Costs
$15,000 minimum for upgrades
$11,000 minimum for Holding Costs
$5,000 for taxes and $1,000 per month thereafter
$69,000 in costs
$31,000 estimated profit at BEST CASE scenario
I looked up at her and said, “You don’t have $100,000 in equity. You have 25% equity if you paid $300,000 and it’s worth $400,000.”
She stood there, staring at the paper, silent.
A year later, I saw her in the office and she came up to me and said, “You were right. I don’t look at any deal based off equity in dollars. I look at the equity in percentages and if it’s not at least 30%, I pass.”
I asked her how she came out on the house from last year.
She shook her head a little and said in a low voice, “I lost $12,000.”
To quote the best manager I have ever worked for,
“I didn’t invent Math… I just have to use it.” -Cody Thompson
I hope this gives you another way to look at equity.