Equity in Real Estate is Dead Money — and This Case Study Proves It

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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!”

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, yada… 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.

Related: Cash Flow vs. Equity: Which Pays Off for Investors in the Long Run? /a>

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).

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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.

Equity Steve
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
Equity $500,000
Cash in Savings $30,000
Net Worth $530,000

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).

Wealth Steve
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
Equity $450,000
Cash in Savings $80,000
Net Worth $530,000

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
Equity $400,000
Cash in Savings $130,000
Net Worth $530,000

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.

Related: Building Wealth: 10 Strategies for Successfully Managing Equity

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!

About Author

Jeff Trevarthen

Jeff Trevarthen is the broker/owner of Veritas Mortgage, a boutique mortgage brokerage in San Jose, California. With 10+ years in real estate finance, Jeff is an expert at coming up with creative loan solutions for all types of residential real estate loans.

25 Comments

  1. Jay C.

    Jeff…great article. In my response I am going to use the same fun humor you did so lets start. Ok…..its the age old leverage vs having things paid for argument. Two sides of the street who will never come together. Your math…I really call it fuzzy math cause you left so much out of it. You left out Leveraged Steve who you created. Leveraged Steve may not have survived the real estate meltdown we had a few years ago but Equity Steve would have flourished. Leveraged Steve makes a much smaller return on his properties then Equity Steve does. You left out Equity Steve is in a position to add to his portfolio over time and grow as he keeps all of his profits not giving any of it away to lenders.. In the end you cannot deny…many Leveraged Steve`s were destroyed in the meltdown when not a single Equity Steve were harmed. Suzie Orman said it best…”Do what lets you sleep well at night”

    • Travis Fisher

      Thanks for speaking up Jay. No one seems to realize that solvency has its benefits. Equity Steve is likely not static and isn’t stopping at 5 rentals. But rentals #6, 7, & 8 are sooo much easier to finance because his debt load is low. He can choose conventional financing, private lending, whatever he wants. Leveraged Steve is very limited in his choices.
      And once Equity Steve picks up his new properties the snowball payments will pay them off even faster, making for much more income than Leveraged Steve could ever imagine.

  2. Very good article. But you didn’t factor in maint. And management costs. You have 16 properties, whose running them and fixing them. I don’t want anymore middle of the night calls. Is there enough cash flow to pay a fulltime employee, plus get your cut after expenses. I know I’m not dealing with 16 renters, I’ve done that and that is a nightmare. With 16 rentals what If a couple roofs or foundations go bad. What if 3 go vacant? Now your out of pocket, no matter how You look at it with sfh. Apartments would be more feasible.

  3. Jay C.

    Dale, …Jeff is a Mortgage guy. He gets paid lending money to those who buy into the myth more more more is a good thing. You make great points about the maintenance that was not factored into the fuzzy math scenario.

  4. Philip Williams

    Or the fact that forget qualifying for 16 mortgages, banks won’t qualify some of us for 2 lol! No debt besides investment properties…..but no regular w-2 day job = one perhaps two mortgages at best. Regardless of your equity cash flow or anything else.

  5. Kevin Yeats

    I have to agree with Jay C’s conclusion. Many novice real estate investors suffered greatly or were completely wiped out and are now doing something else based on the (high) leverage scenario discussed here.

    Jeff, if I accept your premise, then talking to you, a mortgage broker, a real estate investor could approach you and request a 90% LTV loan with all of the closing costs rolled in. Then, a month later should approach you to either obtain a line of credit secured by the same investment property or simply to inform you the he/she obtained a LOC from 1st Bank and Trust. Your reaction should be to congratulate the real estate investor.

    If you think the equity in a parcel of property is “dead,” then so is the equity in a car, a computer, furniture, art work … really any asset. Many assets can be sold and leased back (with the user never losing control of the asset). It is just a matter of the rate of appreciation of that asset versus the interest rate charged by the lender.

    But, as Jay C. pointed out, there are risks to overleverage.

  6. Brandon Stevens

    Id probably fall somewhere in the middle of this debate. Sitting on 500k in equity seems silly to me when i have tax, maint, management etc…cutting into everything with nothing but appriciation on the horizon but i also wouldnt feel great about mortgaging 75% of everything i had. You want your money to work for you and id sure rather have 5 extra properties being paid for by someone else and appriciating at the same time. Your net worth will.simply grow more exponentially in this regard but its all about getting the right terms and being able to sleep at night…but i cant imagine sitting on 500k is the right answer for many of us unless your not trying to grow your wealth.

    • Kevin Yeats

      Brandon, would you like 5 extra properties when real estate prices decline … like in 2007-2008 (+)? Especially when you still have to make mortgage payments or go into default? Or worse, when you lender threatens to call your loans unless you reduce the LTV down to 75%

      • Charles Worth

        Depends if you have a 30 year fixed or not and when you bought. If you bought in 2006 or 2007 obviously not but you probably did not do the right DD.

        Its the same in any asset market. Good assets bought well have come close to what they were before while way overpriced ones from people who chased returns have not.

      • Brandon Stevens

        Hence the reason i said id be somewhere in the middle and that its all about your terms. You sound somewhat bitter to the 07/08 market, plenty of people leveraged or not made it through just fine. If someone was buying 5% or no money down investment properties on 30yr notes at the height of the market just because they could than i’m not suprised. But of course id rather have 5 properties if i bought them right i surely wouldnt b worried about the market. Nonetheless the article is about whether to sit on 500k (which isnt smart if your trying to grow) or to leverage 75% of what you have which is personal preference and just equates to the risk level your comfortable with. The beauty of real estate is that there is 100 ways to get there…..

        • Kevin Yeats

          Perhaps we should ask a few RE investors who were heavily leveraged when 07/08 hit and who were also hit with a few unexpected vacancies or a few higher expenses (new roofs or AC units). These investors has to tap personal savings to pay the bills.

          Oh that’s right. It is tough to find these investors in RE forums. They have moved on to other businesses or other jobs … i.e. didn’t survive as RE investors.

          Brandon, perhaps you can tell us what “buying it right” actually means so that others can follow your example. I doubt that high leverage, the subject of this blog post, is in that formula.

        • William Morrison

          Keith, I agree.
          Kevin, the idea is to tap into your reserve not your savings. If you have a 5 to 10% reserve you will be more in line with the examples above.
          Treat your investment as a business. One which requires liquid reserves, not to be confused with your personal rainy day requirements. Then calculate how long you can cover vacancies or better yet reduced rents and what you have for major repairs HVAC, a roof, hot water heater, etc.

        • William Morrison

          Kevin, I keep mine in places others may not have the same comfort with, the idea is liquid and available. But I’ll answer your question this way.
          I think the idea of dead money as written here is the difference between no leverage and some level of leverage. But not leveraged to the point of not being ready for vacancies and long term repairs. (Not trying to speak for the author but just my interpretation)
          We are talking about multiple properties i.e. a portfolio. You could have that money in Bonds or other liquid assets. Margin accounts allow you to write a check on them instantly. There are other market possibilities with better returns but require a different level of understanding. Be glad to discuss offline. No I’m not selling anything.
          So when I run my numbers I count this reserve in my Return on Cash. I generally don’t count property appreciation because it can be a long term thing (say 10 years or more) that I’m not willing to count on. I don’t count the tenants rents buying down my mortgage either, too far out. But I do hope for both .
          The rental I just bought has about an 18.8% return on cash with down payment (all closing cost) and a 5% reserve. This with 20% of rent subtracted for reserve replacement and vacancies.

          So bottom line it’s just another cost or being prepared for the unexpected. It’s why 2008 affected some worse than others.

        • Brandon Stevens

          Well of course the reserves are dead but the author clearly shows you can grow your wealth and have reserves for things that happen. Kevin you seem to think this article says levrage your life to won more properties, it simply shows you how to go about growing while having sufficent reserves depending on you risk level. Buy deals with equity in them, we buy improve and get our money out all the time on deals leaving a minimum of 20% in properties usually more without ever touching our substantial reserves. Not sure anyone with ample reserves and a property with a fair amount of equity wouldnt be able to ride out most storms. Maybe its just me…we flipped houses when the going was good, bought houses when the floor fell out. People with no reserves who are highley leveraged are playing with fire but i didnt really see that from this article.

  7. Charles Worth

    Jeff great article and a dangerous one as well.

    The math is fairly simple you can borrow at 4%-5% and make 10% – 12% on many ways of investing that are safer than owning rental properties.

    However this is dangerous as well:

    1) Over leverage or getting greedy is a big risk. Someone who spends almost 100% of their income is not going to save what they make here in probably 8 out of 10 cases so when something goes wrong watch out below. You can say well you should save the money you make between now and a hiccup but that only works in theory.

    2) Unless someone knows what they are doing (in which case they likely already know this) buying rental properties carries a high degree of risk esp buying somewhere out of state like most people will do for cash flow. True they can learn, anyone can, which is why I said its a great premise but dangerous at the same time because if 10 people read this article a certain number will get get excited, do their HW and a certain number will buy badly. That is a shame with saved money but a much more risky shame when the recourse is on your house.

  8. I had this conversation with many people 10 or so years ago. The people that were overly leveraged are now in a different line of work and many of the ones that weren’t leveraged are retired!

    If you want to go big be prepared to fall hard.

  9. William Morrison

    I’m in third camp and what I like in the numbers above is the reserve.
    It seems to be missed in some of the comments.
    That and 25 to 30% down works a whole lot better in a down turn than some of the zero or 5% down games being played.
    Those that I know personally that had trouble in the last down turn were in the zero to 5% down and they spent what could have been a reserve.

    I consider a neutral cash flow situation to have your rents at a minimum of 120 to 125% of your monthly expenses. That’s taxes, insurance, maintenance, repairs, HOAs etc.
    The 20 to 25% will generally cover long term maintenance like roofs and HVAC as well as vacancies. Takes self control, to replenish your reserves.

    If your rents are near 1% of asset value you should be cash flow positive and your tenants are buying down you mortgage.

    I do find the interest rates about a 1% higher.

    Now if your rents are cash positive and you have reserves you can better survive a down turn like the ones discussed above, even if you’re underwater. You will have a tough time buying more though until they come back. It also helps to look at your numbers with 20% drop in rents to see if your still positive or how long your reserves can handle that.

  10. Joel Owens

    This comes down to LEVERAGING at the right time in the CYCLE.

    I have talked to many investors across the country. Some have made millions to tens of millions and then lost it all.

    They key was that they leveraged at the right time in the cycle which improved their net worth. The mistake most of them made was not cashing out on the frothy market and de-leveraging some in a down cycle.

    • Charles Worth

      But how does the average person know what the right time is? Even really savvy investors have a tough time calling a cycle how would someone that just found out they can pull equity from their house do it (i.e. early in their journey) and with leverage so there is little room for error?

  11. Matt R.

    I understand the advantages of leverage. I am fully leveraged currently. If it was less risky to use leverage than every advisor would have you leverage big time in retirement. I am not buying it is less risky for the obvious reasons.

  12. CL Tumlin

    Jeff this is a great article. Thank you so much for posting it. The chart represents (similarly) the exact moves I’m taking right now, albiet on a smaller scale. As I said earlier, biggerpockets.com changed my life in seven days last January (2014). Cheers to EVERYONE!!!! Thanks so much, 🙂

  13. Erik Nowacki

    One variation on this theme that I have used is to heavily leverage into a value ad situation. I’ve used subject to as well as lease purchase options to get into or get control of a multifamily property with no or little money, using the funds I didn’t spend on the purchase toward renovations. Once the renovations are complete, cash flow increases and the value increases in proportion with the NOI. Once you have forced the value increase, you can sell, 1031 exchange, refinance or simply hold for cash flow.

    Using maximum leverage for a simple buy and hold strategy usually means very poor cash flow and putting the whole portfolio at risk. If you can leverage into a property and maintain good cash flow, the risk is mitigated, but you can find yourself trapped in a property you no longer want/need if it goes under water.

    Erik

    • William Morrison

      Erik, I agree and I think that approach works for many types of real estate. You buy distressed or under valued, add value and keep or sell.

      Distressed or Foreclosed single family homes work well. But I would separate your/our highly leveraged time and high risk from the long term hold and refinance situation above. You want to get in, get done and get it up and running.

      Buy at say 5% down, spend from hard money, your money, repair loan etc to fix and add value. Then when your done sell, or refinance to a 30 to 40% equity situation like the example above. Keeping your eye on building a reserve and having a positive cash flow when you are up and running if you are keeping the property.
      My idea of a positive cash flow is where rents exceed monthly expenses with 20 to 25% of the rent not needed for your monthly expenses, but there to build and refill your reserve.

      It’s much like any business start up, your biggest risk is that first phase. And you have to have a plan for the unexpected.

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