Many of us get into real estate investing to generate passive income or monthly cash flow from rental properties.
That is a good and a viable reason to get excited about investing in real estate as a part-time investor. Cash flow is king, as many say, and renal real estate is a commonly known way to generate cash flow, also known as passive income.
Equity, on the other hand, is often the unrecognized and unappreciated benefit of owning rental real estate. The irony is that the equity you can accumulate and grow quite often can be greater than your monthly cash flow. Your monthly equity accumulation can often benefit you more and generate more wealth growth than your monthly cash flow.
As a former part-time real estate investor, now full-time real estate investor and owner of a HomeVestors franchise, I understand that the part-time investor is very busy with a full-time career and full-time commitments outside real estate investing.
For that reason, monthly cash flow is particularly important and enticing to the busy part-time real estate investor since they traditionally are already time-starved with their full-time career so the idea of earning on-going passive income with minimal effort is very attractive.
It is of upmost importance that you maximize your return on your real estate investing while minimizing the time, energy and effort you put into your real estate investing. You simply do not have the time as a part-time investor so the idea of generating passive income and growing your monthly cash flow and your equity is very important.
Let’s talk about the equity component, because I trust everybody understands cash flow and its benefits. Equity can be the unappreciated gift, the unrecognized benefit or the pleasant surprise! Here are three ways to look at equity.
No. 1 – How you capture equity when you purchase a property as a real estate investment.
No. 2 – How you accumulate equity as you hold an investment property over time.
No. 3 – How you build equity as your property appreciates over time.
You may not have recognized any of these values of equity. Or, perhaps if you have, you may have only understood or recognized one of them. There are multiple ways equity contributes to your growth of wealth and the return on your real estate investing as a part-time investor.
No. 1 – Equity capture
As investors, we work so hard to find discounted properties on the retail market through Realtors or off-market, through direct mail, advertising or buying directly from wholesalers. You are looking to buy discounted properties below market value that will allow you ultimately to maximize the return on your investment. When you do buy a property below market value, you are capturing equity when you buy that property. Your average investor is going to seek to capture at least 15 to 35 percent equity on every property.
For example, let’s say you buy a $100,000 house and you are all in, including purchase price and rehab cost at $75,000. The equity captured in that instance is $25,000. You bought a property that has a market value of $100,000, after repairs, and only paid a total of $75,000, and therefore captured $25,000 in equity.
You will not put that $25,000 in the bank today. But you will tomorrow when you sell that property. And that is maybe one of the reasons people underestimate the value of equity, because it is not instantly gained. But it is ultimately gained. It is the true wealth driver in real estate investing because when you go to sell that property some day for $100,000, you are going to capture that $25,000 you gained when you originally purchased the property.
This is why so many real estate investors invest so much time and money in advertising directly to sellers, so they can get to those deeply discounted properties. The reason they want the big discounts is because the deeper the discount, the more equity they can capture. This is the origination of the expression, “You make money when you buy.” The money you make is the equity you capture.
No. 2 – Equity accumulation
It is your residents who are working hard each month to deliver this equity to you.
Your residents pay you rent each month and obviously that rent goes to pay the interest on your mortgage, your property taxes, your insurance and the principal on your mortgage loan. Every time a resident pays you a monthly rent check and you turn around and pay your mortgage, that principal portion of that mortgage is real, tangible equity you are capturing.
Referring to our example above, if you have a $60,000 loan (80% of $75,000) on that rental property at 6 percent interest, which is high, but let’s take away all doubt from this example, on a 15-year mortgage, that is a principal payment of about $333 per month that your resident is paying for every month. That is $333 a month in equity that is accumulating, over time, every month that you collect rent on that property and pay the mortgage. You do not enjoy this as tangible cash flow every month, but you do enjoy it as equity gain every month. You will enjoy and capture that equity when you sell the property.
So not only did you capture equity when you bought the property at a discount in our first example, now you are also going to capture equity that your resident accumulates for you each month during the life of that rental property investment when the tenant pays your principal on your mortgage every month. So there are two ways now that equity has accumulated and been captured on that real estate investment you made as a part-time investor.
No. 3 – Equity appreciation
In the United States, residential real estate, depending on your market, appreciates at about 3.5 percent to 5.5 percent per year on average. This is just the value of your property increasing over time as real estate continues to become more and more valuable in our country. Similar to our previous two scenarios, this is equity that you do not enjoy in the form of tangible cash every month. This appreciation is realized when you sell that property, the same as our other two examples.
Let’s assume that $100,000 rental house you bought is going to appreciate at around 3.5 percent a year. That first year it goes from a $100,000 property to a $103,500 property. If you were to sell it you would capture the equity that you gained when you bought it at a discount (refer to our first scenario), yielding $25,000. You would also capture the equity that your resident paid each month in the form of your principal mortgage payment (refer to our second scenario), yielding $2500. And, you would capture the equity that resulted from the appreciation of that property over the course of that one year you held it, yielding $3,500.
You can easily see where if you bought and sold that property a year later – which I doubt you will do so that quickly since you are a buy and hold investor – that $100,000 property could very easily generate around $30,000 in gross equity gain, prior to expenses like maintenance and closing costs, if you sold it after one year.
Oh, and we have not even factored in that monthly cash flow element, that profit, that passive income that you made each month as a part-time investor holding a rental property.
So you can see equity plays in three different ways, often unrecognized and often unappreciated.
So to summarize:
- No. 1 – Equity is captured when you buy. You can see the key is your patience. Take your time. Buy the right house at the right price and that is how you will get that initial equity capture when you buy the house at a discount.
- No. 2 – Equity is accumulated when you hold. Patience and diligence is key, as always. Hold on to your rental property. Resist the temptation to sell it after that first year. Take care of it. Treat your residents correctly, keep your property occupied, and you will continue to generate more and more equity as you hold on to it as your residents pay down your monthly principal payments.
- No. 3 – Equity is realized when you sell. Once again, be patient. Resist the temptation to cash out that property and capture all that money after the first year. Hold that rental. Let it appreciate. Let the market do the work for you. Remember real estate goes up 3.5 percent to 5.5 percent per year. Give it time. Give it patience, and it will do it for you.
So don’t forget when you are out there looking at properties, look at the cash flow – that’s critical. But don’t forget how equity pays you in these three different ways as a part-time real estate investor.
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