Most investors that are just starting out and that have little financial or business background look at things as they are today with little consideration of how they might be tomorrow. This is a dangerous way to conduct business, and is almost certain to lead to hard times. For example, there are a number of courses on the market today where you’ll learn how to obtain a real estate investment as follows:
1. Find a house with no equity and a motivated seller.
There are several problems with this type of transaction. For the purposes of this article, let’s just discuss one problem – the no equity situation.
In almost all cases the investor in this type of transaction either spends the cash gained from the sale of the option, or uses it for some other business purpose. Seldom does the investor turn around and pay down the loan on the property to increase the equity therein.
Therefore the equity in the property remains at zero for the current time. Yes, the investor may be counting on appreciation to raise the property value, but this may or may not happen.
The investor cannot predict the future. For example, events beyond the investor’s control can drastically change the rental market, in some cases very quickly. Likewise, interest rates may shift, which can cause problems if the underlying loan is not of a fixed nature. And finally, if the property is taken subject to underlying financing, as in the example above, issues can arise which require the investor to refinance the property. Any of these situations can occur.
Equity can be thought of as insurance. For example, having equity in a property allows the investor to sell the property without having to take a loss or bring money to the table, which the investor may or may not have. Likewise, if equity is present in the property, the investor may be able to sell the property with partial seller financing, or may be able to obtain suitable refinancing to avoid cash flow problems.
Indeed, if a financial burden arises and the investor fails to have adequate reserves, having equity in property may be the only thing the investor has to fall back on to avoid bankruptcy.
In short, not having equity in a property, for whatever reason is a dangerous strategy. A good rule of thumb is to adopt a policy of having as an absolute minimum $10,000 equity position after all acquisition and initial repair costs are accounted for, or 10% of the fair market value of a property, whichever is GREATER. In most situations, this is the minimum cushion needed to allow weathering uncertain events.
Before you follow the often taught strategies to buy property with little
or no equity, speak with seasoned professionals regarding the dangers
of this type of overly leveraged investing.
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