Five Ways You CAN Eat Equity

Have you ever heard the saying, “You can’t eat equity”?

I use this all the time.

If you invest in buy-and-hold rentals this is something you’re definitely going to run into.

Yes, I invest for cash flow, and that part of rental property investing has changed my life, but the real wealth is built in the equity portion of holding properties long term.

What is equity?

Chat GPT defines it as the portion of a property’s value that is free from any debts or liens. That means it’s totally available for you to use. It’s the portion of the property that you truly own. 

Equity can be achieved simply by finding a good deal and purchasing a property undervalued. Or improving a property where the value goes up more than the cost of improvements. The most common way is to buy a property and hold it for a long time. During that time the property appreciates (is worth more) and you pay down the mortgage making the loan smaller (if you have financing on the property). Over time the difference between the value of the property and the amount owed on the property can increase significantly. Ask me how I know.

This article is written by Brendon Pishny, local housing provider and president of Landlords of Johnson County. He is our guest speaker on how to get started as an investor on February 11th and he is teaching a Landlording 101 workshop over 6 Monday Nights starting February 17th. See the MAREI Calendar to learn more.

Now, why do I say you can’t eat equity?

Because it’s not available like money in your checking account. You can’t use equity at the grocery store or restaurant. Yes, you have to have available cash to live life, but having a ton of cash available is not always the best option when building wealth. What matters is net worth.

The best definition of wealth is the difference between someone’s assets and their liabilities. The bigger that number, the more opportunities that person has to live wealthy. That’s why rental property investing and equity are important. So then the problem we have to tackle is how do we access that equity to do the things we want or use it to build more wealth?

Five Ways to Eat Your Equity

I have five ways that I suggest you use if you have some equity built up in your properties. I’m sure there are more, but these are simple and proven strategies to help you get started. 

1: Sell a Property

The first one is the most simple but has the biggest tax implication.

If you have a property that has built up some equity you can always just sell the property.

If it’s a single family home there are always homeowners willing to buy the house. If it’s multifamily, look for other investors wanting to buy it. Either way, you can just list the property on the open market, pay all your closing fees, and pocket the money. Then you can use that money to buy a car, improve your personal home, or whatever you want.

I would suggest you take that money and put it into some other kind of investment. Maybe it’s another type of real estate. Or you could buy some mutual funds (which I love as well) that are completely passive. You could buy a vacation rental that you use sometimes and rent out the rest of the year. The main thing is you can realize that equity and go get a return on it with another vehicle. The one downfall of this option is you will have to pay capital gains on the proceeds over your cost basis.

Please ask your accountant what your tax liability is before selling any property.

2: Cross Collateralization:

One way I used equity as I was getting started was called cross-collateralization.

This was actually something I had to teach my bank.

Yes, I was new to real estate but for some reason, I was smarter than the people at the bank. Honestly, it’s not always their fault. Bankers are taught how to work with the typical buyer for real estate. Investors are not typical. So sometimes you have to help them along with what you want to do.

At that time I was working with a small bank in my home town in Western Kansas. I was looking to grow my portfolio. I had a good portion of equity built up in a few properties, but not a lot of cash on hand for down payments. The deal we worked out was cross-collateralization.

I would get a property under contract and the bank would finance the deal. They would loan me 70% of the appraised value and use the purchased property for collateral. Then they would tie the 30% down payment portion to another property that had equity. Basically they were adding an additional lien to the other existing property. Some may not want to do this because that 30% lien would be in 2nd position. But in this case, the bank had lent on that property as well, and owned the first lien, so they were ok with being in 2nd position.

They were comfortable the entire transaction because even between both mortgages they were still under the 70% LTV amount. This allowed me to buy more properties without having available funds for additional down payment. Basically I was buying properties with little, to no, money. The only problem I ran into was later when I tried to pay off, or refinance, some loans they made me pay off the entire loan, including the collateral, and not just the portion owed on one property. That was easy enough to work out, but something to keep in mind. 

3: Refinance One to Pay Off One:

This strategy is my favorite. I call it the “refinance one to pay off one” technique.

I was getting ready to refinance a property to pull out some equity. I had some ideas about what to do when my lender, and friend, said I could use that money to pay off the debt of another property.

Let me share an example with nice, round numbers.

Let’s say you own two properties that are each worth $200,000 and they each have an $80,000 loan on them. You may have bought them undervalued, paid down the loan, or held them for appreciation. However you got here, you have some good equity to work with. Each property currently rents for $1500/month. Expenses are an $800 mortgage and $400 in taxes and insurance each month. So the cash flow per property is $300 or $600 total. That’s a great position to be in by the way, but you decide you want to use some of the equity so you decide to do a refinance.

Instead of refinancing both here’s an idea.

Refinance one property at 80% LTV. That is a loan amount of $160,000. The new mortgage payment is $1100 and you still have $400 in taxes and insurance. You’re still getting $1500 in rent so that property has zero cash flow.

Yes, you read that right. Doesn’t sound too good, does it?

Let me explain further.

When you close on the new loan the lender pays off the original $80,000 mortgage and gives you a check for $80,000 (tax-free by the way). Instead of doing something wasteful like buying a new Tesla, you decide to pay off the mortgage for the 2nd property. Now your only expenses on that 2nd property are $400 for taxes and insurance. So the cash flow on the debt-free property is $1100. If we take the properties and look at them together you get $3000/month in rent. One has a mortgage of $1100 and both have taxes and insurance totaling $800. That leaves a cash flow amount of $1100. Here’s the best part. You started with a 40% loan to value on both properties and you’re still at a 40% loan to value overall. Same position, but better cash flow.

Obviously, this is a simplified version, but I challenge you to look at your portfolio and see if it makes sense to pull out some equity in one property and get another property, or two, free and clear. It may be just the thing you need to increase your cash flow. 

4: 1031 Exchange:

Now let’s say you want to upgrade properties or invest in something else that’s similar. You can do that and still avoid capital gains tax. This is through the 1031 exchange. This is a technique that’s used to defer any tax liability until the sale of the property or the owner’s death. Think of it as selling a property and then reinvesting the proceeds into something else. This is a great way to sell multiple lower-end properties and upgrade into fewer, nicer properties. Then you would have less to manage and possibly easier management. Or maybe you want to get out of single-family houses and buy a large multifamily. Or maybe the other way around.

However you look at it this can be a great strategy. The caveat is that 1301 exchanges have very strict rules and timelines. You cannot touch the money, and it must go through an 1031 intermediary. You have a 45 day window to identify possible purchases and a 180-day window to close on a property. If this is something you are considering I encourage you to visit with a tax advisor first and get the low down. Just know this is a common way to use your equity when the time is right.

Note the Lunch & Learn on February 6th with Insight Investment Advisers – topic is DSTs and 1031 Exchange.

5: Line of Credit:

One of my favorite ways to use equity is to open a line of credit. You can do this with one property and use multiple properties to create even more credit. A lender will typically open up a line of credit up to 70% of the value of the property or combined properties. It works best with paid-off properties, but I’m assuming a lender would consider it if they already have the first lien position.

Now what can you do with a line of credit? Maybe you want to use this to buy distressed properties and flip them. You could use your line of credit for the purchase and repairs. Then when you sell the property pay off the line and use the profits.

You could buy properties and fix them up. After they are rented out you would refinance that property into a long-term loan and pay down the line of credit. This strategy is often called the BRRRR strategy.

I have used my line of credit for renovations between tenants. Then I can refinance the loan at a higher amount with better terms and pay down the line of credit. Think of it as being a private lender for yourself. There are never any tax implications and you only pay interest on the money drawn out of the credit line. This means if you are only using $50,000 of a $250,000 line of credit you are only paying on the $50,000. You can pay it down or draw more if needed anytime you want. I highly recommend getting a line of credit in place once you have a significant amount of equity built up in your portfolio.

The better you get at finding ways to use equity the faster you’ll see your wealth grow. Real estate has a way of making equity grow in different environments. People always need a place to live so the value of housing continues to increase. The key is to use that equity strategically. So no you can’t eat equity, but you can use equity to build enough wealth that can buy you all the food you could ever eat.