The concept of equity is very often misunderstood. To be a successful investor, it’s important to break it down and understand exactly what it means and then how you can harness it to build a successful property portfolio. We asked Michael Beresford to give an explanation of all things equity…
So Michael, what is equity?
Well, equity is the difference between what an asset is worth, and what you owe on that asset. For example, if a property is worth $700,000 and you’ve got a $300,000 mortgage than there is $400,000 in equity in that property.
So let’s say you have some available equity in your property. Firstly how do you identify it, and then what are your options to use it?
The way that you identify equity is by getting your property valued by a lender. So they will send out a valuer, and let’s say they set a valuation at $700,000 on your property. The bank will allow you to have up to 80 or 90% of that asset value in debt, as long as its secured by the property. So at an 80% loan to value ratio, the bank will allow you $560,000 worth of debt (80% of $700,000) and you’ve already got a mortgage for $300,000, so the other $260,000 is what we call available equity. The process for using that is that you ask the bank to refinance that loan, then set up a loan for part or all of that $260,000 to use as a downpayment on the deposit and costs on the next property.
We hear so often that equity can be this life-changing thing, what about it is so special?
Equity is life changing because property grows at a much quicker rate than what you can save. The hardest property that you’ll ever buy is the first one. From there, as properties grow in value, you can then access that equity to cover the deposit and costs for the next property and so-on. The time between starting your savings for your first deposit is much longer than the time between purchasing your second property, provided it is a well-chosen investment, and a shorter time again between investment two and three, and then three and four and so-on. Equity is what really allows you to fast track that wealth creation process.
So equity is dependent on good property selection?
In short, yes it is. You can create equity by paying debt down. But equity is created so much more quickly by the rise in the value of an asset, rather than the reduction of debt.
Just say you have $250,000 in available equity ready to use, what is the best strategy to use it? Do you place it all on one property or diversify?
The type of property that you use the equity for will be dependent on your investment strategy. But as property gets more expensive, rental yield decreases, so a key to successful investment is making sure that you can hold multiple properties in your portfolio without it taking too much cash flow that it impacts your lifestyle. You’re going to be far better off putting equity into a deposit and costs for two cheaper properties rather than one more expensive property, but always make sure you’ve left a buffer in there for some emergency funds if you need it.
At what point should you start accessing equity to live rather than re-invest?
Whenever you want. But to ensure that you can live off equity on a sustainable rate into the future, it is important to be sure that you’ve got the right asset base behind you that’s going to perform on a consistent basis. It is very dependent on how your portfolio is tracking as well as how much you want on an annual basis. For most people, who want to replace their income and not go to work, if they are focussed investors who build a portfolio of multiple well-chosen properties over 15 years, they should be in a sound position where they can comfortably live off equity into their future.