Feb042008

What is equity?

What is Equity?

In simple accounting terms, equity is the difference between how much something is worth and how much money is owed on it (Equity = Assets – Liabilities.) People who purchase real estate use the phrase “building equity” to describe the overall increase in equity over time. However, it is important to look at the factors which either create or destroy equity to see how market conditions and financing terms impact this all-important feature of real estate.

 

For purposes of illustration, equity can be broken down into several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity. Initial Equity is the amount of money a purchaser puts down to acquire the property. Financing Equity is the gain or loss of total equity based on the decrease or increase in loan balance over time. Inflation Equity is the increase in resale value due to the effect of inflation. This kind of appreciation is the “inflation hedge” that provides the primary financial benefit to home ownership. Finally, there is Speculative Equity. This is the fluctuation in equity caused by speculative activities in a real estate market. This can cause wild swings in equity both up and down. If life’s circumstances or careful analysis and timing cause a sale at the peak of a speculative mania, the windfall can be dramatic. Of course, it can go the other way as well. If a house is purchased at its fundamental valuation where the cost of ownership is equal to the cost of rental using a conventionally amortized mortgage with a down payment, the amount of owner’s equity is the combination of the above factors.

Initial Equity

The initial equity is equal to a purchaser’s down payment. If a buyer pays cash for a home, all equity is initial equity. Since most home purchases are financed, this initial equity is usually a small percentage of the purchase price, generally 20%. A down payment is the borrower’s money acquired through careful financial planning and saving or from the profits gained at the sale of a previous home. Down payment money is not “free.” This money generally is accumulated in a savings account, or if a buyer chooses to rent instead, down payment money could be put in a high-yield savings account or other investments. There is an opportunity cost to taking this money out of another investment and putting it into a house. This cost and its impact on home ownership costs are detailed in Rent Versus Own.

Financing Equity

Financing equity is controlled by the loan terms as described previously in Financially Conservative Home Financing and Your Buyer’s Loan Terms. With a conventionally amortizing mortgage, a portion of the payment each month goes toward paying down the loan balance. As this loan balance decreases, the owner’s equity increases. This is a substantial long-term benefit of home ownership. With an interest-only mortgage, the loan balance does not decrease because only the interest is paid with each payment. With this kind of loan, there is no financing equity. One of the major drawbacks of using an interest-only loan does not become apparent until the house is sold and the seller wants to take the equity to the next home in a move-up. Since no financing equity has accumulated, the seller obtains less equity in the transaction. This means the move-up buyer will be able to afford less. Over the short-term, financing equity is not significant because the loan balance is not paid down by a large amount, but if the house has been held for 10 years or more, or if the loan was amortized over a shorter term, the financing equity can be a large amount. This can make a real difference when the total equity amount is to be put toward a larger, more expensive home. Also, financing equity is a great reservoir for retirement savings. In fact, it is the primary mechanism for retirement savings of most Americans.

neg-am-equity

The worst possible loan is the negative amortization loan because of its impact on equity. As noted in the chart above, if a negative amortization loan is utilized, it will consume all equity in its path. It is a cash-out financing that reduces equity. This loan relies on inflation and speculative equity to have any equity at all. The negative amortization loan will only begin to build financing equity after the loan recasts and becomes a fully-amortized loan and the payment skyrockets — assuming the borrower does not default. Most people cannot afford the fully-amortized payment, or they probably would not have used this form of financing initially. Even after the recast and the dramatic increase in payments, the loan does not get back to the original balance for many years.

Inflation Equity

House prices historically have outpaced inflation by 0.7% nationally. In a normal market, this is the only appreciation homeowners obtain. This appreciation is caused by wage inflation translating into higher housing payments and the ability of borrowers to obtain larger loan amounts to bid up prices. In areas like Irvine where wage growth has outpaced the general rate of inflation, the fundamental valuation of houses has increased faster than inflation; however, there are reasons to believe that Appreciation is Dead. The related benefit to home ownership obtained through utilizing a fixed-rate, conventionally-amortizing mortgage is mortgage payments are frozen and the cost of housing does not increase with inflation. Renters must contend with ever-increasing rents while homeowners with the proper financing do not face escalating housing costs. Over the short term this is not significant, but over the long term, the monthly savings accruing to owners can be very sizable, and if the owner owns long enough or downsizes later in life, housing costs can be nearly eliminated when a mortgage is paid off (except for taxes, insurance and upkeep.) Although this benefit is attractive, it is not worth paying much of a premium to obtain. The long-term benefit is quickly negated if there is a short-term additional cost associated with obtaining it. For instance, if a property can be rented for a certain amount today, and this amount will increase by 3% over 30 years, the total cost of ownership — even when fixed — cannot exceed this figure by more than 10% to break even over 30 years. The shorter the holding time, the less this premium is worth. In short, capturing the benefit of inflation equity requires a long holding period and a minimal ownership premium.

Speculative Equity

Speculative Equity is purely a function of irrational exuberance. It has become a common element in certain markets, and capturing it is the dream of every would-be speculator who buys residential real estate. As was noted in Speculation or Investment? it is a losers game, but it does not stop people from chasing after it. The first chart in this post approximates the conditions from 1997 to now in Irvine, and extrapolates a future repetition of the same conditions witnessed from 1997 to 2007. Will these conditions repeat themselves? Who knows? Human nature being what it is, the delusive beliefs of irrational exuberance may take root and the cycle may continue. In the aftermath of the Great Housing Bubble legislators may pass laws from preventing it from happening again. Of course, such laws require enforcement, and when greed takes hold, enforcement may simply not occur. For those that purchased at the peak of the bubble, they need another bubble or they will not get back to breakeven in the next 20 years. If however, there is another bubble, those who purchased at rental equivalent value after the crash will have an opportunity to reap a huge windfall at the expense of those who purchase at inflated prices in the future. As PT Barnum noted, “There is a sucker born every minute.”

The speculators who purchased at the peak of The Great Housing Bubble who put no money down (no Initial Equity) and utilized negative amortization loans — and there were a great many of these people — they will have a painful future. The loan balance will be increasing at a time when resale home prices are falling. They will be so far underwater, they will need scuba equipment to survive. Plus, during the worst of their nightmare, their loan will recast, and they will be asked to make a huge payment on a property worth roughly half their loan balance. What default rates will these loans see? Realistically, they will all default. Why wouldn’t they? The only reason they purchased was to capture speculative profits which did not materialize. Even if some of these people hold on, and there is another speculative bubble similar to the last one, it will take 10 years or more for them to get back to breakeven, not including their carry costs. If there is no ensuing bubble, it will be 20 years. If you factor in their holding costs, they may never get back to breakeven.

Conclusion

Equity is made up of several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity. Each of these components has different characteristics and different forces that govern how they rise and fall. It is important to understand these components to make wise decisions on when to buy, how much to buy, and how to finance it. Failing to understand the dynamics involved can lead to an equity chart like the one for the peak buyer who purchased at the wrong time and utilized the wrong terms. Nobody wants to suffer that fate.