If you were to ask a thousand aspiring real estate investors what is the key to a successful real estate investing strategy, I am certain that over 70% of them would say: Buy low, sell high. That answer reflects a very common misconception that the primary key to success in long term real estate investing is the amount of initial equity you get by buying the property below its current market value. Or put another way, “you make your money when you buy the house”. I am sure you’ve heard that one before. Well, in this post I will show you why (initial) equity doesn’t really matter when you are a long term investor. Not only that, but I will prove to you that chasing equity might lead you down the wrong path.
Using the wrong measuring stick
The first issue with using initial equity as a criteria to select investment properties is that it doesn’t align with your goals. Comparing the purchase price of the property to its current market value is only useful if you intend to flip the home two months from now. In other words, current equity is a short term indicator when your focus is long term. Your primary concern should be what that property will do in 5, 10 or 15 years not what it’s doing right this second. Quick arithmetic problem for you. Investor A purchases a property 20% below its current market value in a subpar neighborhood that over the next 10 years will only see 2% annual growth. Investor B purchases a property at market value in a fantastic neighborhood that over that same time period will see 4% annual growth. Who do you think will get to the “train station” faster? Exactly. Understanding this is crucial because your ability to maintain your focus aligned with your long term goals will make or break your strategy.
The opportunity cost of chasing equity
The second reason why equity doesn’t matter is that in chasing properties with “built in” equity, you miss out on other opportunities and your results will suffer from it every single time. When you make equity a prerequisite, you eliminate the majority of excellent properties from contention before you even get started. All under the justification that the deal just isn’t good enough, right now. My friend, you are missing the forest for the trees. When we devise long term strategies (Blueprints) for our clients, by the time everything is executed the client ends up with a million dollars (or two) in paid off assets and fantastic annual income. And you are willing to compromise that over how much? I rest my case. Fight the urge of one dimensional thinking and consider all factors that make a property a great investment. Smart investors pay a fair price for great properties in good condition and even better location. And their long term results thank them.
Playing not to lose
A common rationalization investors use for exclusively going after properties with built in equity is that in the event they had to sell quickly, they could get out and make a profit. My question to those investors is: Are you playing to win or playing not to lose? Because there’s a tremendous difference between the two. By the time you hedge against all the “what if”s that your mind can conjure, you end up with a crippled strategy. Look, I understand that they are trying to be cautious and covering all bases. But being a long term investor requires the discipline to not sell when the market fluctuates intermittently and keep your eyes on your prize. Fact: Prices will go up and down in the short term. They always have and they always will. But over the long term, the track record for Houston real estate is clear. One of the great benefits of a solid long term strategy is that it allows the flexibility to exit the investment when conditions are most favorable. Once you decide you are in for the long haul, execute your strategy and watch it produce results unfazed by news chatter and temporary fluctuations.
There’s a reason why it’s below market
Last but not least, that cherished equity doesn’t come without a price. Ever considered the reasons why banks would sell a property so far below it’s fair market value? After all, they do get an opinion of property value (appraisal) from the agent they will use to list the property. The agent will compile a report with comparable sales of similar properties in the same neighborhood so banks know exactly what is the fair market value of the home. The answer is they strongly consider the condition of the property and the required repairs that are needed it to bring it back to par. By the time you are done calculating the cost of repairs and the value of the time spent getting quotes and rehabbing, that illusory equity has all but evaporated.
Moral of the tale: Don’t use a short term criterion to select long term investment properties. It’ll cause you to miss out on the Big Enchilada because of Small Potatoes. Instead, use a disciplined approach, keep your eyes on the prize and execute.
Happy 4rth of July and be safe.
Photo Credit: janGlass