Most real estate investors face the following challenge: they are real estate rich but cash poor. Meaning, they have purchased their primary residence, second home, or investment property and have enjoyed rapid appreciation beyond their expectation. This may look like a good idea on paper. However, as a real estate investor, is it the wisest choice to have thousands (or millions) of dollars of equity doing absolutely nothing for you?
Keep reading for 4 great myths that prevent property owners from properly managing the equity in their real estate:
Myth: The equity in my home or investment property is a sound investment.
Risk: Real estate throughout the nation has enjoyed rapid appreciation over the last few years, thanks to historically low mortgage rates. However, what few real estate investors realize is there are a number of risks associated with excess equity accumulation:
a)Lack of diversification risk: A successful wealth accumulation program is one that observes the fundamental rule of investing: diversification. When large amounts of equity begin to accumulate, we are violating this rule. We must remind ourselves that at some point real estate values will begin to decrease. If a substantial portion of our net worth is tied to our real estate and this asset class begins to lose its value, so too will our net worth.
Natural disaster risk: Our great nation has historically been plagued with natural disaster, from floods to fire, earthquake, tornados and hurricanes. If a natural disaster strikes your real estate, in many cases the insurance coverage is inadequate to cover the home equity. Most real estate owners only insure for the value of their debt, not their equity. In addition, even though their specific real estate investment may not be directly affected by the natural disaster (flood, fire, earthquake, tornado, and hurricane), properties in their area that were directly affected could dramatically bring down the value of their property, even though it was not directly affected.
Interest rate risk: Historically, real estate appreciation and depreciation have been directly correlated to the rise and fall of mortgage rates. A real estate investor must be aware that if mortgage rates rise, there is potential risk that the value of their real estate could dramatically decline.
Economic slowdown risk: Consumer confidence, CPI, PPI, energy prices, Federal Reserve comments, Wall Street, interest rates, job growth, etc. are just a few of the economic risks real estate investors face. If our economy experiences a decline in any of these areas (or many others) the real estate market could experience a downturn as people lose their jobs and must sell their real estate holdings.
Lawsuit risk: Because real estate ownership is public record, most attorneys look for real estate ownership when preparing a law suit. A Home Stead Exemption only provides protection for a small portion of equity, leaving the vast majority susceptible to lawsuit risk.
Financial emergency risk: Unless a HELOC (Home Equity Line of Credit) has already been established, quick access to the funds would not be available in the unlikely event that an emergency arises.
Missed investment opportunity: Investment opportunities, when they arise, usually occur when we least expect them. If funds are not immediately available, the investor could be faced with a substantial loss of opportunity.
Reward: Implementing a strategy to utilize and maximize the real estate equity will help the real estate investor create a diversified wealth accumulation program and potentially insulate the investor against these risk and potentially, many more.
Myth: Making additional principal payments is wise.
Risk: In many situations, it is wise for a real estate investor to make additional principal payments towards their mortgage debt, to accelerate the original loan payoff. However, as we learned in step 1, essentially, even though we may be shaving years off of the original term of the mortgage, we are now adding to our risk by increasing our real estate stake. Again, if additional funds are directed towards the mortgage and one of the many risks we mentioned occurred, we have now placed more of our assets into an illiquid investment which could lose value.
Reward: The real estate investor should establish a separate investment account. Instead of paying the additional mortgage payment to the lender, the borrower should invest this payment into a safe and conservative tax deferred investment that earns more than the mortgage interest. By doing so, they will be in control of the funds, maintain their interest tax deductibility and therefore, the borrower will be able to decide when and if they want to pay off the home.
Myth: I should pay off my mortgage as quickly as possible.
Risk: Mortgage interest savings vs. the benefits of mortgage deductibility and diversification is the looming question real estate investors struggle with. One must carefully evaluate the true cost of a mortgage after factoring the interest tax deduction. For those investors in a high tax bracket, this is especially important.
Reward: The investor should focus on accumulating wealth outside of the real estate, then at some point use this asset to pay off the mortgage or purchase additional investments.
Myth: The more equity I have in my real estate, the greater the security.
Risk: This is one of the most common misconceptions of the real estate investor. Psychologically, it may feel good to know your real estate has substantial equity. However, as previously discussed, there are inherit risk associated with this thinking.
Reward: As mentioned above, it may be comforting to know you have built up high equity in your investment property. This can be a boost to your self-esteem and your personal wealth or credit.
The Bottom Line: There are many different avenues to wealth accumulation. Real estate investing is a great strategy to building your wealth, so long as you consider the risks and rewards in a balanced way. Always discuss major investment decisions with a trusted advisor and family member.
Jon Sanchez is a registered representative offering securities and advisory services through Independent Financial Group, LLC (IFG), a registered broker-dealer and investment advisor. Member FINRA/SIPC. OSJ Branch: 12671 High Bluff Drive Suite 200 San Diego, CA 92130. Sanchez Wealth Management, LLC and IFG are not affiliated entities. CA Insurance Lic. #0772626.
Jon G. Sanchez is the CEO of Sanchez Wealth Management, LLC, located in Reno, Nevada. He is the host of the Jon Sanchez Radio Show heard each day on Newstalk 780 KOH as well as an author of The 3 Pillars of Life, a speaker, cattle rancher, volunteer firefighter, a husband and father of three beautiful children. He can be reached at firstname.lastname@example.org or (775)-800-1801.