Equity is a cornerstone of evaluating risk when buying real estate notes.
When I talk to investors, this is usually where I see confusion: They think yield is the whole story — until a deal goes sideways.
I once worked with a newer investor who said, “I don’t care about equity. I’m getting a 12% return.” Fast forward six months and the borrower stops paying. Now, suddenly, equity matters a lot.
Equity protects your return OF investment first. Yield is the return ON your investment.
It makes sense that more equity means less risk from a note investor’s viewpoint. The more equity or dollars a borrower has invested in the property, the less likely they are to walk away or default. A payer with equity has something to protect, plus they have more options. They could consider selling the home for a net profit, obtaining a second lien, or refinancing altogether.
For the note investor, it provides an important cushion if a note turns non-performing.
What Is Equity?
Equity is the value of a property above the total of any debts or liens owed by the borrower. Put simply, equity is the portion owned free and clear. If the collateral was sold at fair market value and all the liens were paid, equity is the amount of dollars you would be holding in your hand.
For example, if a home was sold for $200,000 and a mortgage was owed of $180,000, the difference between the two would be the equity of $20,000 (less closing costs). Equity can be expressed as a dollar amount, but is more often referred to as a percentage.
Calculating Borrower Equity on Real Estate Notes
To calculate equity as a percentage, divide the equity amount by the overall value. Let’s walk through an example to show how this plays out.
Keeping the math simple, let’s consider a home purchased for $100,000 with a $10,000 down payment, leaving the balance of $90,000 to be carried on a note and mortgage. The equity portion owned free and clear is $10,000, which, divided by $100,000, equals .10 or 10%. The other $90,000, or 90% of the home’s value, is encumbered by a debt or loan.
The 90% mortgaged amount is also referred to as the loan-to-value (LTV). The equity percentage plus the mortgaged or LTV percentage should equal 100% of the value. If you know one item, you can quickly calculate the other by subtracting it from 100%. If someone says the LTV is 80%, you know the equity is 20% (100 – 80 = 20) and vice versa.
It seems pretty straightforward, but here’s where it gets interesting. Not all equity is created equal.
5 Types of Seller Financing Equity
Not all equity comes from the same place, and not all equity carries the same weight. As note investors, we see 5 main types of borrower equity.
- Down Payment Equity
- Appreciation Equity
- Amortization Equity
- Sweat Equity
- Emotional Equity
Down Payment Equity
The gold standard of equity is cash brought to closing. That means on newer transactions, the equity will be attributed to the down payment funds paid at closing. That would be the $10,000 brought to closing in our $100,000 example.
As time goes by, equity can also be acquired through a variety of methods, including principal paydown on a note, property value appreciation, and/or additional improvements to the property.
Equity through Amortization
Equity is then gained through amortization. As payments are made on the note, a portion is applied to interest, and the remainder reduces the principal balance. As the mortgage balance decreases, the equity increases.
Keeping with the same example, let’s assume 36 months or three years of payments have been made on the original mortgage amount of $90,000. The balance has now been paid down to $87,552.06 (using an 8% rate with monthly payments of $660.39).
The equity has increased from the original $10,000 to $12,447.94 ($100,000 – $87,552.06 = $12,447.94).
The 10% equity has increased to 12%, and the LTV has decreased from 90% to 88%.
Equity through Appreciation
Now we take it one step further and factor in appreciation, assuming the home’s value has increased from $100,000 to $120,000 over the three years.
Using the higher value and the lower note balance, the payer now has $32,447.94 in equity ($120,000 -$87,552.06 = $32,447.94) or 27% ($32,447.94 divided by $120,000 = .2704 or 27%).
The Equity is increased to 27%, and the LTV is reduced to 73%.
What about instant equity? This is a term you hear people use when they feel the property was sold at a below-market value. In reality, most note investors desire 12 months of payments (known as seasoning) before relying on a higher value and equity position through appreciation. This higher value would need to be further substantiated by an appraisal, a BPO (Broker’s Price Opinion), a comparative analysis of property sales, and/or proof of completed improvements.
Sweat Equity
Another form of equity we sometimes see in the seller-financed world is “sweat equity.” Sweat equity is often credit given to the buyer at closing for work or improvements done on the property. Sweat equity can be used instead of or in addition to cash down payment funds.
Paint and elbow grease don’t always equal value. Note investors have greater confidence in equity acquired with hard-earned dollars. Still, they will consider sweat equity, especially if it can be substantiated and documented.
Emotional Equity
When people live in a property a long time, raise a family, and build memories, they form an emotional attachment. Rather than financial equity, it is based on their ties to the property and community.
For note investors, this is a consideration but does not have the same weight as financial equity. It matters, but it doesn’t protect your investment backed by property value.
What About Equity With Junior and Senior Liens?
When analyzing real estate note equity, investors also consider any other liens on the property, such as a second lien or delinquent real estate taxes. A true payer equity calculation combines all amounts owed on the property.
Using the first equity example of a $100,000 home with a $90,000 first mortgage, we find that the buyer brought $5,000 to closing as a cash down payment, and the seller took back a short-term second lien of $5,000 in addition to the $90,000 mortgage. The payer’s true equity is now only 5%, and the combined loan-to-value (CLTV) is 95%.
Once the short-term second was paid off, the equity would go back to the original 10%. The same concept could be applied to any outstanding or delinquent real estate taxes.
Equity and Depreciation
In addition to incurring more debt on the property, a buyer’s equity might decrease at other times. While the past decade has seen appreciation across most of the nation, this increase in property values has begun to slow, with some areas experiencing declines. This can lead to a decrease in equity.
We’ve seen this before, and it pays to be cautious. If the amount owed by the borrower exceeds the property’s value, it is known as an underwater mortgage. This was prevalent after the 2008 subprime mortgage meltdown and led to historical highs in non-performing notes and foreclosures.
How Note Investors Use ITV To Increase Cushion
When presented with a note for purchase, note investors prefer a borrower with 20-30% equity. If the transaction has lower equity or other risk factors, a note buyer can adjust their purchase price. This results in a lower Investment to Value (ITV), providing the investor with an additional cushion that exceeds the borrower’s equity.
- Equity = borrower’s cushion
- ITV = investor-controlled cushion
That’s where the shift happens for most investors.
I worked with a note buyer who loved “low down, high interest” deals. On paper, the yield looked great. But after two defaults in a row, he realized he wasn’t buying notes, he was buying risk.
What changed?
He started by asking one question: “How much equity does the borrower really have?” Everything else came second.
This is where understanding ITV really changes the game. If you want to see exactly how investors calculate and use it, check out our articles on What is LTV and ITV? and What is a Good ITV?
Before we wrap up, let’s answer a few common questions investors have about equity.
Common Questions About Equity in Real Estate Notes
What Is Equity in Real Estate Notes?
Equity in real estate notes is the difference between a property’s value and the total debt owed against it. It represents the borrower’s ownership in the property and serves as a key risk measure for note investors.
How Do You Calculate Equity on a Property?
To calculate equity, subtract the total loan balance from the property’s current value. You can also express it as a percentage by dividing the equity amount by the property value.
What Is a Good Equity Percentage for Note Investing?
Most note investors prefer borrowers to have at least 20–30% equity. Higher equity provides a stronger cushion and reduces risk if the loan becomes non-performing.
Why Is Equity Important in Note Investing?
Equity protects the investor by providing a financial cushion in the event the borrower defaults—the more equity in a deal, the more options available to recover the investment.
At the end of the day, equity is what protects you when things don’t go as planned. Yield might look good on paper, but equity is what helps you stay in the game. As you evaluate your next deal, start there first.
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