People spend cash on real estate for a variety of reasons. Probably the most common reason for spending any cash at all is that the bank making a new mortgage on the property requires a cash down payment or it won't approve the mortgage.
Some people make the biggest cash down payment they can to keep their monthly mortgage payments lower. Others try to pay with as much cash as possible because they don't want to pay interest on borrowed money. And some folks, especially those who remember the Great Depression, prefer to own their property free and clear of any debt.
However, what most cash-paying real estate buyers don't realize is this: Equity in real estate and cash are not the same thing. There is a fundamental difference between the two. While cash goes into the equity market at full value, equity comes back out into the cash market at a discount. Equity is not a liquid commodity and does not move very quickly. Cash is absolutely liquid. It is important to understand this difference.
To illustrate this dynamic difference, let's assume we have $100,000 in cash to buy a piece of property. We find a well-priced home for that amount. We pay cash for it, close escrow and it's ours free and clear. Now, can we break off a piece of the roof and buy groceries with it? Can we take the front door and use it to pay our doctor bill? The answer is "no" because cash is not the same as equity.
We've converted our cash from the cash marketplace, at full value, into $100,000 worth of equity in the real estate market. Soon after the purchase, however, a financial emergency arises. Having no other cash in reserve, we must convert our equity back into cash immediately. We have to sell the property today.
To convert our equity into immediate cash, we need a buyer for the property right now. Finding a buyer willing to pay full cash value for the equity might reasonably take 60 days to six months. Add to that another 30 to 60 days to close the transaction and, when we total it up, it's going to take a long time. And that's if everything goes smoothly.
But we need immediate cash not maybe in six months. To get immediate cash, there are two options available to us. First, if we structure the offer attractively enough, someone will buy our property today. The most obvious way to do that is to reduce the price to an amount that no serious buyer could refuse.
Depending upon the stability of the real estate market, that could mean discounting the price by as much as 35 to 50 percent. That's 50 to 65 cents on the dollar! Now, would you take your dollar bills to the bank and trade them in for the same number of fifty-cent pieces? Would you trade in 1,000 dollar bills for $650? Most likely, you would not. Yet, that's the price we have to pay to convert our equity into cash right now.
Our other option is to refinance the property. We can refinance and get some of our cash out that way. Here again, the full $100,000 equity will not be converted into the same amount of cash.
If you have excellent credit, you may be able to borrow as much as $80,000 against the property. If you have less than excellent credit, or poor credit, you won't get a mortgage for anywhere near $80,000. If your credit is really bad, banks won't loan you a dime on your property.
In both instances, we are faced with the same problem. Everyone agrees the equity in the property is worth $100,000. To convert it to cash, though, we must discount that equity.
Now that you understand the difference between cash and equity, you should always think twice before you exchange very much of your liquid cash for real estate equity. Knowledgeable investors use a variety of creative methods to overcome this dilemma.
