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However, most people think in terms of capturing speculative equity, the equity gained from other speculators bidding up prices.
Everyone wants to make money by doing nothing, and the lure of speculative equity is that one can make millions by simply buying and holding an asset.
To really understand equity, 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.
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).
For purposes of illustration, equity can be broken down into several component parts: Initial Equity, Financing Equity, Inflation Equity, and 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.
It is a loser's game, but it does not stop people from chasing after it.
Will the markets bubble again? 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 may not get back to break even in the next 20 to 30 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 is credited with saying, "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.
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 break even, 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 break even.
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 curve like the one for the peak buyer who purchased at the wrong time and utilized the wrong terms.
Those buyers lost everything.
Nobody wants to suffer that fate.
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