Your equity was always imaginary


You used to hear the term "land rich, cash poor" for people who owned valuable land but didn't have quite enough money to make ends meet.  It's an expression that dates back to the days when property was the only kind of real wealth there was.  It's kind of fallen out of fashion of late.  But as property values keep falling, it's worth thinking about the ways in which land is wealth.

In those days, land was wealth because it produced income--crops, grazing, timber, game, etc.  If the land didn't produce an income, it wouldn't be considered especially valuable (so, the owner wouldn't really be land rich), but it was possible to ruin the income from your land through poor management or bad luck.  That was how you found yourself land rich but cash poor.

The only sort of land ownership that most people have any involvement with nowadays is home ownership.  Ordinary urban and suburban plots don't tend to be particularly productive (although you can grow a garden on one, and actually produce quite a bit), but there's a second way in which land can be valuable:  You can rent it out.  Or--and this is really the same thing--owning a home makes it unnecessary for you to rent one.

Economists use this logic all the time--not having to spend money is equivalent to receiving the same amount.  This economic logic is correct, although you have to take care not to fool yourself about what expense you're really avoiding, as in the old joke:  

This guy gets home from work really late.  When his wife asks why, he explains that he decided save 50 cents by walking home instead of taking the bus.  His wife says, "Idiot!  If you were going to do that, you should have saved $5 by walking home instead of taking a cab!"

This, then is another way of valuing a home--it's worth whatever you'd have to pay to rent an equivalent place to live.  (Of course, you need to adjust for any difference in expenses--taxes, maintenance, insurance, water, sewer, garbage, etc.)

We've mentioned two ways to value land:  its productive value and its rental value.  The third way to value land at its market value.

Market value, of course, is the most common way to value anything.  It doesn't work very well for land for various reasons:  each piece of land is different, most pieces change hands very rarely, owners will resist selling if the sale price won't cover the mortgage, etc.  (It's because of all these problems that we even have such a thing as "appraisers.")

Along with all these problems with valuing land by its market value, the worst thing is that it's prone to lead you to imagine that the "market value" minus what you owe on your mortgage is your "equity."

In It Doesn't Matter What My House Is Worth, paidtwice talks about the difference between equity that's produced by paying down the mortgage versus the equity that appears out of nothing if the market values of the house goes up.  She makes a good point, which is that if house prices in general are rising, then you can't translate that latter equity into an improved standard of living:  If you sell and move, your new house is just as overpriced as your old one was; you don't come out ahead.

The fact is, though, that your equity is imaginary whether it's produced by soaring property values or by paying off the mortgage.  Unless you're going to sell it, your property's only real value is what it can produce, plus what you can rent it for (or save by not having to rent someplace else).

This has always been true.  Hopefully, it'll be a little more obvious going forward.  Confusion about real value is what leads to bubbles and crashes.  When only a few people get confused, they're mostly the people who suffer the consequences.  When you get the sort of mass confusion we've had over the past few years, though, popping the bubble leads to bad consequences for lots of other people as well.

I think we'll know we're clear of these economic troubles when expressions like "land rich but cash poor" make sense again.  It'll mean that people are valuing land by what it's really worth.

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Guest's picture

I think one of the major problems with this, though, is that everyone and his brother is trying to convince us that the home equity is actual money. The preponderance of home equity loans is one example. Then the stupid, at least here, East/West Mortgage ads, their newest is to say,"Tired of paying 18% on your credit cards? Would you like to lower it to 6%?" What that means is you take out an additional home equity loan or refinance your mortgage including the amount of your credit card debt, so then you pay off your credit cards and instead pay the extra loan or mortgage. Which, on the one hand, is basically what credit counselors do, kinda. Consolidating debt into one loan isn't new. But, they don't tell you how that translates into the mortgage, by adding $5k, $10k or more to your THIRTY YEAR payment plan, how much extra are you really paying on that money? Are you saving anything than if you just started paying off your credit cards to begin with?

The fact that there are so many such ads--coming at us from so many directions, from institutions we can rationalize wouldn't try to cheat us, they're trying to make money from us and they can't do that if we can't pay, so if we can't pay, they wouldn't be loaning us the money--is what the problem is. The average American has been conditioned for YEARS to trust information from certain sources (banks, the gub-ment) and they get suckered in by these money grubbing fools. Interest only mortgages anyone? I'm not a finance expert but when those popped up I looked at my husband and said - does anything about that sound like a good idea?? But there are a lot of slick talkers out there with initials after their names and people believe them.

It's so frustrating, especially when the government is bailing out those slick-talkers and their equally guilty prey (for not researching the whole thing more and taking someone at face value) AND I DID THE RIGHT THING AND GOT A LOAN THAT I CAN PAY AND AM PAYING RESPONSIBLY! Where's my bailout? Refinance?

Philip Brewer's picture

The amount of "refinance your mortgage" ads seems to have dropped considerably.  And for all the talk of a government bailout, there hasn't really been one.  (Virtually the entire extent of the government action so far has been to clarify a couple of technical rules to make it clear that lenders can work out problem loans, even if they've been packaged and sold.)

So, I think there's real reason to hope that things will return to normal.  So many people see that "home prices always go up" is false (and so many people have negative equity now), that I think it'll be a generation before people will be so easily fooled again.

Guest's picture

Philip, your post brings to mind one thing that's always been a bit of a mystery to me. You mention two ways to determine the value of land: production value and rental value. I've always thought there was another, and equally valid, way of determining something's worth. For instance, When my mom died, she owned a 35-acre ranch, a very unique property with creek frontage and irrigated fields and end-of-road privacy, and so on. We had a couple of appraisers tell us what they thought of it, but in the end I always came back to the same idea: the land's value is what you can get someone to pay you for it. If someone looking for property comes across a place that they absolutely fall in love with, and must have, they then value the place more (and hopefully fork over more cash for) than someone else who doesn't love it as much. Right? I've always thought that the "value" of land or a homestead was really highly subjective, and that the whole business of appraising was almost pointless.

Guest's picture

Equity is easy to calculate. Especially now that decent approximations of market value are free of charge online.

I'm finding the task of calculating value based on productivity plus rent collected (or not spent) to be a little more subjective. I am assuming that the value is the sum of all future years productivity and rent. Further, the percent of total that each of those two summands contributes, I suppose, would depend on how the property was purposed.

OK. We need to adjust for many factors, as mentioned in the post. Do we adjust for inflation as well, to find the value in today's dollars? We must assume that the property remains purposed in the same way, and isn't the source of unexpected fabulous wealth or ID'd as a superfund site, etc. My point is, that this calculation has some major assumptions behind it, (but I guess the equity calc based on market value does too)

It's an interesting analysis to play with though. And it adds a level of control over one's own property value, where we have little control over our equity. For example, the idea may prompt a landowner, even in a suburban or urban area, to consider innovative ways to gain productivity or rental income on an existing property. (Hopefully innovative within the law). I believe true RE investors tend to do this manner of analysis at some level whether they are fully aware of it or not.

Your garden variety home owner may lack the sophistication, patience, or motive to run this analysis. As previously observed here and in prior posts, the equity calculation is easy to understand, PLUS it was (and will be again, I'm sure) a great way for many folks to sell all sorts of loan 'products.' Which of course all amount to commitments of future earnings, based on some present market value using the property as collateral.

Will the practice of calculating market value fall away in lieu of this other way to determine value. Ha ha. Come on. the astute will always do both and choose how to assert a value depending on what side of the deal they're on. Mwa ha ha.

Philip Brewer's picture

@Greg:  You've put your finger on the problem with market value--it depends entirely on finding a buyer who will pay that much.  I know of some rural land around here that sold for over $5500 an acre back when the market price for similar land was about $3000--because the buyer wanted that exact piece of land.  Was that what the land was worth?  Arguably it was--someone paid that much for it.  But any other owners who began to imagine that their land was worth as much ended up sorely disappointed.

@Guest:  The productive and rental value may be difficult to forecast into the future, but surely it's no more difficult to find out what similar houses rent for than it is to find out what they sell for.  You can get a pretty good idea just by checking the "for rent" ads in the paper.

The thing about rentals is that the information is current: The amount of the rent gets reset every year, and the rent actually gets paid every month.  On the other hand, a house can go years--even decades--without being sold.

Unless you have an offer in hand, the market value is just a guess.

There are plenty of people who will make that guess, based on recent sales of similar properties (and other things).  But I think homeowners who take that guess, subtract what the owe on their mortgage, and then call that their "equity" are just fooling themselves.

Xin Lu's picture
Xin Lu

A lot of people also misunderstood what equity actually means.  For example, one of my friends told me that he is going to suddenly get $500,000 in equity because he is buying a house, and I asked him if he knew that equity means the value of the house minus the amount of debt, and he didn't.  Another couple I know are doing an interest only loan, and they keep on talking about equity to me, too.  It's pretty bizarre because I know they are pretty much just renting the money from the bank. 

Guest's picture

Givem you article, it's not surprising that this far and away the most popular post on my site:

You don't want to live 'land rich ... dirt poor' ... AJC.

Guest's picture

Equity is always there but it only gets a hard value when a contract is inked. It also plays a part in whether banks extend you a line of credit, or whether they rescind it, like what has happened recently.

I don't include my home's equity in my net worth calculations, just the mortgage debt.

Guest's picture

Great thoughts Philip! When market value exceeds economic value of a property it is often combined with a speculative and/or emotional enthusiasm that will not persist over time. It only seems that way when your living through it. Housing is a particularly good example. When comparing the cost of actually renting a property versus owning it one needs to use it generally 4 to 6 months a year to break even. I have a white paper on the topic at .