A term that can be a little confusing in commercial real estate is “imputed equity,” especially when so many different types of equity exist. However, understanding imputed equity is important in any commercial real estate deal.
To put it in simplest terms, Amanda Saltzman, the Director of Capital Markets at Lev Capital said, “imputed equity is the value between what you bought [a property for], and what it’s currently worth.” For instance, if you spent $100M on an asset, and now it’s worth $120M, your imputed equity is $20M.
Of course, the idea of equity gets more complicated than that, with various other factors to consider. But, on a very basic level, the imputed equity is the additional value exceeding actual dollars invested into the property, or what’s left after you subtract the dollars invested from the presumably higher market value.
Backtracking just a bit, though, equity alone is the difference between the market value of the asset and the debt — or the amount you owe to lenders. So if you were to pay off your debt and sell the property, the money you have left is your equity. Imputed equity, on the other hand, occurs before the sale of land and is always an estimate based on market value.
4 Benefits of Understanding Imputed Equity
There are several reasons why it’s beneficial to understand imputed equity:
1. It Helps With Financial Analysis
Aaron Prager, another Director at Lev Capital, said, “The importance of imputed equity is how it affects the capital stack.”
Understanding imputed equity helps buyers and investors gain a better idea of their finances, their net worth, income, asset valuation, tax status, and their margin of profit should they choose to sell their commercial property investments.
2. It Increases Your Chances of Getting Financing
Knowing one’s estimated equity could also make a difference when looking for financing. Generally, a lender will look at the original cost of an investment property. If the imputed equity is higher, however, it could come into play when refinancing a loan.
For instance, if you have imputed equity, then the net worth of your property is potentially higher. This increased value, Prager said, makes you a stronger borrower in the lender’s eyes.
A lender usually won’t give a loan based on imputed equity, but sometimes they might take into account a percentage of that equity, depending on how long you’ve had the property and what factors have come into play to cause an appreciation of value. Then, in some cases, having this higher net worth could allow buyers to negotiate better terms for their loans.
3. It Could Help You Sell an Asset
Imputed equity also comes into play when selling an investment property. Saltzmann gave an example:
“If you buy a $10 million property, and you have a loan for $7 million, you have $3 million in equity. Now, the property’s worth $15 million. You still have your $7 million loan, but the value of your equity went from being $3 million to $8 million. And that $5 million — the appreciation — becomes the imputed equity.” Saltzman continued, “If you sell [the property] for $15 million, your imputed equity just became realized equity.”
For this reason, it’s good to have an understanding of imputed equity and keep track of any major changes.
4. It’s Relevant During Redevelopment
One other benefit of understanding imputed equity occurs in redevelopment, or when making improvements to a property. There are many ways to increase the value of a property, thereby increasing your imputed equity, through new infrastructure, zoning changes, etc. But in doing so, you have to consider the costs of redevelopment versus the resulting appreciation. Basically, you need enough of an understanding of their possible imputed equity to determine if the improvements are worth the cost.
4 Examples of Imputed Equity
There are a few examples of when imputed equity comes into play for a piece of commercial real estate. Other than the first example, all of these scenarios involve circumstances that are partially out of the borrower’s control.
1. Buying Property at Lower Than Market Value
One example, and probably the simplest, is when an investor buys an asset for a lower cost than its valuation. Right off the bat, this transaction creates imputed equity. The value of the property is higher than the cost, for whatever reason. According to Prager, this situation is common.
2. The Passage of Time Increases the Property’s Value
Another more commonplace example is simply the passage of time. If someone bought a property in 1985, for instance, it is most likely worth more today.
“We see this all the time when somebody has owned a piece of property for 20 years,” said Prager.
Of course, this is looking just at the actual dollar amount, not inflation. And that extra dollar amount is the imputed equity. To account for inflation, buyers should talk to a financial advisor or an accountant to make the correct calculation.
3. A Change In Surroundings Increases the Property’s Value
Another instance in which imputed equity can occur is when there is a change in the surroundings. Prager gave the example of the Dumbo neighborhood of Brooklyn. 30 years ago, a vacant industrial lot in Dumbo would not have cost much. But the neighborhood quickly changed, and 20 years ago, a person would have had to pay a bit more. Moving even further ahead in time, 10 years ago, a piece of commercial property in Dumbo would have been quite expensive, and today, according to Prager, there just aren’t many vacant industrial buildings left in Dumbo, as it’s become “one of the most high demand neighborhoods in the city.”
Someone who bought a piece of property in Dumbo 30 years ago, then, would have a great deal of imputed equity today, assuming they still owned the property. This dynamic has happened in a number of cities and neighborhoods across the country, one reason being new infrastructure like parks or shopping areas that increase the market value of the neighborhood.
4. Changes to Zoning Laws Can Affect an Asset
Imputed equity can also occur when there are changes to zoning laws. Suddenly you’re able to build more on a piece of property. According to Prager, zoning changes would definitely modify the valuation of a property.
Best Practices When Working With Estimated Imputations
An estimated imputation is an approximation of what your imputed equity would be over time. It’s impossible to figure out your exact long-term imputed equity upfront because you don’t yet know how the neighborhood might change, or if the zoning laws will ever change. Nonetheless, there are a few ways to actively increase your imputed equity over time, and get the most out of those estimated imputations.
Look for “Secondary Cities” and Do Some Neighborhood Research
Neighborhoods make a huge difference. Saltzman suggested paying attention to the “rise of secondary cities.” Today, buying commercial property in New York, for instance, comes with astronomical costs. However, there are a number of cities across the United States with fast-growing markets. Saltzman mentioned Houston, Austin and Nashville, to name a few, where “secondary markets are growing, and it’s because they have a good quality of life, and companies are going there.”
Furthermore, obtaining financing may be easier in secondary markets with less competition. When applying for financing, consider what you think your net operating income and cash flow will be and whether it can cover your monthly payment and other expenses.
Buyers should do their research on these secondary cities, perhaps talking to a financial planner who might have a better gauge on which neighborhoods show promise.
Take Initiative When It Comes to Getting Zoning Laws Changed
Buyers can also take active steps to improve their imputed equity through zoning laws. While every jurisdiction is different, the FindLaw legal team wrote, “If the zoning on a parcel of land is inconsistent with the use the land owner desires, the owner may apply to the local jurisdiction for a change of zoning.”
Usually this process involves an application, a fee, and a hearing in which the owner presents their case, and sometimes, owners might hire a lawyer or engineer to help with the case. Owners are often able to change zoning laws to further develop their properties, thereby increasing their imputed equity.
Show Finance Officers How and Why the Property Value Increased
In terms of debt, Prager also mentioned the situation in which a buyer might go to a lender “saying I’m buying [the property] for X dollars, but I’m buying it at such a good discount that the real value is Y dollars.” However, as mentioned above, lenders generally won’t offer financing based on the percentage of Y, or the imputed equity.
“If it’s an acquisition, or if you bought a property within the last short term — a couple of years — a lender is usually not willing to lend against the imputed equity,” Prager said.
The exception to this tendency is a bridge loan where the borrower has a viable business plan to create imputed equity by improving the property.
So that’s certainly something for buyers to keep in mind, especially if they plan to refinance in the short term. To refinance based on imputed equity, a buyer has to show that the value of the property increased “for definable reasons beyond short-term market gains,” said Prager.
In general, if you plan to refinance, it’s better to wait longer than just a couple of years.
“A lender does not like to cash out based on a higher value and that additional imputed equity in a very short time period,” Prager continued. “Normally they need to see some duration of hold period, or an actual value add change that increased the value as a result of something you did, like improving the property.”
Buyers should take into account the actual, concrete improvements that increased the market value of a property.
Overall, understanding the concept of imputed equity is very important to any commercial real estate deal. A buyer should always be aware of market changes that could affect the value of their property and, when possible, take active steps to increase that value, thereby increasing one’s imputed equity.