If you are investing in real estate with any frequency, sooner or later you will be required to put actual cash into a deal. If you are investing using other people’s money, then it is their money that is at risk, and this applies to them. If it’s your money, then your money is at risk. Either way, you need to understand how equity can evaporate, who gets paid first, and how to protect your capital.
Buying all cash
If you buy a property all cash, then the amount of equity is impacted by values going up or down, tax liabilities and utility liens, and your maintenance of the property. Tax and utility liens, if allowed to accumulate, are first in line to be paid before you, as the owner, are paid when you sell the property. If you are under insured, and have a catastrophe, then your inability to rebuild also has an effect.
Buying with a down payment and a mortgage
All the above applies, but the mortgage holder is in line before you, the equity investor. The mortgage holder also gets the insurance proceeds before you do.
Being the mortgage holder
If you are putting money into a project, either as a lender or an equity investor, you should understand the differences and who gets paid first. Generally, the 1st mortgage holder is paid before the equity partner. But taxes and municipal liens are paid before the mortgage holder. And if you are listed as mortgagee on the insurance policy, then you are paid the proceeds of any insurance claim before the equity investor.
So here is the rough order of who gets paid when. There are circumstances that affect this, and if any of you want to jump in with comments about special circumstances, please do, it will make for an interesting discussion:
- Property Taxes
- Condo fees – (thanks to Alan Segal and John Holroyd for this update)
- Utility Liens
- 1st position mortgage holder
- Mechanics and medical liens (The contractor you didn’t pay, Medicare, etc)
- Additional liens
- Equity investor
Remember, mortgages and other liens, except for taxes and utilities, are paid in the order that they are recorded in the registry. That’s what creates a 1st mortgage over a second mortgage – the 1st mortgage was recorded first. So it’s important that any liens are cleared before you take title or lend money, as you can end up paying them yourself.
If you are investing in someone else’s deal, you should understand the order of who gets paid first. Although sometimes the owner (equity stakeholder) makes big money, that’s not always the case. So understand your place in line. That’s why some investors choose to be lenders rather than equity investors. Another reason is the hands-off nature of the investment. You aren’t in the trenches with the contractor.
I am not an attorney or accountant, and this is not to be construed as legal or tax advice. This is solely for the purpose of generating discussion about real estate investing and lending. Please consult an attorney and/or accountant when making any investment.