On Calculating Net Equity
Tips For Family Law Attorneys – How To Calculate Net Equity In Property
Part One- The Problem
Here is something I see quite frequently in divorce settlements. (I copied this example from a recent settlement).
Marital Residence
Current Fair Market Value 136,500.00
Current Balance as of 102,965.00
Net Equity 33,535.00
Do you see any problems with this calculation?
In the quest for equitable settlements, most often divorce settlements rely upon an Excel spreadsheet to calculate “equity” in an asset. When it comes to residential properties, the calculation breaks down in several ways.
First of all, “equity” is not the same as cash. If two parties are splitting a checking account balance of $10,000 as of a date certain and the split is 50/50, it’s easy. There are no transactional costs (to speak of). The spreadsheet is accurate. $5,000 to John and $5,000 to Mary.
Stocks, bonds, and other liquid investment assets are the same. There are no significant transactional costs; thus, a calculator or spreadsheet works just fine.
Even retirement accounts are subject to simple math when dividing an account. The QDRO mechanizes an agreed split and only if the recipient chooses are the taxes deducted (if converting to cash). It’s a matter of their choice about the time-value of money. So, by sending 50% of a $100,000 retirement account to a new IRA or 401(k), any diminution of funds is up to the recipient and is not a requirement of the division of assets.
But, “net equity” in a residential property is entirely different; mainly, because it’s not liquid (cash or easily redeemable investments). You cannot eat it, drive it, spend it, sleep on it or use it to buy a ticket to see the Cowboys . . . as they eat, drive, sleep or watch the Super Bowl.
Secondly, in order to convert “equity” to cash, the property (which allegedly possesses this “equity”) must be sold or financed.
Thirdly, that “equity” can disappear without its owner mismanaging it. Stocks, investments, checking and savings accounts can, in theory, be managed so that they grow in value or are protected from losses. But, if the housing market is slow or takes a down-turn as we experienced in 2008 through 2013, that equity can disappear with a “poof.”
Again, it’s clear that stocks and other investments can lose their value in their own markets as well. But, they can be protected from loss by good management.
Now, a home owner can mismanage the collateral (the actual house) for the asset – let’s say, by not caring for it and maintaining it – and thereby reduce the “net equity” since the value of the asset would decrease compared to what it otherwise would have been. But, for the most part, the home’s value is the function of a market outside the control or management of the home owner.
Fourthly, to reiterate a point made earlier, “net equity” is not as liquidas other assets. One can write a check on a checking account and easily transfer funds. One can call their investment broker and sell or buy. It may take a few hours but it can be done fairly easily. Retirement accounts are governed by rules but most can be liquidated or borrowed from in about one week at the most. Homes, where this elusive “net equity” dwells, are not so easily transacted. Moreover, until a house is sold or financed it is by no means clear even ifthis “net equity” can be converted to cash.
HELOC?
But wait a minute – what about HELOCs, Home Equity Lines of Credit? Isn’t that like immediately accessing or mobilizing a home’s “equity?” Well . . . kinda, sorta but not exactly. In the example above, a lender in Texas could only issue a line of credit of $6,235 less the closing (transactional) costs. This would be the legal maximum because of the 80% rule.
Thus…
$136,500 X 80% = $109,200 is the maximum amount of loans that can be outstanding against that house; less the balance of 102,965. That leaves you a HELOC of $6235 less transactional costs. Other states are not much better. They do not restrict Fannie Mae’s or Freddie Mac’s maximum LTV limit of 85% (another 5% of the home’s value or $6,825). So, in 49 other states, the borrower could get a HELOC of $13,060. That’s a far cry from the published “net equity” of $33,535.
Owelty Financing
The better way to access a home’s equity in a divorce is the financing of a buyout via the Owelty Agreement and Lien. This allows for up to 95% LTV financing. So, let’s look at how much of that “net equity” can actually be accessed or converted to cash for a settlement.
Appraised Value $136,500
Max. Loan Amount (95%) 129,675
Balance on loan 102,965
Finance Costs 5,000
Remaining $21,710
That is, the maximum Owelty Lien that can fit in these numbers is about $20,000.
Sale of the property
Without refinancing, this leaves us with having to sell the property in order to convert this intangible “net equity” to usable money. Let’s stick with the example above. Here is what happens when a sale takes place:
Sales price $136,500
Balance on loan $102,965
Seller’s Title Policy $ 1,070
Seller’s Other Costs $ 1,000
Realtor’s Commission 6% $ 8,190
Net Proceeds to Seller $ 23,275 (less prorated taxes)
Recap
The most optimistic estimate of equity that a homeowner can convert to cash is $23,275 in the case of a sale and possibly as little as $6,235 using a HELOC. The point is that these figures are not even close to the alleged “net equity” of $33,535. The real, accessible equity is anywhere from 18% of that figure to 70% at the very most.
So, how should a divorce settlement calculate the “net equity?”
Sell it
If the house is to be sold, no one needs to calculate the equity. Think only in terms of “net proceeds” not “net equity.” The only thing that matters is the check that is cut to the sellers at the end of the transaction after all costs have been paid.
If a house is to be refinanced in order to determine a buyout amount, I advise that the parties enter the negotiations with a rational view of market realities. Begin with the assumption that equity – by itself - has no real value. Then proceed with an appraisal that is ordered as part of a refinance process. (That’s the only appraisal that matters). Make sure a competent *Divorce-Lending Specialistis taking the loan application and processing it to completion. Then, produce a simple formula that takes into account transactional costs (aka “finance” or “closing” costs). Bear in mind that finance costs can vary quite a bit. There is no true standard of costs but there are averages. Your specialist should be able to help you with that.
Appraised Value
Before I suggest a couple of formulas to help you calculate net equity, we need to discuss Appraisals and Appraised Value (AV). The AV is the first number in the calculation and it is the hinge number upon which all others swing. (A thorough discussion of this is very important and available through my CLE-Accredited presentation “Appraisals and Property Valuation Issues in Divorce.”)
This AV number is really an opinion. In fact, that which is commonly called, simply, an appraisal is really “an appraiser’s opinion of value.” Here’s exactly what the standard appraisal form says:
“Based on a complete visual inspection of the interior and exterior areas of the subject property, defined scope of work, statement of assumptions and limiting conditions, and appraiser’s certification, my (our) opinion of the market value, as defined, of the real property that is the subject of this report is $______.”[emphasis mine]
Here is another statement of value taken from an appraisal that was ordered privately (not through a lender) by divorcing parties:
"Based on the degree of inspection of the subject property, as indicated below, defined Scope of Work, Statement of Assumptions and Limiting Conditions, and Appraiser’s Certifications, my (our) Opinion of the Market Value (or other specified value type), as defined herein, of the real property that is the subject of this report is: $_____, as of: [date], which is the effective date of this appraisal. If indicated above, this Opinion of Value is subject to Hypothetical Conditions and/or Extraordinary Assumptions included in this report. See attached addenda." [emphasis mine]
Grant it, the AV is the opinion of a trained and licensed professional arrived at after prescribed research and a stubborn thing called “math;” but, it is also a function of his/her considered opinion. And, this opinion could be “subject to” Hypothetical Conditions and/or Extraordinary Assumptions.”
The appraiser’s statement (above) gives clarification to the phrase C.Y.A. (Cover Your Assumptions). But, think for a moment about the advisability of using this appraisal as any sort of operative number in divorce settlements
- The report is NOT to a lender. This means that the appraiser knows it will not be underwritten by another real-estate or finance professional.
- How many people know how to read an appraisal and interpret the data?
- The STATEMENT OF ASSUMPTIONS & LIMITING CONDITIONS says that “The appraiser will not give testimony or appear in court because he or she made an appraisal of the property in question, unless specific arrangements to do so have been made beforehand.” This means that value cannot be defended in court.
- Most importantly, if financing is required, another entirely new and different appraisal will have to be ordered by the lender with absolutely NO reference to this current appraisal.
Now, on to the calculations…
Two formulas should be considered and no speculation for future value should be taken into consideration.
Formula 1
Appraised Valueless Current Loan Balance less Finance Costs = Equity
Example:
$100,000 Value less $50,000 Loan Balance less $5,000 Finance Costs = $45,000 Equity
Formula 2
95% of Appraised Value less Current Loan Balance less Finance Costs= Maximum Accessible Equity
Example:
$100,000 X 95% = $95,000 less $50,000 Loan Balance less $5,000 Finance Costs = $40,000
The logic of using 95% of the appraised value is that no homeowner is ever likely to touch the top 5% of their home’s value in almost any case – through refinance or through sale.
What’s the take-away?
The point is this: If “net equity” is entered in the same column as other assets like cash and stocks and retirement funds, the calculation should at least be rational and take into account transactional costs if not also the idea of inaccessible equity (that top 5% or so of a home’s value that can never be accessed).
If a buyout is contemplated, the task is to agree on a buyout amount. Of course, so long as the buyout must be financed, more elements must be considered than just the formula. There are limitations to financing that are affected by a borrower’s credit score and debt-to-income ratios. Again, a competent Divorce-Lending Specialist should be looking at this transaction and consulting the borrower and his/her attorney.
*Divorce-Lending Specialist. Currently, there is no certification for this specialty. When I began in 2002, there was no training or information available. No trails had been blazed. To date, it appears that there is a dearth of such mortgage professionals. No problem. Call me. Noel Cookman 817-454-4555.
