Sweat Equity In Real Estate: Benefits, Risks, How To Calculate It

Several factors can determine a property’s market value – from its location to its size, features, age, amenities and more. While you can’t change some factors, there are some you can change that can increase the value of your home. You could invest in upgrades, but there’s another way: your sweat equity – the hard work you put into your property.

Let’s look at what sweat equity is and how you can use it to increase the value of your real estate.

In real estate, sweat equity refers to the increased value of a property or the ownership interest created by an individual’s physical labor. You’ve likely heard this term used to describe a startup or a renovated house. However, real estate investors can leverage sweat equity when investing in a business venture without much cash.

How Sweat Equity Works

Rather than pay someone else to handle renovations or upgrades, you do the work yourself. The hard work and sweat you put into the home improvement project can increase the value of your home or an investment property you want to sell.

While sweat equity can save money on home improvement projects, investors and homeowners may need additional funding to complete their projects before they can enjoy the bump in property value. Investors can seek financial assistance from other investors or apply for a business loan. Homeowners can leverage their home equity and consider financing home improvements with a cash-out refinance.

If you’re a first-time investor, you may be able to use a cash-out refinance to buy your first investment property or fund renovations. Unlike a home equity loan that requires you to cover a second mortgage payment, with a cash-out refinance, you only pay one loan.

If you buy an investment property to fix it up and rent it or eventually flip it, the DIY work you put into the property is your sweat equity. When you sell the property, the difference between the final sale price and what the price would have been without your improvements represents the value of your sweat equity as determined by the market.

Example Of Sweat Equity

Here’s a straightforward example of sweat equity: Let’s say you bought a $150,000 property with an outdated kitchen and bathroom and decided to renovate the bathroom, kitchen and the rest of the home.

After all your hard work, the home’s valuation climbs to $200,000 – but that doesn’t mean you added $50,000 in sweat equity. You’ll also need to account for the cost of furnishings, materials and professionals you hired to help with the remodeling. If you spent $20,000 on cabinets, countertops, appliances, tile, paint and a plumber, your actual sweat equity would be $30,000.

Investing your time and energy through sweat equity can deliver a rewarding payoff when you sell a property, but that may not always be the case. You may lose money for various reasons and spend even more money hiring professionals to finish the job.

Here are some benefits of sweat equity:

Benefits Of Sweat Equity

The benefits of sweat equity can include:

• A large profit: When you do the work instead of hiring someone, you can save money on labor, grow a home’s value and likely get a higher return on investment.

• Property personalization: Homeowners, especially owners of fixer-upper properties, have total control over the customizations and improvements on their property.

• Skip finding a professional: Finding a professional contractor can be difficult. And if you hire a bad contractor, you may not get satisfactory results for your money. When you do the work yourself, you know the quality of the work.

• Reduce taxes: If you’ve completed significant home improvements, you may be able to deduct certain expenses and lower your taxes. When you sell the property, you may be able to exclude any profits you can assign to your sweat equity.

Drawbacks Of Sweat Equity

Some drawbacks of sweat equity can include:

• Project time commitment: You may underestimate how long it will take to complete a home improvement project. If you’re strapped for time, renovations may stay unfinished for months.

• Costly mistakes: Making mistakes, especially on complex tasks like updating electrical wiring, will mean hiring a licensed professional to correct your work. You may pay more to fix the problem than you would have if you hired an expert in the first place.

• Decrease in home value: If you don’t have the experience and the result of your work is subpar, that can decrease your home value.

Some programs allow sweat equity as a down payment on a home. Buyers with smaller savings or who may not qualify for traditional loans can contribute their labor to transform a property into a valuable asset and eventually own it.

• Federal Housing Administration (FHA) 203(k) loan program: This program allows home buyers to fold the cost of renovations into their mortgage, using sweat equity as part of the down payment. If your credit score is at least 580, you’ll make a remaining 3.5% down payment.

• Freddie Mac Home Possible: This program allows buyers to apply sweat equity to the entire down payment and closing costs. You’ll need to keep receipts for everything, and an appraiser must inspect all repairs or improvements.

• Habitat for Humanity: Habitat for Humanity is a nonprofit organization that allows prospective homeowners to partner with volunteers and contribute their sweat equity to building their homes and homes for their neighbors.

Sweat equity can provide great value in real estate. You can become an integral part of a real estate business with little to no capital if you have skills in an area such as DIY construction work, landscaping, plumbing, electrical or any other area.

If you have the skills, time and interest in becoming a real estate expert, try partnering with angel investors, individuals who have capital to invest. Find partners who value sweat equity as much as cash equity and would welcome your skills in fixing the properties they purchase.

If you want to start investing in real estate by leveraging your sweat equity, the following steps can help you get started.

Step 1: Find Additional Investors

The first step is to identify your skills and prepare a short presentation that showcases how you can use your skills to improve a property. Identify potential investors, such as family members or friends with the capital to buy a property.

Make sure your investor(s) understands the risks of real estate investing and has enough money to invest in the purchase without risking their financial future. Discuss the value this combination would offer – them investing the money and you applying your DIY skills to improve the property.

Step 2: Create A Sweat Equity Agreement

To keep both parties on the same page, formalize any arrangement with a written agreement that specifies and defines the value of your nonmonetary contribution. Consider structuring your value as a percentage of the proceeds after flipping the property or a share of the monthly income if you turn the house into a rental.

Step 3: Calculate Your Possible Business Costs

Account for any hard costs you may incur during renovations. For example, let’s say you buy new appliances or purchase materials for a fancy outdoor oasis and you install them yourself. Your time and sweat equity should be compensated through the terms of the agreement, including reimbursing you for any upfront costs.

Step 4: Secure Financing

Although your business partners have agreed to contribute cash to the project, you may still need to apply for financing. This step may include getting a mortgage or using the proceeds from a cash-out refinance on another property to fund the purchase. Either way, discuss your options with all parties to ensure everyone agrees.

Once everyone agrees on financing, you can fill out a loan or refinance application and submit it to your lender. This part of the process may take a few weeks, so take this step as soon as possible to help avoid delays.

Step 5: Purchase The Property

Once you’ve received initial approval from your lender, it’s time to find a property. Look for one with the biggest upside potential – and that might require some creativity, including scanning real estate listings, attending auctions and keeping an ear out for potential new listings. Look for properties that are a good bargain “as is.” Many potential buyers may shy away from these properties because they don’t want to invest time and money into their repairs.

As you research properties, account for your specific skills and how you can use them to improve the real estate. For example, if a home is priced at rock bottom because it needs a new roof and foundation, but your talent is creating luxury kitchens and bathrooms, hiring someone to handle the roof and foundation because you can’t do it will likely take a huge bite out of your return on investment.

You can expand your skills by taking courses that broaden your expertise, especially if you’re noticing recurring issues in the properties you’re interested in that may add up to even higher profits if you fix them yourself. For instance, if you believe learning about wiring smart-home systems will boost your returns, that would be an area to focus on.

Step 6: Plan Out And Complete The Renovations

Once you’ve found a property to renovate that aligns with your particular skills, plan how to handle expenses with your business partners. You and your partners can draw up and complete the paperwork for closing and create a renovation project timeline.

Be realistic about your time commitment and how long some projects will take. Get everyone’s buy-in on how the upgrades you make through your sweat equity will proceed and at what pace.

Your partners may not understand how much time and labor you’ll need to invest in a specific task, so spell out the amount of work you’ll be doing. Remind them of the time and effort you’re investing and the value of teaming up with a sweat equity partner.

Sweat equity also applies to your efforts to create a real estate-related business. Like any motivated entrepreneur, once you’ve acquired several investment properties, you may want to scale your business and hire employees to keep growing your real estate portfolio. The labor you put into expanding your business is also sweat equity.

Generally, start-up business owners don’t have enough cash to offer large employee salaries. Employees often trade a lower salary for a future stake in the business they built and contributed to with their sweat equity.

Small-business owners can formalize these agreements with a business plan that details the terms – such as employee ownership agreements, sweat equity shares or other compensation payout models. If and when the business sells or goes public, employees can share in the proceeds as outlined in the agreement. If the business succeeds, their time, ideas, hard work and loyalty could pay off at a premium.

Now more than ever, a sweat equity partner is an increasingly valuable resource for any start-up real estate business. Many potential buyers avoid homes that need a lot of work. However, motivated entrepreneurs know that, with some sweat equity or by teaming up with a sweat equity partner, they can take a property from eyesore to enviable – to resell at a premium or turn it into a profit-generating rental.

Want to start making money by investing in properties you can improve through sweat equity? Apply online today to tap into home equity with a cash-out refinance and fund projects that boost value.