A Review of Equity Milling

I have never been to a seminar on Equity Milling and I have no other information on this besides what I have found on the internet regarding this process. I expect that some will accuse me of not understanding it correctly, and if I did, then my opinions would change. I think that's probably not the case, since only if I misunderstand the fundamentals, rather than just the details, of Equity Milling would I change my opinion. Just knowing to a greater detail how these things are done will not change the fundamentally what is being done. There is not much public information on what Equity Milling is, and apparently to learn more would require me to attend a seminar. I don't know if they are still doing seminars, and but even if they are, I probably wouldn't pay to go anyway. So I give my opinion based on my understanding, which I think is sufficient for an analysis. To be fair, I have tried to separate what Equity Milling is said to be, and what people are doing in practice.

What Is Equity Milling?
Rick Koerber has labeled (and trademarked, apparently) "Equity Milling" which is a method to make money from investment real estate.

There are two basic ways to make money in this approach:

1. Positive cashflow from renting or leasing the property
2. Selling the property for more than you bought it

These are the two ways anyone makes money from real estate: from rental income or capital gains. So how is Equity Milling different? The major difference appears to be that there is a particular program set up to help an investor maximize the gains from a piece of property. The term "milling" apparently comes from the idea that you are trying to maximize the amount of equity you can get, or mill, out of the property. Equity Milling need not be restricted to real estate, either. Any other asset could potentially be Equity Milled. The program of Equity Milling involves the following:

1. Someone to scout out properties to buy
2. Someone to buy the property, preferably for a price below market value
3. Someone (or company) to provide funds for the purchase
   
4. A property management company to manage the property (do maintenance, find renters)
5. Someone who wants to buy the property that is already being maintained with renters in it (with cashflow already in place)

Below is a diagram that Rick Koerber provided as a high level overview of Equity Milling.

(click on the image for a larger version)

A discussion of this by Rick Koerber can be found at http://www.websitetoolbox.com/tool/post/sdcia/show_single_post?pid=18521726&postcount=28

At this level, this is not a bad idea. You would basically be finding properties that you could turn into rentals and sell the property, with renters already in it, to another investor. You would be providing a legitimate service by setting up a rental for an investor that doesn't want to go through the hassle of converting a property to a rental and getting renters in. The investor (person looking to buy from you) would be able to see if the property could actually bring renters in and have the rental income cover the cost of owning and maintaining the property. You (the one converting the property to a rental) would actually be taking some risk because you don't know for sure if converting the property to a rental will work out and produce positive cashflow. So once it already is cashflowing, that's valuable to an investor. At this level, you could probably describe Equity Milling as a business that converts properties into rentals and sells them to investors for a profit.

Criteria for Property to be Profitable
Regardless of what method someone uses to invest in real estate, certain criteria must be met in order for the property to be profitable:

1. The monthly cost of owning and maintaining the property must be less than the rental income. If your have a property that costs you $1000 a month for the mortgage and costs you $200 a month to pay the maintenance company to take care of it all, then you have to be able to rent the property for more than $1200 a month. Seems obvious, but it's crucial that this criteria is met, or else you won't make any money from renting or leasing it. The cost of maintenance probably can't change and rent levels are pretty hard to change because that's determined by the market, so the only thing that you might be able to change for a given property is the monthly payment on the loan (more on this later).
2. You must be able to sell the property for more than you bought it. It's not enough to buy a property, put renters in it, and have positive cashflow if you can't sell the property for more than you bought it for, otherwise you would take a loss. It would do you no good to buy a property and make it cashflow only to sell it at a loss. You'd be better off not selling, and just keeping the monthly cashflow. If you have positive cashflow on the property, then another investor should be able to have positive cashflow from it also, given the same monthly mortgage cost and maintenance cost. However, if that investor won't buy it from you for more than you originally bought it, the cashflow doesn't matter to anyone else but you. You might as well just keep the property. There is a caveat: if you have gotten so much cashflow to more than make up for the capital loss in the sale, you could, in theory, sell the property at a loss, yet net a gain because the cashflow had more than made up for the loss.
3. The property must be able to pay for itself. If the rental property were to require extra outside funds to make the monthly cashflow positive, then it's not a good investment. If, for example, you had Property A cashflowing $500 but $300 of that went every month to pay for Property B, which was then cashflowing $100 with the help from Property A, then get rid of Property B. It really doesn't have positive cashflow. It's leaching off of Property A.
   

Forcing a Property to "Fit" the Criteria is the Beginning of Problems
Perhaps the criteria above look obvious, but I think it's major way people can get themselves into trouble by trying to justify a property being a good investment for them when it really isn't. If the criteria above are not met in an investment opportunity for a piece of real estate, then you won't make money on it, and tinkering with numbers (like assets values or credit) can get people into lots of trouble. And the criteria above only are criteria for making a profit; there may be other issues with the level of risk involved to you that you should be concerned with, like if the loan uses your own credit or a business's (or someone else's credit), if the loan uses another one of your assets as collateral (like your house or other investment property), etc.

You Can't Make Money from Borrowing Against Real Estate
You can either make money from selling real estate for more than you bought it, or from renting it for more than it costs you to own it. If you are not doing one or both of those, then you are probably either consuming it or borrowing money and using the property as collateral. Some people may argue that you can borrow money against a piece of property and invest that money, but you are still just taking out a loan and putting the property up for collateral. You are not making money from the property, in this case, but are just able to take on more debt and using the property as collateral. Like if you took out a loan and used your stock portfolio as collateral. You are not making money from the stocks; you are just using them to be able to borrow.

A person could continue this pattern of obtaining a piece of property, borrowing against this property to obtain other pieces of property, then borrowing against those to obtain more, ad infinitum. This may be a way to obtain property, but it doesn't necessarily mean you are making money from the property. Only if those properties match the criteria above would you be making money. They must be bringing in rental income that exceeds the cost to you to own and maintain the property, or you must be selling the property for more than what you bought it for. Otherwise, you are just taking on more and more debt, creating a web of properties that you can only hold onto for as long as you can keep borrowing against one to obtain another (or borrow to pay for the ones you already have). You also aren't producing anything, just taking out loans. No matter how complicated, or large, or "diversified" the plan, no matter how long it goes on, no matter how many people are involved, if the plan can be boiled down to just borrowing against one property to obtain (or maintain) another, no one is making money from the property unless the above criteria for profitability are met.

Tinkering with the Mortgage to Make the Property "Fit"
Stll, there are people who will find a property that they want to "invest" in, so they will do everything they can to make the property fit the criteria. One way is to try to lower the monthly cost of the mortgage. For example, lets say you found a property that could bring in $800 a month in rental income, but the monthly maintenance cost was $100 and the cost of paying a mortgage on it would be $1000. You would be spending $1100 a month on it and only bringing in $800. That's a $300 deficit and negative cashflow (you would have to pay $300 a month). This should be "no deal" and you'd be better off not getting the property (ignoring resale for now). But what if you could cut the monthly mortgage cost in half to $500? Then the monthly cost would be $500 (mortgage) + $100 (maintenance) = $600. That's $200 less than the rental income so you'd be cashflowing $200 a month.

But how could you drop that monthly mortgage that much? This is a problem area, one that could really burn people. One way is to get an adjustable rate loan, where the monthly mortgage would be low for awhile, but then go up after some period of time. This would make the numbers work out to get the property in this example, but only for so long, then you have to sell. Hopefully you will be able to sell the property for more than you bought it for. If this sound just like the problem with adjustable-rate mortgage that people have when they got into a home they really couldn't afford - it is the same, except this is dealing with investment property, not a person's primary residence. Your only other hope besides selling when the rate goes up is that rental income would go up by as much. But that's just hoping.

There are several variations that could be done to lowering the monthly mortgage cost besides getting an adjustable rate mortgage. I won't try to list them all, and new ones are devised all the time. But the point remains that a temporary or artificial reduction in the monthly mortgage cost will only work while the temporary reduction is in place, and you must get out of the property before the reduction goes away. It's better to find a property that you can cashflow as a rental using a 30-year fixed mortgage (or similar) rather than one you can't cashflow unless you get some weird "creative" financing with strange changes that kick in after 12 months or whatever.

Decrease the mortgage costs using a big down payment
Another way to reduce the monthly mortgage cost is to simply borrow less, and this could be done be putting down a large down payment. Suppose that I could have positive cashflow on a property as long as I only paid $700 a month on the mortgage, but taking a mortgage on the property would cost me $800. But suppose if I could make a down payment of $20,000, and the monthly mortgage cost would drop to $600 ($100 below the line where I'd make positive cashflow). Should I do it? Should I put the $20K down just to reduce the monthly mortgage cost and so I could have positive cashflow? Probably not. You'd have to see what else you could do with that $20K as an investment and how what rate of return you'd get elsewhere. It would depend on the particular numbers, but you probably should not use a large down payment in order for you to have positive cashflow. If the property can't cashflow without a large down payment, then it's probably not a good investment.

However, there is risk in not putting anything down or getting a 100% or greater mortgage on the property, because in order for the property to be a good investment and be sold for a profit (to be Equity Milled) you have to sell it for more than you bought it for, or more correctly, more than you owe on the mortgage (plus your down payment and anything you spent on improvements, etc). For example,

• if you bought the property for $100K and took out a $100K mortgage on the property (100% loan) then you must sell it for more than $100K, otherwise it will be a loss to you.
  
• If you bought the property for $100K and got an $80K loan with $20K down (80% loan), you still must sell the property for more than $100K, otherwise it will be a loss.
  
• If you bought the property for $100K and got a $125K mortgage (125% loan) you must sell the property for $125K! Otherwise, the property will be a loss to you. That's one problem with taking out a mortgage for more than the purchase price (which should be at the market value): you then must sell the property for more than the loan amount, not the just the original purchase amount. You have basically committed to being able to sell the property for 25% more than what you bought it for, or else it will be a loss to you. I suppose that you could take the $25K from the 125% loan and just hold on to it, but then you'd just have to give it back when you sell (to pay off the 125% loan). Or you could "invest" it, but you'd still have to sell the property for $125K, or come up with the extra $25K when you sell (either by paying cash or liquidating assets). But this "chaining" of assets and liabilities (using the money borrowed against one asset to acquire another asset) can significantly add risk and can cause all your assets to depend on each other. If something happened to one, then all of your assets could be affected (this is actually a special circumstance of the third criteria above, that each investment property needs to be able to pay for itself).

If you get a 100% or greater loan on the property, you must be able to sell it for more than you bought it for. This assumes capital appreciation, that prices will keep going up. If you sell for less than what you owe on the loan, then you have to come up with the cash that makes up the difference between what you owe and what you are selling it for.

The More Middlemen There Are, the Less Profit You Can Capture on the Sale
Refer again to the diagram above. Look at all the people and companies between the Seller and the End Buyer. If you were to engage all those people and companies in a property that you are going to Equity Mill, everyone of those people and companies are going to get a piece of the proceeds. This effectively increases your costs in obtaining and owning the property (because you will have to factor in everyone's fees and commissions before the sale to the End Buyer). This makes finding properties that match your criteria as a good investment harder, because the costs to you will be greater over the course of the transaction.

But there is another side-effect to having all those middlemen: they get paid to do their service, which may or may not match your goals in finding a good investment property. The acquisition guy is going to acquire, the financial institution is going to lend, etc. Whether you make money from you investment is not their concern. They will do their service and take their fee (unless they are "in on the deal" with you, but that gets really sticky. More on that in another post). So you as a person looking to find properties to convert to rentals and sell may experience pressure from these middlemen who just want to do their service and get paid. This is actually a problem in other financial circles. The vast number of mortgage companies that originate a mortgage do not hold onto it. They sell the new mortgage as an investment to some other company. So there are companies who are in the business of making mortgages, not keeping them. This causes them to make more mortgages then they probably should, since they will just hand it off to someone else. The same may be said of other people or companies that offer services for investment properties.

Real Estate Compared to a Gold Mill
Rick Koerber explained that he came up with the idea of Equity Milling when he was involved with a group of people trying to get a gold mill. He drew some parallels between the gold mill and real estate. You don't try to put money into a gold mill, but rather get it out. He concluded that the same could be said for real estate: "Don't put gold in the mountain, get the gold out." He also concluded that you can't always see all the gold in a mountain, so the same could be true of real estate. So the "Equity Mill" process for getting all the money or value out of real estate is akin to getting all the gold, including what you can't see, from a mountain, he reasons.

I think there are two major problems with comparing real estate to a gold mill:

1. Since you can't see the gold in the mountain, you are speculating on how much there is, and how much you can get out. They were called "gold speculators" for a reason. If no one knows how much gold there really is, then it's a gamble of whether you are going to "strike gold" or not. With real estate, the value shouldn't be "unseen" or "unknown" unless there is some short-term market distortion going on, like a "highly-motivated" seller who needs money quickly. There may be people with different estimations of the worth of the property after it is changed or improved some way, but I think that's due more to different estimations of how much work and cost it would take for the improvement and how much the market values the improvement, not if there's some unseen, hidden value no one has discovered yet.
2. Drawing the value out of real estate produces nothing. I suppose that if you were to get gold out of a mountain, then you are actually producing a commodity that people value. But what are you producing by maximizing the equity that you can draw out of a piece of real estate? It seems to me that you are not actually producing a good or service that people value or that didn't exist before, but rather you are just more cleverly drawing value from as many places as possible, to the greatest extend possible. You could argue that this isn't to produce anything but rather obtain funds to then go produce something somewhere. But that would be exactly my point.
   

A mortgage on a mountain that may have gold will probably be for the amount that the bank thinks it can sell the mountain in the market if you were to fail to make your payments. If you get a mortgage on a mountain, then you believe that it contains more gold than everyone else thinks (or everyone thinks they have found better mountains with more gold). The expected value is factored into the market price of the mountain, that is, what everyone else thinks the mountain is worth, assuming free market conditions. Someone will be right about their mountain, and some will be wrong, but the expected value should take that into consideration.

For real estate, there shouldn't be the same type of unknown value. What is it that is unseen in real estate? Everything must be disclosed in a real estate purchase contract. This is why banks want an appraisal on the property before the loan. It is the best estimation of market value. If the appraisal comes in lower than the contact price, then the bank is nervous that they would be lending more money than they will probably be able to get if they have to sell the property in foreclosure. If the appraisal is much above the contract price, the bank is nervous that there is some undisclosed or unknown problem with the property which would otherwise bring down the market price. The bank wants the appraisal to come in right at the contract price to indicate that the bank is lending money that reflects how much the market values the property, so that if they have to foreclose and sell the property in the market, the bank can get their money back.

The only unknown in regards to value in real estate in a free market is potential future value if you change it or work on it somehow. But the same could be said for the mountain: the value may be different based on the value of gold itself, or the changing costs in getting the gold out. But those are all uncertainties about the the cost of producing the gold and the value of the gold, not whether there is any gold. Real estate is no different: the thing that is unseen is the cost of changing the real estate or the value of the real estate after the change. But there should be no "unseen" value in free market conditions. At best it would just be a temporary price distortion (which would be buying property at a discount, which is great if you can find them, but you are basically saying that the seller has the wrong price or the market is slow to notice, but it's more likely that the market is right).

Nothing Wrong with Equity Milling at a High Level
Although I disagree with the metaphor of "milling equity" from property, there's nothing wrong I see with Equity Milling in theory at a high level in order to make a profit. It appears to include the two ways to make money from real estate: from rental income, or from selling it for more than you bought it. The challenge is that you still have to find properties that will be profitable to you, not just be able to be borrowed against. There seem to be a lot of middlemen involved in the process which I would think would make it harder to actually make a profit, but it still could be done. The Equity Milling process itself does not seem state that only properties that will be profitable should be used in the process, and I'll assume that more detailed information on what properties should be used would be include in other discussions. However, there sure seems to be a lot of people that have gotten themselves into trouble with all this. This would indicate that the criteria for profitability were ignored or down-played or perhaps misunderstood. We'll look at that phenomenon next.