It's fairly common for new homeowners or aspiring investors to have the knowledge or drive to invest in a real estate project but not the cash to back it. Sweat equity provides investors or entrepreneurs the opportunity to participate in a business venture or real estate investment by contributing their time, knowledge, expertise, or hard work instead of money.
Sweat equity comes in many forms and can be difficult to place a value on, especially when investing in real estate. Learn what sweat equity is and the pros and cons of using sweat equity as well as how to value it and get the most out of your efforts.
What is sweat equity?
Sweat equity is a term used to describe a person's contribution to a company, business, or investment, where the investor offers their time, knowledge, and effort rather than money. Commonly used in a business start-up when an investor is tight on funds to contribute, sweat equity allows the investor to improve or add value to the investment through hard work, earning a portion of the property's cash flow, equity compensation, or shared ownership in return.
While the investor may not make a monetary contribution to the business, they are invested in the venture's success.
In real estate, sweat equity could be:
- Homeowners doing work and improvements to the home themselves rather than buying a move-in ready home or paying for a contractor to do the work for them.
- An investor working with a passive capital partner to fund the purchase of property, where the investor manages and oversees the rehab, investment, or deal themselves.
Pros and cons of sweat equity
The biggest pro of sweat equity is that you can still purchase and invest in a property, start-up, or business without having to contribute large amounts of your own money or capital. By having a unique set of skills, expertise, or experience, you can participate as an equal partner.
The main con of using sweat equity is that your effort may not produce a profitable investment or start-up. Outlying factors, like a declining market, unforeseen additional expenses, or business partners not doing their part as agreed, can affect the outcome. It's also really easy to contribute far more effort than the profit of the property, businesses, or start-up produces in the end. Using sweat equity can pay off, but it can also be a flop.
How to value sweat equity
Valuing sweat equity can be difficult, especially in real estate, because it heavily relies on:
- What the venture is.
- Who the investor is.
- What they are contributing.
- The quality of effort they put into the business.
One of the most widely known examples of sweat equity in real estate is crowdfunding, where investors pool their money to help fund the purchase of a real estate investment in which the sponsor, a third-party investor, manages the deal themselves.
Potential investors will review the business plan; look at the sponsor's experience, knowledge, and past performance; review the local market and supply and demand for the investment type; and confirm the valuation of the asset at present and after pro forma. This helps them determine the value of the sponsor's sweat equity and the valuation of the investment or business as a whole.
If the sponsor has little experience, knowledge, or effort to contribute, their sweat equity would have less value. In return, the sponsor may have a smaller ownership percentage or less vesting in the company.
How to get the most from your sweat equity
If you're going to partake in sweat equity, make sure you are doing your part and putting forth your full effort to make the business, company, or investment as successful or profitable as possible. Monitor your partners, and try to avoid sharing too much equity with other partners.
Sweat equity can be a great way to get started when you have a limited amount of capital to invest, but use it carefully and cautiously. Weigh the pros and cons, and make sure your effort will be worth it in the long run.