After owning a property for a few years, is using return on initial investment the best way to measure the performance of your rental property? No, it’s not. You’re building equity, which has an opportunity cost. Do you leave it in the current property or take some or all of it out to buy more properties? What you do or don’t do with the equity can have a big impact on your rental portfolio.
This post will cover:
- How to calculate and understand return on equity.
- The three common scenarios for determining your equity opportunity costs.
- An overview of the “Equity Optimization” Spreadsheet.
- A real-world case study for optimizing return on equity.
This post is part of the Investment Property Anaylsis Course. The course teaches you how to analyze a rental at purchase and how to review it annually to optimize your returns.
Three Learning Options:
- Listen to episode “#120: IPAC #3 – Return on Equity” on the Denver Real Estate Investing Podcast
- Watch the YouTube video at the bottom of the page.
- Read the blog post.
Return on Investment (ROI) vs Return on Equity (ROE)
Before you dive into this post, be sure to read or listen to the first part of this course at The Four Returns in Real Estate Investing: Cash Flow is NOT Everything. As discussed in that post, calculating your return on your initial investment is a great way to analyze rental properties at the time of purchase. After a few years, it becomes an inadequate way to measure your return. Calculating the ROI is nothing more than a simple fraction that takes your total return and divides it by your total initial investment.
What happens to the fraction and the math over time? The denominator, or the “Total Initial Investment” stays the same every year. If your initial investment in a rental property was $50,000 in 2015, it stays at $50,000 every year. The numerator, or the four returns from real estate, changes every year.
Fast forward to five years after you purchase an investment and calculate your ROI. At year five, you’re taking returns in today’s dollars and dividing it by an investment from five years ago. The result is not a great way to measure your return. However, return on equity (ROE) is.
Return on equity is taking the four returns of real estate (the numerator) and dividing it by your equity (the denominator):
Return on equity gives you a more accurate return, because it’s taking numbers from the current year for both the numerator and denominator. Every year, the numerator and denominator are changing.
I put together a table to show you ROE vs ROI. The Return on Equity column takes the four returns and divides it by the current equity in the property. The Return on Investment column takes the four returns and divides it by your initial total investment.
Spend a few minutes to review the table, but pay particular attention to the Return on Equity and Return on Investment columns and what happens to their percent returns every year. FYI, the table uses a real-world rental property that is a 3 bedroom, 2 bathroom condo in Aurora. I rounded the purchase up a couple thousand to $200,000 for simplicity.
What jumps out to you? The ROE goes DOWN every year while the ROI goes up! Surprising? It surprised me the first time I learned about ROE.
The embedded spreadsheet has tabs at the bottom to view different sheets. The “inputs” tab has the inputs and variables. Appreciation and rent growth are at 3%. The higher the appreciation rate, the faster the equity grows and the quicker your return goes down.
It’s common to have greater cash flow (more cash in your pocket at the end of the year) but have a lower ROE percentage. Typically, mortgage payments are fixed and stay the same which is your biggest expense. Generally, rent increases every year. You’re getting a bigger spread (profit) between rental income and expenses.
While you’re making more cash flow, your equity is growing, driving your return on equity down.
Is this bad? No, it’s just an observation. It ultimately depends on what your goals are and what phase you’re in of building your rental portfolio.
Equity Opportunity Costs
It took me a few months to really wrap my head around the idea of equity opportunity costs. In discussing this with my clients, I’ve found many of them had the same learning curve. Here’s my best attempt to explain in a blog post.
Envision a real piggy bank. It has a slot on the back to stick loose change in. You can keep putting money into it, but it’s not making you any money. Most people eventually open up the piggy bank to use the money. Now, when I was a kid I used it to buy He Man and Teenage Mutant Ninja Turtle toys. Now as an adult, I use it to buy assets.
I look at equity as “money in my real estate piggy bank.” Your piggy bank grows from market appreciation and your tenants paying down your loan. Once you have enough equity built up, you have the option to open up your piggy bank and tap into your equity. But should you?
That’s the opportunity cost! If you tap into your equity, it’ll change the performance of your current rental property. My intent is to not convince you to tap into it or not but discuss the pros and cons, so you can make the best decision for your real estate goals.
You have three options with a rental property:
- Keep it as-is and do nothing. Let the cash flow grow and the equity build!
- Do a cash-out refinance, or get a HELOC to tap into the equity. You retain ownership and can use the equity for other investments.
- Sell the property to buy other rental properties.
What’s the best? It depends on you, the property, and the market.
Case Study: Optimizing ROE
This is where the discussion gets fun. I’ll explain the three options above by sharing my thought process and numbers on a recent personal transaction.
In 2011, before I was an agent or in real estate investing, I bought my very first property. Without knowing it, I was Nomading,™ because after a couple of years I moved out and converted it to a rental. It was a 2 bedroom/2 bathroom condo in Reno, NV purchased for $67,000.
From 2011 to 2019, the rent increased by 30% from $1,000/mo to $1,300/mo, and value increased by 235% to around $225,000 from $67,000. The market gifted me with equity.
ROE Option #1: Keep It
I built a spreadsheet called “Equity Opportunity Costs” to run scenarios on properties through the three different options. Sorry, the spreadsheet is not available for download. It may be in the future, but for now, I use it for myself and with clients.
When you’re analyzing a rental property, use the current numbers, not what you bought it for years ago. Using today’s numbers is key in giving you a correct analysis. I entered the numbers as if I were buying it as a rental today.
Ignore the yellow fields as they are indicators to me for input fields. Here’s the analysis:
- It’s a 3.58% cap rate if purchased today. Fortunately, I can easily find much better cap rates in Denver.
- I’m making $1,837/year in cash flow. That has a very minimal impact on my lifestyle and savings rate.
- I’m getting a 6.92% return on equity ($13,341 / $192,700.) A 6.9% return doesn’t excite me nor is it what I need to achieve my goals. I need more.
All three of these bullet points indicate that I should do something better with the $192,700 in equity than leaving it in the property.
Now, here’s the really interesting thing: I’m getting an almost infinite return on my initial investment on this property! I purchased the property on a 15-year mortgage with 0% down, and all the closing costs were wrapped into the loan. I brought zero dollars to the closing table! It was a private loan. Back then I knew it was a good deal, but now I realize how amazing the loan was! I really wish I picked up a few more properties. Oh well…
It’s infinite return, because you can’t divide by zero. If I plug in the first months’ mortgage payment, it came out to a crazy return of around 48,000% over the last 9 years. Yes, that is a forty-eight thousand percent return.
But now I’m getting a 6.9% return on my equity. Pretty crazy!
ROE Option #2A: Max Cash-Out Refinance
Both a HELOC and a cash-out refinance will pull equity out of a property. HELOC’s are great if you’re going to pay the money back within a one to two-year time frame for flips or BRRRR properties. Cash-out refinances are the ideal choice if you’re not paying the money back quickly. The equity would be used as a down payment on another rental which is a slow payback. I explored doing a cash-out refinance.
The spreadsheet may be confusing! Read the notes below to understand it.
It’s a negative cash-flowing property when doing a max cash-out refinance at a 75% loan-to-value (LTV) loan. Yes, I can pull out $132,000, but the property is negative cash flowing $2,400 a year. It’s a bad idea and risky to pull out money and turn your rental into a negative cash-flowing property.
There is a red box labeled “Debt Coverage Ratio” (DCR). I put this calculation in there to measure the risk of how much I should refinance. DCR is a commercial lending underwriting guideline. The formula is DCR = NOI / Annual Debt Service.
The common rule of thumb for lenders is that they want $1.25 in NOI (Income after your operating expenses) for every $1 of debt service (just principal and interest). The 25 cent difference is a buffer that they are comfortable with, because the property has enough income to pay back their loan.
If you don’t understand DCR, don’t get hung up on it. Understand that it’s a quick way to measure the property performance in terms of the debt load to see if it’s “safe” to pull out equity.
ROE Option #2B: Safe Cash-Out Refinance
Since pulling out the maximum amount of cash is a bad idea, let’s pull out a safer and smaller amount of cash.
It’s a positive cash flowing property with a safe DCR! However, I’m making 1,677/yr in cash flow and will have $66,933 in cash.
However, it’s a 46% LTV loan. I wouldn’t put 50%+ down as a downpayment, so does it make sense to leave that much equity in there? Not for me since I’m currently in my accumulation phase of buying rentals. But it’s a safe option to pull out equity. Let’s compare it to option #3.
ROE Option #3: Sell to Buy Better Rentals
This is the simplest part of the spreadsheet.
I’m selling an asset and losing the returns that it generates, but I’m walking away with $174,000 to use to buy other rentals.
It’s important to note that doing a cash-out refi is NOT a taxable event. Selling your property is a taxable event. Many investors who sell utilize a 1031 exchange to defer their capital gains taxes.
Comparing the Options
The summary page from the “Equity Opportunity Costs” spreadsheet has a lot going on! The majority of it is restating what was covered above. It’s designed to give a high-level overview of returns from each scenario.
The “New Rental Assumptions Inputs” section is where to enter the rental property data. It’s not analyzing a specific property, but rather taking the current market and interest data to calculate ballpark returns.
The “Current Rental” section is pulling data from the previous tabs of the existing rental and displaying the returns from each scenario.
The “New Rental” section takes the equity pulled out from the current rental “Cash from equity” row to use it as a downpayment on purchasing a new rental using the data from “New Rental Assumption Inputs.” It then calculates the returns on the new rental property.
The “Returns on BOTH properties” section combines the cash flow and returns from the current rental and the new rental. It’ll show you what scenario maximizes cash flow and the total return.
The Winner Is…
Scenario #3 – Selling the rental, using a 1031 exchange and then buying a new rental property gave me the greatest cash flow AND the greatest overall return.
Scenario #3 will generate $16,422 a year in cash flow and about $50,000 in total returns the first year! That’s a big step up from keeping the existing rental which is returning $1,837 a year in cash flow and about $13,000 in total returns.
The Final and Real Numbers
The numbers above are the real numbers I used to model my own decision on whether to sell the condo in Reno, NV to buy a fourplex in Denver, CO for $850,000. I did put 25% down and needed to bring additional cash to closing on top of the $174,000 from the sale of the Reno, NV condo. Below are screenshots of the Return on Investment Quadrant™ estimated returns from the detailed property analysis.
Reno, NV condo vs Denver, CO fourplex
|Reno, NV Condo||Denver, CO Fourplex|
|True Cash Flow™|
(=cash flow + Depreciation)
The Reno, NV condo was generating a 6.9% return on equity. By selling the property, even with all the real estate transaction expenses, to reposition the equity as a down payment, the capital is now earning me an estimated 28% ROI. I took the equity and converted it into an initial investment on a new rental property.
Here are some key principles in mind as to why it’s generating a greater return:
- More leverage – The Reno, NV condo was at a 15.9% LTV, and the new fourplex is at a 75% LTV. Leverage gives you greater returns.
- Better rental – The Reno, NV condo is a 3.58% cap, and the Denver fourplex is a 6.0% cap. I purchased a better rental property.
By selling and utilizing a 1031x, I got the best of both worlds – – more leverage and buying a better rental property.
What’s the highest and best use of the equity in your rental properties? It depends on the property and your goals. I’m in the accumulation phase of building my rental portfolio, so my goal is to acquire as many properties as possible. Plus, I’m not a fan of out-of-state investing, so moving the money from Reno, NV to Denver, CO is a better fit for my investing goals.
If you’re nearing retirement, then keeping the property and paying it off may be the best option for you. Then you’re in the debt payoff phase, not the accumulation phase, of your real estate investing strategy.
Every year I’ll put all my rental properties into the spreadsheet to calculate my return on equity and the opportunity costs of my equity. I’d advise you to do the same. One of my current projects is to build a real estate tracker spreadsheet to better track and calculate ROE and opportunity costs. If you’re a client of mine, you’ll get a copy once it’s ready. We can sit down every year to review your portfolio and numbers.
The next module of the Investment Property Analysis Course goes through a case study of utilizing the equity in one my of client’s primary residence. Like many Denver homeowners and investors, they are sitting on lots of equity.
Webinar recording – Watch it here or listen on the podcast.
Podcast: Play in new window | Download | Embed