Depending on how long you have held your property, it might not be a good investment anymore.
There are four financial benefits of owning investment real estate.
- Cash Flow: After you pay all expenses and loan payments, cash flow is the money left over.
- Principal Reduction: The loan is paid down with money collected from tenants.
- Income Tax Savings: IRS rules allow property owner to take depreciation deductions, which shelter the cash flow and principal reduction. Any leftover depreciation creates a paper loss, which in many cases, can be used to shelter other income.
- Appreciation: Over time, the property may increase in value.
By calculating your “return on equity”, you might be surprised to learn that your rate of return is getting lower. Your original investment has nothing to do with today’s rate of return!
Example: Return on Equity Drops from 18 to 7 Percent.
Assume you bought an investment property 16 years ago for $70,000. You invested $10,000 and borrowed the rest. Your goal is to retire in another 15 years and use the investment property to provided retirement income.
So, how good was your investment 16 years ago? Let’s total your benefits. Assume the cash flow, principal reduction and tax savings added up to $1,800 that first year. You were earning 18 percent ($1,800 divided by $10,000) on your investment.
Fast-forward 16 years to the present. Let’s assume the following, your benefits from the investment property now look like this: $5,000 cash flow, plus $2,000 principal reduction, minus $1,400 tax paid. A total of $5,600. You might think you are a genius if you measure the $5,600 against your original $10,000 investment: that’s a 56 percent return. But that’s where most people go wrong!
Your investment is not the amount you originally invested years ago. You’ve got way more “tied up” today. Your investment is the amount you could get out of your property is you sold it today. That’s called your “net equity.”
Over the past 16 years, your property has increased in value and your mortgage has been paid down. The current difference between the property’s net value (after selling expenses) and your mortgage balance in $80,000. If you sold the property today, you could walk away with $80,000.
However, if you keep the property, in effect you’re reinvesting the $80,000 in the property. You’re earning $5,600 in benefits on an $80,000 investment—that’s only 7 percent!
What if you did this instead? Use your $80,000 equity as the down payment on a different property—one that produces 18% again? With that down payment you could probably afford a $400,000 investment property. Once you have owned the property for a few years, your equity will have grown again (and your rate of return fallen), so you repeat the process. The goal is to maintain the highest possible rate of return, which will make a huge difference in your future wealth.
Three Ways to Move Your Equity. Here’s a key point. If you decide it’s time to “move your equity,” be sure to explore all your options. There are three common ways to move equity:
- Sell: You should sell your current property and buy another. The problem with selling is you have to pay capital gains tax.
- Refinance: You could refinance our current property and use the loan proceeds to buy another property. The problem with refinancing is you’re probably not able to borrow the entire $80,000 equity.
- Exchange: The third, and best, way to move your equity is to exchange. Exchanging allows you to move your entire $80,000 net equity to another property without paying tax. It’s wealth building’s most powerful tool.
The wise thing to do is re-evaluate your property every year. In essence, make the decision to “re-buy” the property. As soon as the rate of return on your equity could be higher in another property, it’s time to take action.
Interested in learning what your “return on equity” is on your current property? Give me a call and I will do an analysis for you. Mike Brass 612-750-4312.
Content for the article is from Tom Lundstedt, CCIM article “Does Your Investment Property Still Measure Up?”