HOW HARD IS YOUR INVESTMENT WORKING?
The question as to when to sell an investment property depends on many factors including: the likelihood of future appreciation, the cash flow it produces, the ease or difficulty of managing the property, and the property’s fit in the investors overall investment portfolio.
However, real estate investors should not overlook a simple measure to determine how hard their invested dollars are working: the property’s “Return on Equity.” By doing this, an investor can compare a particular property with other potential investments in an effort to maximize the return on their investment equity.
Example: A small four-plex was purchased several years ago on very favorable terms. It produces a nice cash flow that resulted in an extraordinary 20% return the first year. Even with the following assumptions, which would produce a high return on equity, the return falls to less than 5% after 7 years.
- 10% down payment
- 90% Loan-to-Value (LTV), 7% fixed mortgage over 30 years
- Appreciation at an average of 4% per year
- Annual net income increasing by 2% per year
|YEAR||VALUE||DEBT (7%)||EQUITY||EQUITY AS % OF VALUE||ANNUAL NET INCOME||RETURN ON EQUITY|
As evidenced in the chart above, the investor’s return on equity starts diminishing significantly after about 7 years of ownership. In order to continue obtaining a much better return on invested equity, an investor should consider exchanging this one investment property after 5-7 years and acquiring multiple replacement investment properties. Later on, they will benefit again by exchanging these investment properties and exchanging into more (or larger) properties with leverage that will continue to produce a higher return on their equity.