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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
1  $300,000  $270,000  $30,000 10.0% $6,000 20.0%
2 312,000 267,020 44,980 14.4% 6,120 13.6%
3 324,480 264,062 60,418 18.6% 6,242 10.3%
4 337,459 260,890 76,569 22.6% 6,367 8.3%
5 350,957 257,489 93,468 26.6% 6,494 6.9%
6 364,995 253,842 111,153 30.4% 6,624 5.9%
7 379,595 249,931 129,664 34.1% 6,756 5.2%
8 394,779 245,737 149,042 37.7% 6,891 4.6%
9 410,570 241,241 169,329 41.2% 7,028 4.1%
10 426,993 236,419 190,574 44.6% 7,168 3.7%
11 444,073 231,249 212,824 47.9% 7,311 3.4%
12 461,836 225,705 236,131 51.1% 7,457 3.1%
13 480,309 219,760 260,549 54.2% 7,606 2.9%
14 499,522 213,385 289,137 57.2% 7,758 2.7%
15 519,502 206,550 312,952 60.2% 7,913 2.5%
16 540,282 192,220 348,062 64.4% 8,071 2.3%
17 561,894 191,361 370,533 65.9% 8,232 2.2%
18 584,370 182,934 401,436 68.6% 8,396 2.0%
19 607,744 173,897 433,847 71.3% 8,563 1.9%
20 632,054 164,207 467,847 74.0% 8,734 1.8%

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.

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