Woohoo! Your investment property has risen in value!
But before we go out celebrating, let’s talk quickly about return on equity. Having more equity doesn’t necessarily mean that your returns are increasing.
In fact, as your property value increases, your return on equity decreases.
Wait a sec… What the heck does that mean?
Let’s run through a quick return on equity scenario on the whiteboard.
Return on Equity Example:
Let’s say in 2015 you bought a rental property for $200,000. You put 25% down ($50k). It’s in a great neighborhood, and you bought this property for cashflow. It’s paying for itself, and then some.
After all expenses are paid (mortgage, tax, insurance, other), the property yields you $5,000 at the end of year 1. This is a good return – great buy!
Equity you have: $50k
Return you’re getting: $5k
2015 Return on Equity = 10%
Not bad at all!
But Now It’s 2018…
The property has risen in value quite a bit. It’s now worth $250k! And you’ve been able to increase the rents also to keep up with rising taxes and bills etc.
This year, after all expenses paid, you project a bigger yield of $7,000! This is a much greater return than the 5k you got a couple years back. Great work!
But, although the annual return seems more, let’s compare it to the equity you’ve accrued.
Equity you have: $100k
Return you’re getting: $7k
2018 Return on Equity = 7%
As you can see, the return on equity has actually decreased from 10%, to 7%. And, it will continue to go down as the property appreciates more and more. You can see a real life example looking at the annual breakdown number in my first investment property.
Don’t Worry: Appreciation Is A GOOD Thing
So you might be wondering, “The house increased $50k in value – that’s a good thing, right?” or “7% of 100k is more than 10% of 50k!”
Definitely. Appreciation is ALL goodness. You absolutely want your properties to increase in value.
But, the increased ‘extra’ value just sits there. It doesn’t actually do anything for you. It has potential, but will never be anything more unless you tap in and put it to work.
Set and Forget = Regret.
I have some bad news for you. As you grow wealthier, you have more and more work to do. Buying an investment property is a smart move. But it’s only Step #1.
If you stop there, you’ll be missing out on additional returns. It may seem small, but this is what separates truly wealthy people from average investors.
Plain and simple: Successful investors continually evaluate their overall return on equity.
Just because your investment was good at the time of purchasing, it doesn’t mean it’s still good later on.
OK, now we can go out celebrating. Let me buy you a beer and talk to you about Step #2… Cash-out Refinancing, 1031 Tax Exchanges, HELOCs, and other boring stuff that can boost your returns.
Comments, questions? Write me below!
Cheers!
Sounds hard… good thing we don’t do real estate. Ha!
Wimp! Haha
I am interested in that conversation about step #2. Have you done a blog post about it?
I have a nice chunk of equity in an investment property but I can’t decide if I should tap into it or not. What criteria do you use (for example, expected return on new investment > HELOC rate)?
Also, I think that I want the cash flow from the current investment property to also cover the HELOC expense to be conservative until the new investment can cash flow. If so, I can only access a small chunk of the equity. Good idea or too conservative?
Thanks,
Colin
Hey Colin,
I haven’t done a HELOC yet. I called a bunch of lenders and looked into it for one of my high equity properties but ended up deciding not to go forward because of:
– Most lenders won’t give HELOCs on investment properties unless they hold the 1st lien (so i was told). Or, since I don’t reside in the property they requested a very high LTV, like 50%, so it didn’t make sense.
– The variable interest rate on HELOCS scare me a bit. I think it’s a great ‘short term’ loan option, but I would want to have a plan in place to pay it off/back within a few years.
– If using the HELOC for downpayment on a new property, technically I’d be borrowing 100% of the new property purchase. (eg. borrowing 25% from the HELOC lender, and 75% from the new mortgage lender, total borrowing = 100%). I guess this fact freaked me out a little because the new deal would have to be wicked profitable to service it all.
Refinancing didn’t make sense at the time either, because the cost to refinance vs. the chunk I could pull out wasn’t really worth it. Refinancing is kind of like buying the whole house all over again. I haven’t done a 1031 yet either because the 2 places I sold last year went into ‘other types’ of investments and didn’t qualify.
Would love to hear your numbers and thoughts on getting more out of your equity.
Joel
Thanks for the info re HELOCs. I own a townhouse, which used to be my primary. Its worth about $550k and I owe $340k. It is currently financed with a 30-year fixed at 4.25%.
It sounds like I may not be able to get a HELOC anyway if the LTV requirement is 50%. However, my thinking was to pull out some equity (at around 5%) and invest that in a multi-family syndication with a preferred return of 6-8%. If the syndication performed as expected, I would profit on the spread and still have the potential for appreciation, etc. from the multifamily. Any thoughts on that strategy?
I reckon try it. Are you an accredited investor? PM me your number and let’s chat. I can also introduce you to a few syndication sponsors I’ve gotten to know.