Assessing Return on Equity
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 an investor’s overall investment portfolio.
A real estate investor should not overlook a simple measure to determine how hard their invested dollars are working: the property’s Return on Equity.
By analyzing return on equity, a real estate investor can compare a particular property with other potential investments in an effort to maximize the return on their investment equity.
Example: A small quad (4 units) 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 | 286,137 | 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 in this example has a return on equity that 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, the investor 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.
Dana Ash-McGinty
Principal Broker | Realtor® | “The Real Estate Maven”
