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!