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Own a Rental Property? Be Sure to Track this One Metric

Summary: We covered the metrics to track (1% rule, cash-on-cash return) when evaluating potential investment properties in a prior post. But what metric should you track once you own a rental property? Many investors get caught up looking only at cashflow. If a property is bringing in amazing cashflow, it’s all that matters, right? Read on to find out!

 

I recently had a conversation with an investor about a condo that she owns and is using as a rental.

The rental is generating great cashflow, about $15,000 per year, and based on her initial investment of $100,000 she’s making a cash-on-cash (COC) return of 15%.

Sounds great right?

Not necessarily.

It turns out this condo is in a hot area of Seattle (near Amazon’s main campus) and has appreciated significantly over the last several years. She estimates that she has over $300,000 in equity in the property, mostly from appreciation.

So while the absolute cashflow is good, relative to the $300,000 of equity she has in the property, the cashflow is actually quite low.

As the story above illustrates, it’s important to look beyond COC return and see how your cashflow compares to the equity in your property to get a true idea of your property’s performance.

For this purpose, we would recommend tracking a different metric called return on equity.

 

What is return on equity?

Return on equity is defined as the amount of money your property generates (return) relative to the value you have tied up in the property (equity).

It tells you how hard your equity is working for you.

As the above example illustrates, if you only looked at cashflow, you would miss the fact that the $300,000 of equity you have tied up in the property isn’t working very hard for you.

 

How do I get my equity working harder?

In order to get the equity working harder, you have to free up the money that’s tied up in the property and reinvest it. There are two main ways to free up the equity in your property.

You can either 1031 exchange the property for a more expensive investment property or pull out money using a line of credit or cash-out refinance.

To illustrate this, let’s say you sell the above property and use the entire $300,000 in equity as a down payment for a $1.2 million property.

Assuming you receive 10% cash-on-cash from your new property, your cashflow is now $30,000 ($300,000 x 10%).

By releasing the equity and getting it working for you, your cashflow doubles from $15,000 to $30,000.

 

How do you calculate return on equity?

Now that we’ve demonstrated the value of tracking return on equity and taking action when you’ve built up a significant amount of value in your property, let’s look at how you calculate it:

Return on Equity = Total Annual Return divided by the Total Equity you have in the property

Let’s break down each component.

 

Total annual return

Total annual return consists of three main components: annual cashflow, equity build-up (the amount of equity you accumulate over the year from making your mortgage payments) and tax savings.

Calculating the return can get complicated when you include equity build-up and tax savings, so to keep it simple, we recommend that you only use cashflow in the numerator (as we did in the example above).

 

Total equity

Total equity is the difference between the current market value and the remaining loan balance.

Equity goes up over time in two ways: 1) the market value goes up as the property appreciates, and 2) your loan balance goes down as you make mortgage payments.

To figure out the market value, you’ll need to do some research.

We use a couple of different methods to estimate current market value. The choice of method depends on the type of property.

For single family homes or condos, we tend to rely on Redfin or Zillow estimates. It’s not perfect, but it’s useful because the information is readily available. If you want a more refined estimate, you should ask your agent to pull recent comparables from the MLS.

For multifamily rental properties, we use the following formula: Market Value = Net Operating Income divided by Cap Rate.

Cap or capitalization rates differ by area. In rapidly appreciating areas, cap rates tend to be lower. For example, in the area around Amazon’s campus, cap rates might run as low as 5%. In an outlying suburb of Seattle, cap rates will generally be higher.

Your agent should know the cap rate for each area where you have properties. You can also get a general sense of the current market cap rate by checking out the average cap rate of comparable properties for sale online.

 

Calculating return on equity using our example

Using the formula above, let’s calculate the return on equity for the condo in our example. Using cashflow of $15,000 in the numerator and $300,000 in equity in the denominator, the return on equity is 5%.

Let’s assume the property appreciates another $100,000 and she now has $400,000 of equity in the property. Assuming her cashflow stays roughly the same, her return on equity now drops down from 5% to 3.75%.

As mentioned before, this is an extremely inefficient use of her equity and she should consider unlocking that equity and using it to generate a higher return.

 

How often should I track return on equity?

We recommend that you track return on equity at least annually.

The reason you don’t have to check more frequently is that property values and equity build-up don’t change very much in shorter increments of time.

It’s important to point out that return on equity is more important to follow during the growth phase of your investing, when you are trying to maximize your returns. At a certain point in your life, you may want to start paying down your mortgages and choose to accept a lower return on equity in order to be less leveraged.

We have started to do this slowly as we transition from our growth phase. We had been using the debt snowball method to pay off some of our mortgages, but we recently found out that our lender allows us to recast our mortgages without a fee, so we’ll likely switch to this strategy instead. If you haven’t heard of these strategies, stay tuned, we’ll cover them in a future post!

 

What metrics do you use after you’ve purchased a property?

How often do you track these metrics?

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Semi-Retired M.D. and its owners, presenters, and employees are not in the business of providing personal, financial, tax, legal or investment advice and specifically disclaims any liability, loss or risk, which is incurred as a consequence, either directly or indirectly, by the use of any of the information contained in this blog. Semi-Retired M.D., its website, this blog and any online tools, if any, do NOT provide ANY legal, accounting, securities, investment, tax or other professional services advice and are not intended to be a substitute for meeting with professional advisors. If legal advice or other expert assistance is required, the services of competent, licensed and certified professionals should be sought. In addition, Semi-Retired M.D. does not endorse ANY specific investments, investment strategies, advisors, or financial service firms.

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Hi, we’re Kenji and Leti

we provide coaching and mentorship for doctors and high-income earners

Several years ago, we were newlyweds working as full-time hospitalists. On paper, it looked like we had everything: the prestigious careers, the happy marriage, the luxurious rental home, the cars, etc.

But in reality? Despite having worked for several years, we had very little savings. Despite our high income, we had very little freedom in terms of time or money.

One thing was clear: we had to do something.

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