The Critical Calculation Most Buy and Hold Investors Miss

Return On Equity

The property was a marginal rental in an expensive New England market when it was purchased in 2007. Now, 2016, it's nearly doubled in value. If you go by the conventional buy and hold metrics for evaluation, you're mainly looking at two things: monthly cashflow and cash on cash returns. But that misses one very important metric: return on equity. 

In the question, the cashflow and cash on cash (CoC) were fine, but, BUT! the property had doubled in value! What those metrics don't tell you is that you may have significant unallocated equity. We don't want that. Cash is a big bottleneck for a lot of investors, including me, which means I want all of mine doing work for me at all times. 

How To Calculate Return On Equity

The calculation is dead simple. It's yearly cashflow divided by total equity in the property (initial cash outlay + appreciation + principal paydown).

Let's look at a real life example, a 3/2 SFR I own in Nashville. I bought it as a primary residence (house-hacked with roommates covering my PITI), but rent appreciation turned it into a decent rental.

Purchased: 150k (20% down, financed 120k)

Cash Outlay: $34,500 (downpayment + closing + reno)

GRM: $1700

Monthly Cashflow: $600 (no management)

Yearly Cashflow: $7,500

CoC: 21.5%

Looks pretty good, right?! I mean, maybe not spectacular, but for Nashville it's pretty damned good. However, due to the appreciation I have a whole pile of equity that isn't doing anything for me. Let me calculate my return on equity (which is just my CoC calculation but using the property's equity rather than just my initial outlay). 

Total Equity: $104,500 (34.5k initial out + 70k appreciation)

Yearly Cashflow: $7,500

ROE: 7.4%

Yikes! Once I calculate my true returns (equity tied up in the house is my money, so it has to be included in my returns) this goes from looking like a good rental to an absolute stinker. I need to cashout refi or sell and buy something better IMMEDIATELY.

When To Calculate Return On Equity

It's not something that needs to be done every day, but if you invest in an area where significant appreciation is happening (like Nashville), I recommend looking at your ROE annually. I flatly stole that recommendation from Ray Dalio, who's one of the richest and most influential men in America. He recommends rebalancing and reallocating your portfolio at least annually. I figured if it's good enough for him it's good enough for me. 

But that's just for my Nashville properties. I also own some stuff in Central Indiana, which hasn't really seen any appreciation in ten years. I don't anticipate doing an annual ROE for those properties.

And, for the example property above, I actually did run this number last year and decide I had to access the equity. I established a HELOC on the property (since I'd bought it as my primary residence I was able to do this) and used that low interest equity loan (2.99% on the initial draw) to rehab a basement unit in another property. So, I turned free money into an extra $750 per month in rent!