The Metric That Decreases As You Own Your Property

[Justin Moy]

Many investors look for cash on cash return as a king metrics in evaluating deals, but there is another metric - return on equity - that can help investors make informed decisions on their portfolio.

Return on equity typically decreases as you hold a property long term.

Return on equity is different from cash-on-cash because it is the amount returned versus the equity you have in a property - not the cash investment you’ve made.

Let's say you purchase a $100,000 property with a 20% downpayment and also you paid 5% in closing costs.

You’ve invested $25,000 into the deal, and every year you have a net positive cash flow of $3,000 after debt service.

To calculate cash on cash you’d take $3,000 and divide it by the $25,000 cash you put in and you’d get a 12% cash on cash return, which is pretty good.

Now if you’ve purchased your property in an appreciating area chances are the rents from that property will increase, so it wouldn’t be uncommon to see your cash on cash grow slightly every year as you can charge a bit more for rent and you experience some loan paydown as well.

If you put in 20% as a downpayment on a property, that means the bank owns 80% of it. So in this case you have 20% equity on the property. So in this scenario you still owe $80,000 to the bank.

But, here’s where return on equity comes into play.

Let's say it’s been 10 years of owning this property, and in that 10 years you’ve paid down your debt from $80,000 down to $60,000.

This increases your equity in the property from $20,000 which was your initial down payment, up to $40,000 because now you’ve also paid off $20,000 from your mortgage payments.

Lets say during that 10 years you’ve also increased your annual cash flow from $3,000 to $4,000. Since you still only invested upfront cash of $25,000 your cash flow has jumped from 12% to 16%, because now you’re taking $4,000 in annual cash flow and dividing it by the initial $25,000 invested.

But if you take into account the additional equity you have in the property, your return on equity actually drops.

Now you’d take the total equity you have in the property, your $20,000 down payment plus the $20,000 in loan paydown you’ve made to equal $40,000 of total equity.

If you take your annual cash flow of $4,000 and divide it by $40,000 of total equity you have in the property, you get a 10% return on equity.

This is an important metric because as investors we’re always looking to keep our velocity of capital high, and as we pay down loans and increase our equity in a property we will eventually see that return on equity amount decrease and once it gets to a certain threshold you may be able to pull out that equity from either a sale or refinance and deploy it into another asset.

When you have properties and locked up equity you should always ask yourself if there are other opportunities that equity would be more effectively deployed to and you can use return on equity as another metric you can use to make educated investing decisions.