Why does ROI % seem to go down after a certain number of years?

[Brian Paine]

I don't quite understand this so called "law of diminishing returns". It shows up in the BP calculator each time I analyze a property. The ROI percentage starts to go down at about the 10 year mark. Plus I keep hearing that investors tend to sell after 5 to 7 years because of this.

I would think that the pay down on principal and increase in appreciation would create a compounding return.

What am I not seeing?

[Ben Zimmerman]

Returns go down because the degree at which you are utilizing leverage is also going down.

If you buy a property for 100k with a 75k loan then you only have 25k of equity in the deal so your LTV is 75%. If you get 3% appreciation then your property is now worth 103k and you "made" 3k returns on your 25k in equity which is a 12% return via appreciation alone.

Fast forward a few years when your home is now worth 150k and your loan is paid down to 70k. In this instance you now have 80k worth of equity making your LTV ratio is much lower at only 46%. So the same 3% appreciation means your home is now worth 154.5k so you made 4.5k in appreciation. 4.5k returns on 80k worth of equity is only a 5.6% rate of return via appreciation.

If you own the property long enough to completely pay off the loan, then a 3% appreciation rate means that you are only earning 3% profit off of your money via appreciation.

The longer you own a property the more equity you have via appreciation and loan paydown.  This equity means you are using less leverage and therefore your rate of return becomes lower.  Higher amounts of leverage amplifies your gains, but also amplifies any potential losses making it generally riskier if the economy suddenly turns for the worse.  So the tradeoff becomes creating a sufficiently high rate of return, while also not exposing yourself to an unnecessary amount of risk.  Peoples have different degrees of risk tolerance so there is no best way to go about doing things, just find a sweet spot as far as risk/reward that works well for you and your investing goals.

Some people choose to sell their properties after awhile to buy new properties (hopefully at below market value) and thus earn instant equity by buying correctly, and it also resets their leverage back to a higher amount thus amplifying their gains. The downside is that repeatedly paying closing costs can become expensive. Alternatively some people choose to take out second mortgages via a HELOC against their property or simply refinance the entire thing and pull money out of it that way so that they can increase their leverage.