Part Three: Return on Equity // How to Calculate the Return on Investment of a Rental Property
This is the third article in my three part series to help the new or potential investor learn the basics of calculating the return on investment of a rental property.
This article is most helpful for a property owner who either has a paid off rental property or is otherwise sitting on a significant amount of equity in a present or potential rental property.
Check out parts one and two of this series here:
Part One: Cap Rate - helpful if you are considering making a full-cash purchase or considering the market value of a rental property you plan to sell
Part Two: Cash-on-Cash Return - helpful if you have a mortgage on a rental property
Note: This article focuses on basic cash flow calculations and does NOT take into account your individual potential tax implications. Please consult with a CPA prior to making any decisions.
Return on Equity
Return on Equity factors in the ongoing changes of the market value of a home and an increasingly paid down mortgage in a way that cap rate and cash-on-cash return do not.
This is a particularly helpful calculation for homeowners whose existing home has gone up in value and they are considering keeping it as a rental property when moving into a new home.
The math would look something like this:
Annual Net Profit / Current Equity = Return on Equity
Current Market Home Value: $500,000
Current Mortgage Balance: $200,000
Current Equity: $300,000
Annual Income: $2,000 rent income per month * 12 = $24,000
With a Mortgage
Annual Expenses - $1400/mo (mortgage, taxes, insurance, maintenance/utilities + $100 reserves = $1500/mo * 12 = $18,000
Annual Net Profit: $24,000-$18,000 = $6,000
Return on Equity Calculation: $6,000 / $300,000 = .02
Return on Equity: 2%
Note: As a mortgage gets paid down, unless rents increase accordingly, the Return on Equity decreases.
Using the Cash-on-Cash illustration above that assumes $6,000 annual rental income profit
Owe $240,000 on a $300,000 home = $60,000 equity
10% return on equity
Owe $234,000 on a $300,000 home = $66,000 equity
9% return on equity
Owe $100,000 on a $300,000 home = $200,000 equity
3% return on equity
Why does this matter?
Return on Equity is a big deal because many new or potential landlords I speak with are running numbers based on the “wrong end” of the investment calculation.
For example, generating $12,000 annual on a property that you bought for $100,000 years ago might seem great investment. After all, isn’t $12,000/yr a good return on a $100,000 investment?
It is until you realize that home is now worth $600,000 and you are sitting on $500,000 in equity.
If you sold the home and invested that $500,000 into the stock market at 12% return in the stock market, you’d generate $60,000 per year.
Perhaps as well you could sell the one property and use the profits to purchase three more and start to really snowball your wealth building.
What are your options?
If you do the math and believe a rental property will be a worthwhile investment, feel free to reach out to me if you’d like a “second set of eyeballs” on your situation.
If you’re considering selling instead of renting, or have a rental home that no longer makes financial sense, please reach out to me for a confidential selling consultation.
There might be important tax deadlines to consider or creative options such as a 1031 Exchange that allow you to stay involved in owning investment real estate that will provide you a greater ROI.
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Check out parts one and two of this series here:
Part One: Cap Rate - helpful if you are considering making a full-cash purchase or considering the market value of a rental property you plan to sell
Part Two: Cash-on-Cash Return - helpful if you have a mortgage on a rental property
If you have a desire to buy or sell in the coming year, let’s chat.
Life has a way of keeping us all moving, and I’d love to be your real estate agent.
Contact me here to set up your free and confidential consultation.
Kevin
