When you are buying rental property more than likely you are going to be putting cash down toward your investment. This is most likely the reason you are buying rental property to make a better cash investment. We are all looking for a better return on our cash and real estate investments or more specific rental property is by far the best option due to the multiple benefits including cash flow, principal reduction, appreciation and taxable income reduction
Let me describe how these work for you as a investment:
- Cash Flow- rents pay for all expenses, mortgage and provide you left over income
- Principal reduction- Your tenants rents pay down the mortgage buying the building for you!
- Appreciation- Over time the value of your property increases if maintained
- Taxable income reduction- real estate provides the ability to expense and depreciate a percentage of income usually enough to show a paper loss
So while all these benefits are working for you and should be creating wealth for you in the long run, does not mean it continues to be a good investment?……..
Lets go back to when you first made your investment of cash into the property, you should have calculated your ROI or return on investment.
Return on Investment “ROI” = How fast your investment is returned back to you every year in %.
For example, let’s say you made $50,000 investment down on a 4plex worth $250,000
Now let’s assume you made that cash investment with the intention of earning a 20% ROI, every year from the cash flow.
Every year you look at your cash flow and you are happy because you have hit your target ROI, assume 10 years go by and your rents have increased showing a increase in ROI by 10%. Now your cash flow has grown to 30% ROI. Sounds pretty good right?
You would be right if your only benefit to owning rental property was cash flow but we have to go back take into account benefit #2.
Why you ask?………..
Well that benefit is a big part of your ROI because even thought you put down $50,000 investment that is no longer investment basis. In other words your purchasing power has grown. Your investment power is not your original $50,000, your investment is what equity you could recoup if you sold today.
So even though your tenants are paying down the mortgage and buying the building for you, it is creating more investment power and increasing your equity.
Let’s assume you $250,000 property is reducing its principal by $5,000 a year, that’s great for your net worth! But is your capital working as hard as it was 10 years ago?
Well lets add this up…your properties equity is growing $5,000 every year x 10.
That’s $50,000 in additional equity after 10 years which now brings your total investment equity to $100,000. If you were earning a 30% ROI on $50,000 your cash flow would be $15,000 per year.
Now your cash flow of $15,000 needs to be compared to your investment equity of $100,000. That is a significant drop…now your ROI is actual 15% and cut in half!
Look at it this way…. You are making $15,000 on an $100,000 investment. Because your investment is not what you started with its now $100,000
Not so great, your investment power has grown but your earning power has dropped!
To make you capital investment as efficient as possible you need to compare your cash flow to your “current” investment equity.
Now your investment power is $100,000 and could double the size rental property you could purchase to $500,000. Earning you the same 30% ROI, cash flow would now be $30,000 per year!
Now your earning power has increased as you put your investment equity to better use.
Now I am not saying you own a bad deal or property but after 5,10 or 15 years your property will not only provide you will all the benefits above but will increase your investment power as your equity grows. Your earning power will simply not be able to keep up to your equity power.
What does this mean? Well it just means your capital needs to be moved to hit your target growth and you can do it a few different ways.
You could sell and realize your gains but you also give away an already excellent income stream. Not taking into account the other benefits that are still working for you. This is still a better option than accepting a continually decreasing return every year.
Or refinance and pull the equity out, this will give you the opportunity to find other properties were the ROI will be competitive.
With rental property your investment will change the longer you own it, so re evaluate the property every 5 years to decide if your equity efficiency is as competitive as when you first purchased it.
If not take action to increase your capital growth rate when it’s no longer keeping up!