Return on Equity

Return on Equity is the subject today. In an earlier blog, I promised to get back to the ideas that were presented last Saturday at the Omaha Landlord Association’s event that featured Tom Lundstedt, “the funniest investment and tax guy in America.” The crux of what I took out of the seminar was that we should all examine our RETURN ON EQUITY periodically (Tom suggests once annually) and shift our equity into more lucrative investments when it is clear that a better return can be obtained.

First off, let’s highlight the four means of making money in investment real estate:

1. Cash Flow Before Taxes (CFBT)—what’s left over after you’ve fulfilled all of your obligations relating to the property.
2. Principal Reduction—each month that you make a mortgage payment, your tenants are buying the property for you.
3. Income Tax Savings—you get to tell the government that you’re losing money
4. Appreciation—while the property is going up in value (most of the time…).

Let’s now go to an example. Here are the assumptions: Fifteen years ago, you bought a rental house for $100,000. You made a $15,000 down payment on the house. The first year, your CFBT, Principal Reduction, and Tax Savings amounted to $2,800. Before even considering any appreciation, your Return on Equity in the first year was 19% ($2,800 divided by $15,000). As Tom would say, “Plus appreciation? You’re an investment genius!”

Next set of assumptions: CFBT increases annually. Principal continues to be reduced every year. Taxes continue to be treated in the same manner as they were in Year One.

Here’s a pop quiz—after fifteen years of this pattern, is your Return on Equity higher than in Year One, or lower than in Year One? Think about that while you review the next set of assumptions:

Year Fifteen Assumptions: CFBT has increased from the first year’s figure of $934 to $2,500. In the first year, principal reduction was $784; in Year Fifteen it is $2,232. The property is still sheltering some of its income from taxes, but not all. The depreciation of $3,091 per year is not enough to completely shelter the $4,732 in CFBT plus Principal Reduction. In a 35% bracket, $574 will have to be deducted from the $4,732, which results in a net of $4,158 (excluding any appreciation again). So the net from the property before appreciation has gone from $2,800 to $4,158. Now to answer the question in the previous paragraph.

If you apply the Year Fifteen return of $4,158 to the initial investment of $15,000, you’d have a pretty nice return of 28%. But is $15,000 still your equity in this investment? Hardly…

At a rate of appreciation of 3.5% (certainly not stellar appreciation over the long term) and assuming that the $100,000 you paid in Year One was fair market value, after fifteen years the house would be worth $167,500. And after fifteen years, your loan balance would be paid down to $64,113 (that’s at 7.5% with a 30 year amortization). Your gross equity in Year Fifteen has risen from the $15,000 that you invested to $103,387! ($167,500 minus $64,113.) Applying the $4,158 return to that number results in a Return on Equity of only 4.0%!! ($4,158 divided by $103,387.) That’s a traditional passbook savings rate, but you have to manage the property to get it—not my idea of a good investment.

This blog has gotten very long and very cumbersome with all of the numbers, so let’s close it out with a promise to do the next blog on the solution to the declining Return on Equity. I’ll give you a hint in advance—it has a lot to do with my business of tax-deferred exchanges. Thanks for reading.

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Ken Tharp

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