The purpose of this page is to give a friendly reminder to people who own
investment property. You probably made a good investment when you first bought
your investment property. But have you owned it too long?
Depending on how long you’ve held your property, it might not be a good
investment anymore. We didn’t say not a good property; we said not a
good investment. Read on to find a simple way to determine if your property
is still measuring up. You may be in for a surprise!
First, let’s quickly review the four financial benefits of owning investment
real estate:
-
CASH FLOW: After you pay all
expenses and loan payments, cash flow is the money left over.
- PRINCIPAL REDUCTION: The loan is paid down with money collected from tenants.
- INCOME TAX SAVINGS: IRS rules allow property
owners to take depreciation deductions, which shelter the cash flow and principal
reduction. Any leftover depreciation creates a paper loss, which, in many
cases, can be used to shelter other income — such as salary from your
job.
- APPRECIATION: Over time, the property increases
in value.
These four benefits are powerful! You earn tax-sheltered cash flow, your
tenants buy you the building, you get to tell the IRS you’re losing money,
and all-the-while, the property goes up in value.
So why are we challenging you to reconsider whether your property is still
a good investment? Simple! Your “return on equity” is probably low
— and getting lower by the year!
Let us show you an example. Don’t get all tangled up in the numbers.
Just concentrate on the big picture and how it applies to you.
Return on Equity Drops from 18 to 3 Percent
Assume you bought a rental house 10 years ago for $70,000. You invested $10,000
and borrowed the rest. Your goal is to retire in another 15 years and use
the rental house to provide retirement income. (A great plan!)
So, how good was your investment? Let’s total your benefits.
Assume the cash flow, principal reduction and tax savings added up to $1,800
that first year. You were earning 18 percent ($1,800 divided by $10,000) on
your investment. Not bad. Plus the rental house was appreciating.
Fast-forward 10 years to the present. Let’s assume the following: Your
yearly cash flow has increased to $5,000 and the principal reduction is $2,000;
a total of $7,000 — just from the first two benefits! In addition, let’s
assume the net value of your rental house has appreciated over the years so
it’s now worth $220,000 and your loan has been paid down to $40,000.
However, because you’ve owned the property so long, the depreciation
deductions (assume they’re $3,000) are no longer enough to shelter the
$7,000 of cash flow and principal reduction. That leaves $4,000 of unsheltered
(taxable) income. Instead of saving tax, you have to pay tax. If you're in
a 35-percent bracket, (combined federal and state), you pay $1,400 tax.
So, your benefits from the rental house now look like this: $5,000 cash flow,
plus $2,000 principal reduction, minus $1,400 tax paid. A total of $5,600.
This is all summarized on the “Return on Equity Worksheet” below.
(The blanks in the right column are for you to use on your own property.)
A more detailed form is available at www.kenandvicki.com/InvestmentWorksheet.xls
If you measure the $5,600 against your original $10,000 investment: that’s
a 56 percent return. But that’s where most people go wrong!
Your Original Investment Has Nothing to Do with Today’s
Rate of Return!
Your investment is not the amount you originally invested years ago. You’ve
got way more than $10,000 “tied up” today! Your investment is the
amount you could get out of the property if you sold it today. That’s
called your “net equity.”
Over the past 10 years, your property has increased in value and your mortgage
has been paid down. The current difference between the property’s net
value and your mortgage balance is $180,000. In other words, if you sold the
property today, you could walk away with $180,000.
However, if you keep the property, in effect you’re re-investing the
$180,000 into the property. Now, how does your investment look?
Not so good. You’re earning $5,600 in benefits on an $180,000 investment
— that’s only 3 percent! What if a REALTOR called you up and said,
“I’ve got a great real estate investment for you. You’ll earn
3 percent.” You’d hang up on them! Well, you already own it!
If you wouldn’t buy a property like that, why would you continue to
own it?
What if you did this instead? Use your $180,000 equity as the down payment
on a different property — one that produces 18 percent again? With that
down payment you could probably afford a $600,000 rental property your tenants
would buy for you. Once you’ve owned that property for a few years, your
equity will have grown again (and your rate of return fallen), so you repeat
the process. The goal is to maintain the highest possible rate of return,
which will make a huge difference in your future wealth.
You’ll maximize your wealth by wisely moving your equity from your current
property to another as soon as your rate of return would be greater in the
next property.
Just for fun, take out your calculator and figure how much money you’d
have in 15 years if you leave the $180,000 invested at 3 percent. Then calculate
what $180,000 invested at 18 percent grows to in 15 years.
Three Ways to Move Your Equity
Here’s a key point. If you decide it’s time to “move your
equity,” be sure to explore all your options. There are three common
ways to move equity:
- SELL:You could sell your current property and buy another. The problem
with selling is you have to pay capital gains tax.
- REFINANCE:You could refinance your current property and use the loan proceeds
to buy another property. The problem with refinancing is you’re probably
not able to borrow the entire $180,000 equity.
- EXCHANGE:The third, and best, way to move your equity is to exchange. Exchanging
allows you to move your entire $180,000 net equity to another property without
paying tax. It’s wealth building’s most powerful tool. Click
here for more information on exchanging. (www.kenandvicki.com/1031exchange.htm)
So, what does this all mean? Well, if you own rental property, congratulations.
Your investment brilliance shines brightly. However, the longer you own that
property your glow begins to fade.
The wise thing to do is re-evaluate your property every year. In essence,
make the decision to “re-buy” the property. As soon as the rate
of return on your equity could be higher in another property, it’s time
to take action.
If this has sparked any interest in seeing what your property is worth please
contact us today.
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