The purpose of this post is to give a friendly whack upside the head to people who own rental property. You probably made a good investment when you first bought the property. But does it measure up today? Depending on how long you’ve owned your property, it might not be a good investment anymore. I didn’t say not a good property; I said not a good investment. Read on to find a simple way to determine if your (or your client’s) rental property investment is still measuring up. You may be in for a surprise! Plus, register for my course: Real Estate Investing: Beyond the Basics.
Benefits of rental property investment
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 most cases, can be used to shelter other income—such as salary from your job (subject to the Passive Loss Rules).
- Appreciation: Over time, the property might increase in value.
These four benefits are powerful! You earn tax-sheltered cash flow, your tenants buy the building for you, you get to tell the IRS you’re losing money, and all the while, the property goes up in value. What a country!
So why am I 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!
Return on investment drops from 18% to 7%
Assume you bought a rental house sixteen years ago for $70,000. You invested $10,000 and borrowed the rest. Your goal is to retire in fifteen years and use the rental house to provide retirement income.
So, how good was your rental property investment sixteen years ago? 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% ($1,800/$10,000) on your investment. Not bad. Plus the rental house was appreciating. You’re an investment genius!
Fast-forward sixteen years to the present. Today your rental house has appreciated to $120,000. The 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!
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% bracket (combined federal and state), you pay $1,400 tax.
So, your benefits from the rental house today look like this: $5,000 cash flow, plus $2,000 principal reduction, minus $1,400 tax paid. A total of $5,600.
It’s no wonder you consider yourself an investment genius if you measure the $5,600 against your original $10,000 investment: that’s a 56% 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 invested 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 16 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 likely to be $80,000 (or more). In other words, if you sold the property today, you could walk away with $80,000.
However, if you keep the property, you’re, in effect, re-investing the $80,000 into the property. Now, how does your investment look?
Not so good. You’re earning $5,600 in benefits on an $80,000 investment—that’s only 7%. What if I called you up and said, “I’ve got a great real estate investment for you. You’ll earn a measly 7%.” You’d hang up on me! Well, you already own it!
What if you did this instead? Use your $80,000 equity as the down payment on a different property—one that produces 18%? With that down payment you could probably afford a $400,000 rental property. 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. You accomplish this by wisely moving your equity, from property to property.
Just for fun, take out your calculator and figure how much money you’d have in fifteen years if you leave the $80,000 invested at 7%. Then calculate what $80,000 invested at 18% grows to in fifteen years. I could give you the answer but you might not believe me, check for yourself . . . it’s gigantic!
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 gain 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 $80,000 equity.
- Exchange: The third, and best, way to move your equity is to exchange. Exchanging allows you to move your entire $80,000 net equity to another property without paying tax. It’s wealth-building’s most powerful tool.
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 diminish.
The wise thing to do is re-evaluate your rental property investment—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. And keep your brilliance shining brightly.
About the author
Tom Lundstedt, CCIM, is known as the funniest investment and tax guy in America! His programs for REALTORS® have entertained and enlightened thousands of audiences from sea to shining sea. He’s a former Major League Baseball player whose striking combination of humor and real world examples makes powerful subjects spring to life. He’s the author of a series of audio CDs and Study Guides on the subjects of investment real estate and taxation. Visit his website at www.tomlundstedt.com or contact him at (920) 854-7046.
Learn to help your clients with rental property investment
Many agents lose business by not being confident about working with real estate investors. Want to gain the skills and tools necessary to capture this rewarding market and assist clients with rental property investment? Register for How to Work with Real Estate Investors – Part 1 and How to Work with Real Estate Investors – Part 2, taught by Tom Lundstedt, CCIM.
Check out the following continuing education courses, taught by author Tom Lundstedt:
- Real Estate Investing: Beyond the Basics
- How to Work with Real Estate Investors – Part 1
- How to Work with Real Estate Investors – Part 2