The goal of this post is to give those who own rental property a gentle thump upside the head. When you first purchased the property, you most likely made a smart investment. But how does it hold up today? Depending on how long you've owned your home, it may no longer be a suitable investment. I didn't say it was a bad property; I said it was a bad investment. Continue reading to learn a simple method for determining whether your (or your client's) rental property investment is still performing well. You might get a surprise! Register for my Real Estate Investing: Beyond the Basics course as well.
The Advantages Of Investing In Rental Property
First, let's go over the four financial advantages of owning investment real estate:
- Cash flow is the money that remains after all costs and loan payments have been met.
- Principal reduction: Money received from tenants is used to pay down the loan.
- Income tax savings: Under IRS standards, property owners can deduct depreciation, which protects cash flow and principal reduction. Any unused depreciation generates a paper loss, which can be used to conceal other income, such as your pay (subject to the Passive Loss Rules).
- Appreciation: The property's worth may rise with time.
These four advantages are really potent! You get tax-free cash flow, your renters buy the building for you, you get to tell the IRS you're losing money, and the property appreciates in value. What a place!
So, why am I daring you to rethink if your property is still a viable investment? Simple! Your "return on equity" is most likely low—and decreasing by the year!
The Rate Of Return On Investment Falls From 18% To 7%
Assume you paid $70,000 for a rental house sixteen years ago. You put $10,000 down and borrowed the rest. Your plan is to retire in fifteen years and use the rental house to supplement your income.
So, how did your rental property investment perform sixteen years ago? Let's add up your advantages. Assume that the cash flow, principal reduction, and tax savings totaled $1,800 in the first year. You were making 18% on your investment ($1,800/$10,000). Not too shabby. In addition, the rental house was increasing in value. You're a financial genius!
Let's go ahead sixteen years to the present. Your rental house has increased in value to $120,000 today. The annual cash flow has increased to $5,000, and the principle has been reduced by $2,000, for a total of $7,000—all from the first two advantages!
However, because you've held the property for so long, the depreciation deductions (say $3,000) are no longer sufficient to cover the $7,000 in cash flow and principal reduction. That leaves $4,000 in taxable (unsheltered) income. Instead of saving tax, you must pay it. You pay $1,400 in taxes if you are in the 35% tax bracket (federal and state combined).
So, currently, your rental housing benefits look like this: $5,000 in cash flow, plus $2,000 in principal reduction, less $1,400 in tax paid. $5,600 in total.
When you compare the $5,600 to your original $10,000 investment, it's no surprise you think yourself a financial genius: that's a 56% return. But this is where the majority of folks go wrong!
Today's Rate Of Return Has Nothing To Do With Your Initial Investment!
Your investment is no longer the same as it was years ago. You've invested far more than $10,000 today! Your investment is the amount you could obtain if you sold the home right now. This is referred to as your "net equity."
Your home's worth has improved and your mortgage has been paid off over the last 16 years. The present difference between the net value of the property and your mortgage balance is most likely $80,000 (or more). In other words, if you sold the home today, you could pocket $80,000 in profit.
However, if you keep the property, you are effectively reinvesting the $80,000 in it. How does your investment look now?
That's not so good. On a $80,000 investment, you gain $5,600 in perks, which is barely 7%. What if I called you and said, "I have a fantastic real estate investment for you." You'll only make 7%." You'd cut me off! You've already got it!
What if you instead did this? Use your $80,000 equity as a down payment on a different property that pays an 18% return. You could certainly afford a $400,000 rental home with that down payment. After a few years, your equity will have grown (and your rate of return will have fallen), so you repeat the process. The goal is to maintain the maximum rate of return achievable. This is accomplished by prudently shifting your equity from property to property.
Take out your calculator and calculate how much money you'd have in fifteen years if you left $80,000 invested at 7%. Then figure out what $80,000 invested at 18% will rise to in fifteen years. I could tell you the answer, but you might not believe me; see for yourself... it's massive!
Three Methods For Transferring Your Equity
Here's an important point. If you feel it's time to "move your equity," consider all of your possibilities. There are three common methods for transferring equity:
- Sell: You might sell your existing home and purchase another. The issue with selling is that you must pay capital gains tax.
- Refinance: You might refinance your current home and utilize the loan proceeds to purchase another. The issue with refinancing is that you are unlikely to be able to borrow the entire $80,000 equity.
- Exchange: Exchanging is the third and greatest way to shift your equity. You can exchange your whole $80,000 net equity for another home without paying taxes. It is the most effective method for accumulating riches.
So, what does all of this mean? Congratulations, if you own rental property. Your investment brilliance is evident. However, as time passes, the radiance of that feature begins to fade.
Every year, you should re-evaluate your rental property investment. In other words, decide to "re-buy" the property. When the rate of return on your equity in another property is higher, it's time to act. And keep blazing your light brightly.