Return On Equity- Second part
Okay guys, so I just want to drive this point home and give you a real illustration of this. If you’re in the position of maybe you own a couple of properties and you’re looking to grow your portfolio, get into a bigger property, more units. So, this is how I would look at things on the big picture level using return of equity. So let’s say you own Properties 1 and 2 here, and Property 3 is on the market for sale, listed by another broker, and it’s one that you are considering.
So just to keep the numbers very simple, let’s say, you want to look at, okay, you’re looking at your personal financial statements, your whole portfolio, and these two properties maybe you bought them a while ago. They’ve appreciated, the value today of Property 1 is $1.5 million, and you’ve paid down the loan quite a bit. So, the loan balance on it is only $500,000. Meaning, you have equity of $1 million in that property. And let’s say it’s a good cashflow property. And you’re continuing to pay down the debt. So your total return on this property is $80,000. Remember that’s cashflow plus your principal pay down. That would give you a return on your equity of 8%. Because your total return is 80,000 and your equity in that deal that you own, your equity there is $1 million. So you’ve got an 8% return on equity.
Property 2 in your portfolio is a $2 million property today. And the loan balance on that one is $1 million. So, again, on this property, you have $1 million in equity. Now, unfortunately on this property you’ve noticed maybe your cashflow is a little bit lower. It’s just not cash-flowing a whole lot. Maybe at the time you purchased it, interest rates were higher, you couldn’t get as good terms on the loan. So your total return is only $40,000, meaning that your return on equity on this deal is 4%. So that’s half of what you’re getting on the other one.
Now you look and you say, “Okay, if I was to sell either one of these properties, then I would have approximately $1 million to invest. So this is a property that’s on the market, and it’s a bigger property, it’s worth $4 million. So let’s just keep it simple. This is, $2 million property is twice the size in terms of the value, maybe it’s twice as many units. So the $4 million property and using similar terms to what you would get today, you could get a loan for this new property of $3 million, at 75% of the value. Meaning that you would need $1 million in equity to purchase the property. And, because loan terms are very good today, interest rates are extremely low, meaning that most of a lot of that loan payment, that annual debt service, a lot of that is going to go towards paying down principal, so you’ve got big principal payments each year, and the property is also cash-flowing pretty nicely.
So maybe this one you’re putting your total return on this new property is $120,000 per year, giving you a total return on the equity of 12%. So this is really nice. Either one of these properties that you already own are not performing as well this one that you could own.
So, again, not everything is done purely by the numbers because there’s a lot more to it than just the numbers on the page. There’s location of the property, the quality of the tenant base, a likelihood of future appreciation. And remember none of these calculations we’re using factor in appreciation or potential appreciation. You can do this same thing, adding in an estimated appreciation amount for each location that you own. I do that all the time, because it is a valid thing to consider. If you have an apartment building in a really good location that might be cash-flowing a little less simply because there’s a lot of, it’s a more expensive neighborhood, you still may want to hang on to that because you think that the appreciation rate is going to be significantly higher than a building in a not so good of an area.
So, again, these numbers here that we’re doing do not factor in that appreciation. So just keep that in mind, and this is always, it’s a mix between an art and a science. You’ve got to use your own judgment on these things. But, for argument’s sake here, we now have two buildings that you own. One is giving you 8% return on equity, the second one is giving you 4% return on equity. All other things being equal, you might say, “Hey, you know what? It’s time for me to sell Building Number 2 here, and I’m going to invest in Building Number 3, which is on the market. So by doing so, I’m going to, to increase the number of units that I own. I’m going to increase the return on my equity, and just grow as an investor.
So guys, I learned this from other investors who are way smarter than me. It was something that I used to not really pay too much attention to, but since I have paid attention to this number, it has dramatically increased my skill as an investor and just the decision-making process that I go through. I really pay attention to this a lot, because I don’t want my equity sitting there not making any money. If it’s sitting piled up in a building, not earning me and the thing, it’s not helping me to grow and become a more successful investor.
So, that’s the way I look at this. Hopefully, this was helpful, and I’ll catch you on the next one. Thanks.