by Marc Halpern, Part Time Investors LLC
February 29, 2024
Many investors live by the mantra “your money should work for you instead of you working for your money.”
An advantage of rental real estate is that your investments increase both cash flow and net worth (equity) over the long term.
However, when looking at the long term (10-20 years), it is rare that the rates of increase of cash flow and equity are the same.
In particular, after a seller’s market in which market appreciation is particularly high, the increase in equity may be disproportionately higher than the increase in cash flow. Investor-landlords are happy that both are increasing and may not realize that the equity has grown so much that it is not being leveraged as efficiently as possible to maximize the generation of cash flow.
Some investor-landlords solve this issue of leverage efficiency by stripping equity (e.g., BRRRR method) that reduces equity and increases cash flow.
In this article, I submit for your consideration to calculate the cash-on-equity return to understand and benchmark how efficiently you are leveraging your equity in your rental portfolio to alert you to the possibility of maximizing your cash flow without sacrificing equity.
More specifically, during the recent run up in the value of single family home rentals, I found that when the cash-on-equity return fell below about 8%, my equity was not being leveraged efficiently to generate more cash flow.
This often happens when holding on to real estate that has appreciated significantly.
I rarely see investors calculate cash-on-equity return, let alone use it to decide if they should sell and redeploy the proceeds more efficiently.
Before examining the numbers, I want to preemptively raise the question of long term capital gains taxes and depreciation recapture since those drain the net proceeds after taxes when selling rentals. I do not suggest ignoring the impact of taxes. At the same time, it is not prudent to use taxes as an excuse to avoid an hour of “what-if analysis.”
I sat down with a landlord last week with 40 doors and we went through his cash-on-equity return. The “analysis” took less than half an hour. He immediately understood that while holding the existing rentals satisfied his need for cash flow, keeping the properties on cruise control was resulting in having to manage many more tenants than necessary to achieve the same cash flow.
To illustrate…
Let’s say you buy a rental unit at a discount, renovate it and you have $400/month positive cash flow and $50,000 equity on the first day of the first lease. That is 9.6% cash-on-equity return in Day 1.
Let’s say that 10 years later your positive cash flow (after vacancy, repairs and admin costs) is $600/month and your equity is $100,000. That’s a cash-on-equity return of 7.2%.
If you look at the actual numbers for rent increases, appreciation, inflation of insurance, mortgage loan balance reduction, etc. for a rental property since 2010, you are likely to find that your cash-on-equity return might be closer to 5%.
Yes, cash flow went up, but equity went up faster.
You should really perform this spreadsheet exercise and make sure you look at ACTUAL CASH FLOW after vacancy, repairs and admin costs (VRA) and not just look at PITI. To learn how to calculate your ACTUAL historical VRA, watch my training video on "How to Choose Houses for Rentals."
If you perform this cash-on-equity analysis honestly, you may find that if you sell rentals with low cash-on-equity return (e.g., 5% or less) and redeploy the proceeds, your new cash flow may be significantly higher than your old cash flow. If not, don’t sell YET.
Another way of looking at it is…would you rather make 8% cash-on-equity return on your old $50,000 from 10 years ago ($4,000/year) or would you rather make 8% cash-on-equity return on your current $125,000 of equity ($10,000/year)?
I don’t know anyone who teaches this simple metric (except me).
In my case, I exited out of self-managed rentals and property manager-managed rentals in favor of private placement investments and my cash-on-equity returns (averaged over 5 years), are MUCH higher than when I had rentals in my own entities AND I don’t manage people anymore (not tenants, it contractors, not property managers, not anyone!).
On top of that, several of my rentals were in my self-directed 401(k) and Roth 401(k), so the tax ramifications were not even a factor in my decisions.
When I sold the single family home rentals and redeployed the proceeds, I chose to redeploy them in truly passive private placement investments as a limited partner, so I could benefit from simultaneous financial and psychological freedom after performing DEEP due diligence before making each investment AND diversifying my portfolio with multiple investments in multiple sectors with multiple syndicators, fund managers and project sponsors.
Each of us makes our own decisions, takes our own actions and lives with our own realities. I cannot say what is right for you or anyone else. I can only suggest to invest a few minutes calculating your cash-on-equity return, consider tax ramifications and see on paper if it makes sense to continue to hold or consider selling and redeploying proceeds. Consult with your licensed professionals before making any decision or taking any action.
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