At the end of 2019 I added my next multifamily property to my portfolio, a duplex in Salisbury, North Carolina. With a little rehab my partner and I knew we were looking at a long term asset that would comfortably surpass the 1% rule and provide consistent cash flow.
Less than 12 months later we sold it.
Why? The story of this property though comes down to one idea – return on equity is every bit as important to measure as return on investment (if not more).
I’m not going to spend a lot of time on the specifics of the property, I encourage you to check out my YouTube video on this property to get the nitty gritty details. But what I want to dive into is why you should think about not just ROI but also ROE.
We’re going to break this discussion into three parts:
What is equity and return on equity (ROE)?
Why is equity and return on equity so important?
How do you make the most of your equity?
(1) What is equity and return on equity (ROE)?
In a very simplistic manner of speaking, equity equals wealth. The equity you have in a property is the difference between what the property is worth and what you owe on the property. This equity may come from getting a great deal below market value, from putting down a down payment, from foreseen appreciation through a rehab, from market appreciation, or from paying down your loan.
Return on equity is a measure of the income that you receive from the property, or cash flow, compared to that equity. It tells you how much income your wealth is producing for you
(2) Why is equity and return on equity so important?
These metrics are critical because they are what truly indicate our wealth. In real estate we often talk about cash on cash return, which is how well our cash is performing, but talk less about return on equity. That's a mistake in my opinion.
Think about equity like your stock portfolio and dividends. If you invested $100,000 in stocks that provide $8,000 a year in dividends you’re getting an 8% return. If the value of your $100,000 doubles but your dividend stays the same, now you’ve cut your return in half and you’re only getting a 4% return. You may look for ways to tap into that new wealth to increase your yield, maybe by re-balancing your portfolio in order to increase your yield (this is not financial or tax advice!!!!)
Your equity and ROE works much the same way. If the market appreciates, your $100,000 in equity doubles, but your cash flow remains at $8,000/year, you've created a lot of paper wealth but haven't made effective use of that newly created $100,000.
When you compare return on equity to return on investment you see two different stories. Because the basis of ROI (i.e. your initial cash expenditure) is effectively fixed, you'll see your ROI trend up over time as rent increases. On the other hand, because equity continues to grow year after year through market appreciation and loan paydown, you'll see your ROE stay relatively even or even potentially trend down over time. This is a huge opportunity!
This graphic depicts the ROI vs. ROE on this duplex over the next 10 years, assuming a rent and equity growth of 3% per year. My ROI looks great as it continues to increase, but my ROE is incredibly low and very flat. We had an enormous amount of equity in our property, just over $97,000, which is why our ROE is and would remain so low.
(3) How do you make the most of your equity?
I'm glad you asked! You can tap into your equity one of two ways:
Tap into the equity through credit (either a line of credit or a cash-out refinance)
Sell the property to realize the equity
Let's start with refinancing. At the time that we sold, if we chose to do a cash out refi at 75% LTV we would have pulled out roughly $41,000 (leaving ~$4,000 in this property). This would allow us to essentially purchase the exact same duplex (property 2) while holding onto the current one (property 1), so let's see what that looks like!
Property 1: because we have only $4,000 left in the property, our ROI skyrockets! 76% in year 1? Are you kidding me?? But as we've discussed, that doesn't tell the whole story.
Our ROE barely ticks up even though we've tapped into so much equity. Why? Because the refinance has increased our loan payment significantly we've cut our actual cash flow in half.
But now we have a second property providing us with cash flow, so let's look at that
Property 2: in this example we essentially purchased the same property. So while we're maintaining the same ROI and ROE as before, now we're doing it with a second property.
It is with these principles in mind that the BRRRR strategy was born. By being cognizant of your equity it forces you into taking a deeper look, and even though the ROE for these properties certainly didn't increase much at all, now there are 2 properties where we're increasing our equity and increasing our cash flow. You can do the same thing with each of these properties, and at this point you've really started pushing your wealth snowball down the hill with massive momentum.
While there is absolutely no denying the wealth building power of refinancing our duplex and continuing to BRRRR, I evaluated that 6% return on my equity against my alternatives and decided that 6% wasn't going to cut it.
Remember that while our profit was ~$45,000 from selling the property, our equity was significantly higher than that and my partner and I were each able to walk away with more than $30,000. Now that I'm actively flipping, that $30,000 can go a very long way in the same time period.
Thanks to hard money lenders and leverage, I can do a 4 month flip with $30,000 in cash and net $15,000 in profit. Obviously there are tax implications to flipping and to realizing capital gains (unless you utilize the 1031 exchange which I won't get into here), but if I can flip 3 houses a year with that money I've now created $45,000 in profit which equals a 150% return on that equity!!!
If I choose to, I can take that $45,000 in profit to purchase another duplex like in option #1 while still continuing to flip with my $30,000. Talk about a snowball...my equity is essentially buying me a duplex every year, and each of those duplexes can follow the BRRRR path to build long term wealth while still flipping.
By continuing to replicate option 1, I can effectively add 1 new properties a year and by the end of year 5 I'd have between 5 cash flowing duplexes.
By continuing to replicate option 2 & combine it with option 1, I end up with 15 cash flowing duplexes at the end of year 5!
Maybe you’re just starting our and can keep this in your tool belt. Maybe you already have a portfolio and have some equity to put to better use. I’m either case, can you imagine how a focus on equity can impact your portfolio and wealth as your business grows?
Cash flow produces income; equity builds wealth. Both are critical to the success of any business, and shifting Your focus towards both of them has the potential to unlock massive opportunity in your business!