Return on Equity
March 19, 2014
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In previous blogs we have discussed making money from cash flow, appreciation and potential tax benefits. Today we will look at another attribute of investing in real estate that is sometimes, but not necessarily, researched properly before being executed. The idea is known as Return on Equity.
The equity in a property is the difference between what the loan amount is and the fair market value of that property. This equity, which belongs to the owner, has the potential to be used as investment money for future projects. The question is when the owner of the asset should use the equity to invest in that next project, and when the equity should not be used and just left in the asset. With mortgage rates near record lows and job prospects improving and although we’ve had a cold winter, housing starts are trending upward. Mortgage lenders, such as Wells Fargo, indicate that in the next 12 months there will be an increase in housing prices, activity in sales and in housing starts, even though the U.S. economy is slow to recover.
So the question is: when should the owner consider using the equity in one asset to purchase another asset? When the Return on Equity meets the owner’s criteria.
That means the return they receive on their equity is greater than the return they receive from other types of investments ie. Stocks, bonds, etc… The Return on Equity is calculated when you take the annual cash flow, plus the annual appreciation and divide that by the equity that is left in the asset.
Therefore, first an investor would calculate the return on equity on the asset before they refinance and see what the return is. Second the investor would then do the same return on equity calculation after they refinance to see what that return is. There is one additional piece to the puzzle. The investor will also calculate the return on investment on the money used to invest in the next project. If the return on equity after refinance plus the return on investment added together are greater than the return on equity before the refinance, then that is the time to refinance and move the equity into that investment.
Richard Maryanski and Erik Maryanski
Rich Dad Advanced Trainers and Mentors