In the real estate world, everybody talks about ROI. Everybody wants a return on their investment, right? You put some money in, you want to get some money out. That’s the fundamentals of investing. But what about your equity?
The thing that a lot of people don’t talk about is ROE, which is return on equity. Fundamentally the basics of rentals are great because you have tenants that are paying down your mortgage balance every month. Of course, when you make a mortgage payment there’s a certain portion of it that goes to interest. There’s also a portion of it that goes to principal. Your mortgage balance over time drops.
Now the thing with that is everyone’s like “Great, this is like a forced savings account, so when I go to sell that property, I’ll get this big paycheck from what my tenants have paid off!” This is true, and there’s nothing wrong with that, but a lot of people don’t realize is that rental gets less profitable because your return on equity goes down over time.
What a lot of people don’t realize is that rental gets less profitable because your return on equity goes down over time.
How Does Return On Equity It Work?
Let’s say you have a rental property and you have 10% equity and it’s making you $500 a month net. If you take that $500 and you divide it by the $10,000 in equity, that’s actually a very good property because you’re highly leveraged. You’re making a lot of money based off the amount of equity that you have in it.
Now, let’s say you’ve had a property for 20, 25 years. You’re still making $500 a month net, but you’ve got $150,000 in equity. The return on your equity is incredibly low because you have this large chunk of cash that’s sitting there not doing anything. I think as a hard money lender, this was something that really encouraged me to sell all of my rentals. Ultimately, I looked at all the equity that we had in all of my properties and I thought to myself, “We’re making this much in free cash flow, but what could I make as a hard money lender if I were to lend that out?” And of course, everyone says it’s just not the same because it’s taxed at ordinary income, you don’t get the depreciation, etc.
Call me crazy, but I kind of think that depreciation might be over glamorized.
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Sure, it’s great because you get to “write stuff off.” The thing is, the IRS does not let you just write things off, there’s some point in time where you have to pay for that. Yeah, you get to defer it, but you still have to pay that in the long run. It’s not like the IRS is just letting you get off scot free.
Do I care about depreciation?
Honestly no, I really don’t.
I care more about the here and now and what we’re doing to make money now.I think people need to put more emphasis on their ROE instead of ROI, simply because it’s another metric to look at and to track your profitability.
How Knowing About My Equity Has Helped Me
Coming full circle, this is similar to our blog that we had last week where I talked about why we decided to become hard money lenders in the first place. It was more passive and it was it was much easier. I looked at all the equity that I had locked away in all of these rentals and properties and I thought to myself “What if I were to cash these out? And what if I were to lend those profits instead?”
I realized I would have to pay capital gains and, to be honest, last year’s tax bill sucked because of this. It stung quite a bit because we had a couple million dollars in equity that we’ve acquired over the last 5 or 6 years through rental properties. This was another point for depreciation because we sold those properties, then we had to pay back all that depreciation.
It does sting but I think people need to ultimately realize what’s best for them.
How This Has Helped Others
You need to analyze the situation and say “Do I want to keep these rentals? Can I make more lending it?” Or maybe you do some sort of a hybrid approach like this:
I’ve heard of one lender who actually pays off all of his rental properties and then will use a line of credit. Once the properties are paid off, he will go to a bank and say “Hey, I want a line of credit.” Typically they don’t lend much. You’re not going to get 80% or 90%. Most of the time, I’ve seen 60% to 65%, and that’s only as long as the bank is in first lien position. I’m not talking about big institutional banks either. I’m talking about smaller credit unions who are a little bit more flexible on their terms and the things that they can do, as far as being creative.
I have a friend that does this. He has paid off his rental properties, gone to a credit union, put a line of credit on these properties, and then he uses that cash to lend out as a hard money lender. He’s still getting rent checks and it’s kind of just like an ATM that you can tap into.
I see why he would do that, because he gets the best of both worlds. Personally, I don’t like the fact that 35% of my equity would be tied up in this asset that I control, but I wouldn’t have full access to. Also, in these instances, the credit unions and the banks still dictate the terms. I like to have full freedom and full autonomy for everything that I want to do.
How It Can Help You
Maybe take a closer look at the assets you have. Can you make more money just by lending that out in a more passive way? If you think you can, we can help.
The reason I ask is because I got to a point where I did not want to be a landlord anymore and it was more of a headache than it was worth.
We did short term rentals, we did long term rentals, we did medium term rentals and when we really got down to the nitty gritty and ran the numbers, we did okay. I just think everybody thinks they’re more profitable than they really are. When you take a look at the actual numbers, the nightly rate, the QuickBooks, the net income, etc, I think a lot more people would actually make more money lending than doing rentals. Just like I said, everybody over glamorizes everything in the end.
Even with the lack of depreciation, the ordinary income being taxed at ordinary income, people think they’re more profitable than they really are. All that to say, maybe just analyze your portfolio and take a look at the equity that you have and see what you can lend that out at. In turn, you could make more and also have a more stress free life.