Buying Rental Property Strategies Part 6: Return On Equity (ROE)


When does it become a good idea to use the equity you have built in your property (s) and use it for a better cash flowing property or a property with a better value growth potential? 

Let’s find out! 

Maximizing Your Real Estate Wealth: Assessing Return on Equity

Hey there, fellow real estate enthusiasts! Today, let’s dive into an essential aspect of property ownership that often gets overlooked but can make a huge impact on your financial success: assessing your properties from a return on equity (ROE) perspective. Whether you’re a seasoned investor or just starting out, understanding ROE can help you unlock new opportunities and maximize your real estate wealth over time.

What Happens to Equity Over Time?

Imagine you buy a property. Over the years, as you pay down the mortgage and the property (hopefully) appreciates in value, you build equity. Equity is essentially the portion of your property that you truly own outright—the difference between its market value and what you owe on it. So, as you pay off more of the principal on your mortgage and property values rise, your equity grows.

The Evolution of Debt Service

Now, let’s talk about debt service. When you first buy a property, you’re likely making monthly mortgage payments. These payments typically include both principal (which reduces your loan balance) and interest (which is the cost of borrowing money). Over time, as you pay down the principal, your monthly debt service—especially if you have a fixed-rate mortgage—may stay relatively stable or even decrease slightly.

Assessing Rent vs. Total Equity: When is the Right Time?

Here’s where it gets interesting. As your equity in a property grows, you should periodically reassess whether the rents you’re collecting are keeping pace with the equity you’ve built. Ideally, you want your rental income (cash flow) to be in proportion to the value of your investment (equity). If your equity has grown significantly but your rental income hasn’t kept up, it might be time to consider your options.

Options for High Equity: Refinancing, HELOC, or 1031 Exchange?

So, what can you do when your equity is sitting pretty high? Here are three common strategies:

  1. Refinancing to Cash Out: Refinancing allows you to take out a new mortgage on your property, potentially at a lower interest rate or to access the equity you’ve built up as cash. This cash can then be reinvested into additional properties, renovations, or other investments. Pros include access to liquidity and potentially lower interest rates. Cons may include fees associated with refinancing and resetting the loan term.
  2. HELOC or HELOAN: A Home Equity Line of Credit (HELOC) or Home Equity Loan (HELOAN) allows you to borrow against the equity in your property while keeping your existing mortgage intact. These are typically flexible and can be used for various purposes, including home improvements or investments in additional properties. Pros include flexibility and potentially lower interest rates compared to other forms of borrowing. Cons may include variable interest rates and fees.
  3. 1031 Exchange: A 1031 Exchange, also known as a like-kind exchange, allows you to sell a property and defer capital gains taxes by reinvesting the proceeds into another property of equal or greater value. This strategy is popular for investors looking to leverage equity into properties with higher income potential or better appreciation prospects. Pros include tax deferral and portfolio diversification. Cons may include strict IRS rules and timelines to follow.

  4. A reverse 1031 exchange is a transaction where an investor acquires a replacement property before selling their current property, contrary to the typical 1031 exchange process where the sale of the current property precedes the purchase of a replacement property. This method allows investors to defer capital gains taxes by temporarily holding the replacement property through a qualified intermediary.

    Pros:

    1. Flexibility in Timing: Investors can acquire the replacement property first, which can be advantageous in competitive markets or when timing is critical.
    2. Risk Mitigation: Avoids the risk of not finding a suitable replacement property within the strict timelines of a traditional 1031 exchange.
    3. Strategic Planning: Enables investors to strategically acquire a replacement property that better aligns with their investment goals without the pressure of selling first.

    Cons:

    1. Complexity and Compliance: Reverse 1031 exchanges involve stringent IRS rules and timelines. Non-compliance could jeopardize tax deferral benefits.
    2. Higher Costs: Typically more expensive than a standard 1031 exchange due to the added complexities, including fees for qualified intermediaries and legal advisors.
    3. Market Risk: Holding two properties concurrently can expose investors to market fluctuations and increased financial obligations.

    A reverse 1031 exchange offers flexibility and strategic advantages in real estate transactions, it requires careful planning, adherence to IRS regulations, and consideration of higher costs and market risks. Investors should consult with qualified tax and legal professionals to assess whether this strategy aligns with their investment objectives and financial situation.


Pros and Cons: What to Consider

Each of these strategies has its own set of advantages and considerations:

  • Refinancing: Provides immediate access to cash, potentially at lower interest rates, but may reset your mortgage term and involve closing costs.
  • HELOC/HELOAN: Offers flexibility and lower rates, but comes with variable interest rates and the risk of leveraging your home as collateral.
  • 1031 Exchange: Defers taxes and allows for portfolio growth, but requires careful planning, adherence to IRS rules, and finding suitable replacement properties.

In Conclusion

Assessing your properties from a return on equity perspective is crucial for optimizing your real estate investments over time. By periodically evaluating your equity position relative to rental income, you can make informed decisions about whether to leverage that equity into new opportunities, enhance cash flow, or diversify your portfolio. Whether you choose to refinance, take out a HELOC, or execute a 1031 exchange, each strategy offers unique benefits and considerations. Remember, the key is to align your investment goals with your financial strategy and always seek advice from qualified professionals when needed.

Here’s to building wealth through real estate—smartly and strategically!

Please read my other blog posts on here as they have a wealth of information and knowledge. 

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My name is Sebastian Marroquin with Keller Williams Realty and looking forward to helping you plan and build a real estate portfolio! 

Fit Home Rental (Financial Independence Training through Rental Property) 



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