Return on Equity of Real Estate
For things like real estate, most dream about increasing cashflow as the mortgage is paid down, and the ultimate dream is paid off properties that provide consistent rent cheques and appreciation. Though in terms of return on investment (ROI), per dollar you are making less as more of your money is used to make a similar amount of money. Most speak of investments in terms of either ROI, or cash-on-cash returns. However, on top of those, of interest is return on equity (ROE) – as for a given profit, ROE decreases with increasing equity as the mortgage is paid down. That is, as a loan is paid down, more of your dollars (equity) that have sunk into it, are used to make a similar amount of money. Per dollar you have sunk in, you make less. These are dollars you can be doing something else with.
Return on equity (ROE) is simply:
ROE = dollar return/equity
When a property is first purchased, ROE = ROI, as the initial investment is equal to the equity when the downpayment is made. But with each mortgage payment, part goes to interest, and the rest goes towards the principal – increasing equity in the home. Also the appreciation gained is money that can be otherwise used for something else if the home is liquidated; this is also equity. For a given return amount, then ROE decreases with every increase in equity.
For example, suppose a $350,000 property purchased with 20% down ($70,000) with the following characteristics:
Rental income: $1,850/month; $22,200/year
Condo fee: $484/month; $5,808/year
Property tax: $213/month; $2,556/year
Agent commission and legal fees: $7,500 (spread over 5 years, assuming we sell in 5 years); $1,500/year
Mortgage interest: $7393, 7177, 6955, 6727, 6493 (year 1 to 5, in that order; 2.69%/5 yr term
Principal contribution: $7979, 8195, 8417, 8645, 8879 (year 1 to 5)
Appreciation: $14000, 14560, 15142.40, 15748.1, 16378.02
Assume 0 vacancy and maintenance for simplicity.
Year 1 ROE = 26922 / (70000 + 7979 + 14000) = 29.3%
Year 2 ROE = 27914 / (70000 + 7979 + 8195 + 14000 + 14560) = 24.3%
Year 3 ROE = 28940.4 / (70000 + 7979 + 8195 + 8417 + 14000 + 14560 + 15142.4) = 20.9%
Year 4 ROE = 30002.1 / (70000 + 7979 + 8195 + 8417 + 8645 + 14000 + 14560 + 15142.4 + 15748.1) = 18.4%
Year 5 ROE = 31100 / (70000 + 7979 + 8195 + 8417 + 8645 + 8879 + 14000 + 14560 + 15142.4 + 15748.1 + 16378.02) = 16.5%
Therefore, from a ROE perspective, the utility of your equity diminishes with time as the mortgage is paid down and the property appreciates. At some point, you’re better off liquidating it or re-mortgaging it at the end of the term to increase ROE by decreasing its denominator.