We’re often asked to evaluate properties for investment purposes, whether for income or redevelopment. When looking at properties in your portfolio, we need to determine if how the property is performing as an investment and whether it might be time to trade that property for a larger property.
Answer this question, a very useful tool we use is what we call the “Return on Equity Worksheet”. The owner may say, “I get terrific cash flow on this property, how can you tell me it’s not a keeper?” Well, if you have a lot of equity in an investment property, or even own it for cash with no mortgage, it may well appear that it’s a great “investment”. But you need to look at the return you’re getting on the equity that’s in the property, not just the cash flow.
For example, let’s say you own a $1,000,000 building and have a $250,000 mortgage. And let’s say your yearly cash flow is $25,000. That may seem like a reasonable return on your original investment when you bought the property. But you have $750,000 in equity sitting in this building, and your return on that equity is what really matters. After all, what if that $750,000 were invested elsewhere? In this example, the return on equity would be calculated as follows:
$25,000 / $750,000 = 3.3%
Not a great return, you could do better in a broad market stock fund!
The question for an investor at that point is whether they would be better served using that $750,000 as a 25% down payment on a $3M property!