This is a follow-up to a posting written yesterday about Return on Equity. In that blog, I promised to return to offer solutions for increasing the investor’s Return on Equity, and that is the subject of this post.
Please check out yesterday’s blog if you have any question about what Return on Equity is and why it is so important to monitor the ROE of an investment. Assuming that you’re up to speed on that, let’s investigate what
can be done to maximize Return on Equity.
To increase your ROE in the world of real estate, you must re-leverage your equity periodically. In English, that means you need to get the equity out of your investment and use it as a down payment for another investment. How can that be done? I can think of three ways:
- Sell the property.
- Refinance the property.
- Exchange the property.
One by one, let’s discuss these alternatives:
Sell the property. A logical solution, but there are tax ramifications. A healthy portion of your equity is going to be eaten up by those pesky taxes. While it is certainly possible to re-leverage your investment this way, it’s not a smart way to increase your ROE.
Refinance the property. Better, but still some problems. In most cases, you will not be able to pull out 100% of your equity. Your lender may limit you to 80% loan-to-value, or some other percentage. If you have great enough equity in your property, you may be able to raise a significant amount of money by refinancing, but you generally will not be able to get at all of it. Nor may you want to even if you can; the potential negative cash flow that could result may be burdensome.
Exchange the property. Since my company is in the exchange business, it may seem a forgone conclusion that I might claim
that exchanging is the best way to re-leverage equity to increase ROE. But let’s dig deeper. A successful exchange allows the investor to release all of his equity from a property to use in new property (minus the costs of the sale; there are costs associated with virtually any solution). This can be a tremendous wealth generator. Take an individual who owns a $100,000 property free and clear. Setting transactional costs aside for a moment, by releasing that equity into a new investment, the investor could conceivably purchase a $500,000 property using his $100,000 equity as a 20% down payment. Again, setting aside the other benefits of ownership addressed in the previous blog (CFBT, Principal Reduction, and Tax Savings), if the two properties appreciated at the same rate, let’s say 4% per year, in five years his old investment would be worth $121,665. By exchanging into the new property, in five years the new property’s value would be $608,326. His equity would be $86,661 more than had he left it in the old property ($108,326 minus $21,665).
Stated another way, his $100,000 equity would have grown to $121,665 if he had stayed in the old property. By exchanging into the new one, his $100,000 equity grew to $208,326. And again, this disregards the other benefits of ownership cited in the paragraph above, which would likely all be higher in the new property as well.
To conclude, examine your Return on Equity every year or so. When you can do better in a new investment, exchange out of the old and into the new. Don’t get married to your properties! Move on and move up!!
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Please consider IOWA EQUITY EXCHANGE as your source for answers to your questions about Section 1031 like-kind tax-deferred exchanges. Contact us at your convenience for prompt, accurate information. Please think of us for your next exchange.
Ken Tharp
Providing Qualified Intermediary services for Section 1031 tax deferred exchanges all over the United States. Headquartered in Iowa, our services are available in Missouri, Kansas, Nebraska, Colorado, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, and all other states.
INTEGRITY. PRECISION. SECURITY.
Copyright © 2008 By Ken Tharp, All Rights Reserved. * Solutions to Increasing Your Return on Equity * Contact Ken Tharp for information on Section 1031 tax-deferred exchanges anywhere in the United States.
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