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Last Updated : July 5, 2024

Maximizing Return on Equity for Real Estate Investors

During a fascinating episode of the Tax Smart REI Podcast, Brandon teamed up with Chris Lopez, a seasoned real estate investor and author from Denver, to unpack the complex topic of Return on Equity (ROE) in real estate investments. This discussion is particularly relevant for investors who aim to optimize their portfolio’s performance and understand the deeper financial implications of their investment choices.

Understanding Return on Equity

Return on Equity (ROE) is a critical metric in real estate that measures the return on the investor’s equity in a property. It takes into account all forms of return: cash flow, appreciation, debt reduction, and tax benefits, providing a holistic view of an investment’s performance.

The Shift from Infinite Returns to ROE

Chris Lopez shared a compelling narrative about his initial investment strategy, which focused on achieving infinite returns through no-money-down deals. However, as his property appreciated and equity increased, he realized the limitations of the infinite return mindset. This realization prompted him to consider the actual equity tied up in the property and its potential to generate higher returns elsewhere, highlighting the concept of opportunity cost.

Traditional Mindsets

Many investors subscribe to a traditional buy-and-hold strategy, planning to hold properties indefinitely for consistent returns. Chris and Brandon discussed the pitfalls of this approach, emphasizing that it often ignores the changing dynamics of property values and market conditions. They argued that what may have been a lucrative investment at one point could become a stagnant asset if not re-evaluated over time.

One of the most enlightening aspects of Chris Lopez’s discussion with Brandon on the Tax Smart REI Podcast centered on the strategic use of equity in real estate investments. Many investors overlook the potential that lies in the equity they have accumulated in their properties. By not considering how this equity could be more effectively utilized, they may miss out on opportunities for higher returns. This part of their conversation sheds light on the critical concept of “opportunity cost” and how equity can be leveraged to maximize an investor’s portfolio performance.

Understanding Opportunity Cost in Real Estate

Opportunity cost in real estate refers to the potential gains that investors forego when their equity is tied up in one property instead of being deployed elsewhere for higher returns. For example, if an investor has significant equity in a property that yields a 5% return but could potentially achieve an 8% return by reallocating that equity to a different investment, the 3% difference represents the opportunity cost.

Strategies for Reinvesting Equity

  • Equity Harvesting through Refinancing:

    One common method to free up equity is through cash-out refinancing. This involves refinancing the property at its current value and pulling out the excess equity as cash, which can then be reinvested into higher-yielding opportunities. This strategy can be particularly powerful in a rising market where property values have increased significantly, allowing investors to access substantial amounts of previously untapped equity.

  • 1031 Exchanges:

    For investors looking to reinvest in another property while deferring capital gains taxes, a 1031 exchange offers a valuable tool. By selling an existing property and reinvesting the proceeds into a new property, investors can keep their equity working for them continuously, often scaling up their investments or moving into higher-quality assets.

  • Diversifying Investment Portfolios:

    Reinvesting equity does not necessarily mean buying more real estate. Investors might consider diversifying into other types of investments, such as mutual funds, stocks, or bonds, depending on their individual risk tolerance and investment goals. This can provide a balanced portfolio that mitigates risk across different asset classes.

Considerations When Reinvesting Equity

  • Market Conditions:

    The decision to reinvest equity should take into account current market conditions. For instance, if real estate prices are at an all-time high, it might make sense to pull equity out and wait for a more favorable buying opportunity.

  • Investment Goals:

    Each investor’s goals are unique. Some may seek to maximize cash flow, while others might prioritize capital appreciation. Understanding these goals is crucial in determining the best way to utilize extracted equity.

  • Risk Assessment:

    Reinvesting equity increases exposure and, potentially, risk. It’s important for investors to assess their risk tolerance and ensure that the new investments align with their capacity to manage potential downsides.

Impact of Efficient Equity Utilization

By efficiently utilizing the equity from existing investments, real estate investors can significantly enhance their portfolio’s growth potential. This proactive approach encourages continual assessment and adjustment of investments to align with changing market conditions and personal financial goals. Chris Lopez’s emphasis on understanding and applying the principles of return on equity and opportunity cost thus serves as a pivotal strategy for investors aiming to optimize their investment outcomes and achieve sustained growth in their real estate endeavors.

Conclusion

The episode concluded with a powerful call to action for real estate investors to embrace a more dynamic and financially savvy approach to managing their portfolios. By focusing on return on equity and recognizing the importance of opportunity cost, investors can not only safeguard their investments but also enhance their potential for higher returns.

Are you interested in refining your real estate tax strategy? Contact us today. Continue reading for this episode’s transcript.

Transcript

Chris Lopez’s Background

Brandon: Chris, welcome to the show.

Chris: Hey Brandon, I am glad to be here and excited to talk some shop.

Brandon: Yeah, I am backfilling for my partner Thomas Castelli today, and Ryan had the stomach bug unfortunately right before we pressed record, so I’m running solo here. Welcome everybody, or I guess welcome me back to the show. But Chris, really excited to hear your story. I know we’ve got a really interesting topic today on return on equity. We were kind of chatting beforehand, and I want to rehash that conversation because I think it’s funny how when you talk to people about return on equity, you kind of get poo-pooed for some reason. I do at least; I don’t know why, but I definitely want to touch on that. Before we do, tell us a little about yourself, your background, and where you’re at today.

Chris: Yeah, so to give everyone context out there, I’m in my 40s, I got a great family, three young kids, but it was just over 20 years ago I got bit by the bug to be an entrepreneur and get into real estate investing. This is like early 2000s. I wanted to get into real estate but wasn’t able to at the time and ended up really focusing on online marketing. Built a great business, had a great lifestyle with monthly cash flow, and then spent a couple of years day trading the stock market. Well, I learned two things from that: I’m not good at day trading, I’m not good at stocks—I’m an index fund guy now.

Real Estate and Infinite Returns

Brandon: Is anybody good at day trading?

Chris: The only people that are good at day trading are people that sell courses about day trading.

Brandon: Yes, that is where a lot of that money is made.

Chris: But I realized so much money is made in real estate. The other lesson I learned as a young entrepreneur was I “escaped the rat race” based on Robert Kiyosaki’s definition where I had more money coming in passively than expenses. However, it was business income, not continuity income. If you don’t work that business, those start going off every single year. I was like, “Oh, my income is slowing down. I need to find a way to make income but have it keep growing while I’m hands-off.”

As I looked back at things, I realized real estate was the best asset class to go into. If you put active time into it, you can outperform the market, unlike the stock market. Second, you have a very high probability of earning a really good income and building a good net worth and portfolio. So I pivoted towards real estate investing.

Chris’s First Deal

I bought my very first deal, a two-bedroom, two-bath condo in 2011, pretty much the bottom of the market where I was in Reno, Nevada. I bought this condo for $67,000. Before the crash, it was trading in the 230s, 240s. I bought this property with 0% down from a private note, 15-year mortgage, 5% interest rate. I was so excited that I bought a great asset on sale but put 0% down. Textbook creative financing, no money out of pocket, and a long-term deal. It was just a private individual that wanted some safe money. My attitude was, “Hey, I’m going to buy this place, pay it off, and I will never sell it.” Why would I? I bought it for so low with no money down.

After I got in there, a couple of years as I started getting more into real estate, I realized I needed more properties. Even if I paid off that property, it’d be making me like $8,000-$9,000 a year with no mortgage—that’d be the NOI on there. I realized I needed another 20 of these condos to hit the income goal I wanted. But I didn’t have $800,000 to buy more of these properties. Doing 0% down is tough to do consistently. I started having this internal debate: I was getting an infinite return on this property because I put zero down. My first payment was 30 days post-closing for my first mortgage payment and my $300 monthly HOA. Infinite return, but sitting on $200,000 in equity. I was making a 9% or 10% return on equity. That was the shift for me.

Challenges with Return on Equity

Brandon: Yeah, we were talking before we pressed record. I posted about this one time on Twitter, or X, and if you’ve not experienced the Twitter mob coming after you, it is something you should try to do at least once in your life. It’s fascinating. I posted this one time on Twitter, and I had so many people tell me that’s a dumb way to look at the return on your investment.

I think there’s a difference between what I originally invested when I’m pre-acquisition and looking at, “I’m going to make this investment, get paid back within this timeframe, and then it’s just going to be an infinite return, and I’ve got my cash back and can redeploy it.” In theory, yeah, 100%, that’s amazing and a great way to look at it. But when you’re three, four, five, six, seven years down the line, that original spreadsheet you built might still be accurate, but it’s not really real. It’s different. Now you’ve got an asset.

Return on Equity Adversion

Chris: Yeah, outdated or even if you projected it perfectly correctly, it’s different. Now I think of it as I have equity parked in this asset that is generating an NOI on an annual basis. That’s where I posted about return on equity on Twitter and got torn up. Why do you think people are so adverse to this idea of return on equity? Maybe we’ve framed it wrong, but I don’t think there’s anything wrong with saying, “Yeah, I’ve got 200K sitting in this property generating $5,000 or $10,000 in cash flow. I’ve already extracted all my money back plus some, so technically I crushed it on this investment.

But the reality is still 200K in equity now generating 10K in cash flow. The question is, is that good? Could I redeploy the 200K of equity somewhere else?” That’s the question we should be asking. A lot of people don’t—they just look at it as, “I’ve got an infinite return on my original capital deployed,” which is an odd way of looking at it, I guess.

The Debate of Return on Equity

Chris: Yeah, it’s interesting because a lot of times you get very emotional reactions. From traditional finance people, they have their “Twitter mob” you got on there. I’ve always had this goal of finding a different term. Return on equity doesn’t compare to a stock return on equity, but I haven’t gotten there yet. From a real estate investor perspective, I think it bumps up against a very powerful paradigm wall. A lot of us are taught to buy properties and pay them off—that’s the mantra that many books talk about.

That’s essentially how Monopoly works: you keep buying properties, go around the board until you win or lose. It’s this huge paradigm shift. I went through a year or so of wrangling with myself, like, “Well, I’m making an infinite return, but I have this opportunity cost. I can extract this money and yes, I will have to pay 7% or 8% in transaction costs. Then I can extract $185,000 out of that condo and reuse it. I should measure how hard that’s working for me and compare the opportunity cost.”

The Opinion Progression

I went through my progressions of building a bunch of spreadsheets, talking to people to say, “Hey, shoot holes in this. How am I crazy?” Every time I went through the math, I saw that keeping it as is was not a bad move, but I didn’t have enough capital or creative deal-making ways to acquire more properties to hit my long-term cash flow goal. The best way was to pull the capital out and reinvest. I debated it myself, talked with others, and people have a hard time letting go of a good-performing asset. It’s an emotional decision. It goes against the Gary Keller books and other books that talk about buying properties and paying them off.

The Cash Flow Mindset

Brandon: It came up in the BiggerPockets forums. Love BiggerPockets, love that whole ecosystem. We get a lot of our clients from BiggerPockets, so nothing against them at all. I still support them with content. But the big influencers on BiggerPockets over the past 10 years have all been about cash flow. You buy for cash flow. We started with the 2% rule, then as things got more expensive, it was the 1% rule. Then it was like, do the percentage rules even make sense as things just got more and more expensive?

There is this concept of, “I used my original 150K, deployed it, and was able to pull it back out of the property using the BRRR method. Now I’ve got this cash flow that I didn’t pay for because I was able to pull my equity back out of the property.” But I think that is flawed thinking. You mentioned opportunity costs, which is key here. I think it’s flawed thinking like, “I’ve got this free asset.” You don’t give yourself any credit for the value you created. You’ve put 100K in, pulled 100K back out, and now you’ve got this free cash flow stream, but it’s not free. You added so much equity that you were able to extract the 100K again, but you still have equity in the property that you’re not giving yourself any credit for.

What I’ve seen over the past few years, and this is what really made me start thinking about return on equity, is if you owned real estate in 2020, 2021, 2022, you did very well in most parts of the country.

Brandon’s Experience

This is when I really started thinking about it because I have a property in Hickory, North Carolina, a tertiary market nobody’s ever heard of. It used to be the furniture capital of the world until everything was shipped out to China. It’s where I grew up, so I know the neighborhoods well. I bought a three-unit property in 2015 for $91,000. Today it’s worth 300K. I never thought I would have that appreciation in Hickory, North Carolina. I bought it for cash flow originally, and that thing cash flows like a beast. It cash flows $1,200 a month on a 91K acquisition. Amazing, right? I always thought I was kicking butt. Then 2021, 2022 happened. I call my broker up and ask how much we can sell this thing for. 300K. My debt on that property now is 50K. I’ve got 250K generating 12K a year.

The question becomes, is that good? I don’t think that’s good, especially when I could sell, pay the transaction costs, and invest in T-bills and earn roughly the same with no risk and no pain and no management issues. I think when you just look at the cash flow piece on your original investment, you miss all of that analysis. You miss the ongoing portfolio maintenance that you should really be doing. That’s what originated my original post on Twitter, and then I got blown up for it. I look at it as, you have cash, and what does that cash generate for you? Are there other alternative means to generate similar returns with less risk and less hassle?

Opportunity Costs and Paradigm Shifts

Chris: That’s where the opportunity cost comes in. The other thing you mentioned, I went through this and many of my real estate clients go through it as well. You said you bought it for $91,000, probably at a 10% cap rate. Now it’s a six or 7% cap rate. Investors get stuck in the past. We all remember what we bought the deal for, but that was 8, 9, 10 years ago. I tell my clients, you have to factor in today’s numbers. Ten years ago, I had a six-pack; now I don’t. Things change. The market changes, and so do the opportunities.

When you bring everything to current value and numbers, it’s like, “Okay, now I own this place. Here are the current numbers.” Do a SWOT analysis and see if it still makes sense based on today’s numbers, your current situation, and other opportunities. It’s a bad idea to stay stuck on the numbers you bought it for and focus on return on investment versus return on equity. All those investment dollars eventually return to equity dollars. Equity has an opportunity cost; it’s your real estate piggy bank. You can pull that money out; therefore, it’s real.

Return on Hassle (ROH)

Brandon: While you were talking, I was thinking about ROH, return on hassle. I think that has to be part of this conversation too. Yeah, my return on equity is 12-15% a year, but how much time do I have to spend managing this investment? You’ve got to weigh that as well. When do you think return on equity doesn’t play a big role, or should it always play a big role? Should this be something we look at once a year?

Chris: The way I approach it, I’ve gone through many iterations and had great mentors along the way. I piece together what I’ve learned from smarter and wealthier people than me. What I do now is an annual portfolio check. I review all my properties, update the operating expenses, and look at return on equity once I’m past year one. My investment no longer matters; I have to look at return on equity because that’s what I have in there.

Some of my rules of thumb are when my return on equity gets close to historic stock market returns, 8-10%, it raises a yellow flag. If my estimated appreciation, cash flow, benefits, and tax benefits equal about a 10% annual return on the stock market, it makes me think twice. If I can get that same return with no headache, no personal guarantees, no tenants, no toilets, I would much rather have that.

Risk-Reward Ratio

I can ride the stock market coast. Once things get close to 10%, it really makes me reevaluate the headache and liability. We can get sued; we can have huge six-figure claims against our properties. There is real risk, which is why I want a higher return than the stock market for a good risk-reward ratio. Historically, I would take money out, cash out refi, buy another property, or sell and trade up. That worked well when interest rates were low. Now it’s tougher, but there are opportunities. It’s always worthwhile looking at that exercise.

Calculating Return on Equity (ROE)

Brandon: So 10% on equity. How do you calculate that? You mentioned cash flow, tax benefits, and appreciation. Can you step us through how you get to that percentage?

Chris: There’s no one definition of return on equity. I try to capture all four ways to make money in real estate. One of my pet peeves is people comparing cash flow returns in real estate to total returns in stocks. To keep it simple, the four ways are appreciation, cash flow, debt paydown, and depreciation tax benefits. When I calculate, I take the property’s equity today and estimate the next 12 months’ cash flow, appreciation, debt paydown, and tax benefits. The tax benefits and debt paydown are easy to figure out. I take all four and divide by equity. That’s a gross snapshot of the returns. When all four ways total 8-10%, it tells me to reevaluate the opportunity cost in real estate.

Brandon: How do you handle capex? Say the HVAC goes out and kills your cash flow. Does that just lower your ROE for the year?

Handling CapEx and Big Expenses

Chris: I generally try to amortize it based on the market and property age. I ballpark 5-15% for routine maintenance and capex. Of course, we have lumpy years. If the HVAC and water heater go out, that’s $8,000, and no cash flow that year. Hopefully, it evens out. Another rule is to reevaluate the property before a big expense, refinance, or re-rent. I ask myself and my clients, “Would I buy this property again today knowing what I know now?”

It elicits a different set of emotions and ways of viewing the property. For example, I had a pipe freeze and burst, and tenants left their lease six months early, giving it a light trashing. It cost almost $40,000 to remodel. I put that into the property and asked, “How much more cash will that generate?” The numbers were okay but not great. I sold the property and almost doubled my money. It’s important to reevaluate before a big expense or lease renewal, asking if you’d buy the property again today.

Brandon: That’s smart because I struggle with that. We go for two, three years with no issues, then the HVAC goes out, the roof needs replacing, or there’s flooding. That can wipe your cash flow out for 12-18 months. I’m glad you went into that because I’ve wondered that myself. Looking across your portfolio, the properties that produce the highest return on equity, why do you think that is? How do you get your lower-performing ROEs up to where you want them to be?

Improving ROE

Chris: Great questions. Higher ROE usually correlates with higher LTV and less cash flow. It’s hard to have both growth and cash flow. Real estate is one of the few assets where you can get amazing leverage. Higher leverage means higher return. If a property generates $25,000 next year, and I have $100,000 in equity, that’s a 25% return on equity. If I pay off the property, that return drops. To increase ROE, we used to do cash-out refis or get HELOCs when interest rates were low. Now, with higher rates, it’s tougher. If I refinance at 7% on a 5% cap rate property, I’ll be negative cash flowing. At that point, I might leave it as is or sell and buy a better-performing property.

Brandon: That makes sense. I’m glad you went into the financial engineering aspect because I think operators not thinking about that would say we need to force appreciation through value-add improvements. But you focused on debt and leverage. It’s about capital management and debt. Is there ever a time when return on equity wouldn’t matter?

Difference in Priority and Return on Equity

Chris: For me, no, because I can’t unsee it now. But I’ve met investors in their 70s and 80s who just don’t care. They’ve got $10 million worth of real estate and want cash flow, not hassle. They might not manage for 8-10% stock market returns but look for 3-5% in T-bills or munis. I hope to still be active like Warren Buffett in my 90s, enjoying the game. But if you care about a 5% return, sell some properties or do 1031s into triple net properties. Rebalance your portfolio for simplicity and lower hassle.

Brandon: You mentioned return on hassle. It becomes more important as you get older. If you need X dollars, weigh the hassle against the return. If it doesn’t align, either increase the return or reduce the hassle. We’ll get you back in 50 years to check in.

Chris: Hopefully, we’re all rocking and rolling in 50 years. My college degree allows me to sit for the Certified Financial Planning exam. I never did because I found the advice simple and boring. But in real estate investing, I apply financial planning principles. I encourage everyone to analyze their real estate through a financial lens. Traditional financial advisors might not be great for rental properties, but you can develop the skill yourself. I eventually turned my spreadsheets and consults into an online application called Property Llama. It’s an online tool to track investments and analyze return on equity.

Property Llama: Analyzing Your Portfolio

Brandon: Tell us more about Property Llama and how it works.

Chris: Sure, I can do a quick demo. It’s like a spreadsheet but easier to use. You go to propertyllama.com, enter your properties, and get today’s values. It shows a global overview of your portfolio. For example, a client’s portfolio worth close to $2 million, with over a million dollars in equity, cash flowing $220,000 a year, at 43% LTV, and a 3.7% cap rate. It’s a low cap rate, low LTV portfolio, low cash flow due to Denver’s appreciation. We show the numbers and ask clients how they feel about it. If their return on equity is low, we discuss options like cash-out refis, selling, or reinvesting. It’s about understanding the current performance and aligning it with goals.

Brandon: That’s really cool. This is called Property Llama, and it’s a great tool for analyzing return on equity. If you’re listening, check us out on YouTube to see the demo. Any last words of advice on return on equity?

Final Thoughts on Return on Equity

Chris: Calculate your real return on equity. Use software, spreadsheets, or get a CMA. Understand your equity and how your properties are performing. Do a SWOT analysis and align it with your goals. Rebalance as needed. Don’t be lazy; do it this weekend. If you’re surprised by low returns, start planning your next steps. Homework is to run this analysis and make informed decisions.

Brandon: Chris, thank you so much for coming on the show. If people want to reach out, learn more about your story, or Property Llama, where can they contact you?

Chris: Go to propertyllama.com. The software is free, and we offer a free portfolio analysis. Myself or a team member will review your portfolio and give our insights. I love looking at deals and helping people achieve their goals.

Brandon: Awesome. Thank you, Chris, for coming on the show. It’s been a pleasure.