Anchorage Daily News

It is early in the new year and a good time for real estate investors to take a hard look at their properties to see if it is time for a change.

Many investors in Anchorage bought some time ago when property prices were much lower, and with the growth of the economy they have enjoyed strong cash flow and appreciation. But they might not realize their rate of return on equity has gone down significantly.

When there is debt on a property, the rate of return on equity goes down over time because equity increases proportionately faster than cash flow. Let's take this one step at a time.

Equity is the difference between what a property is worth and the mortgage balance. It is a common mistake to think the equity is the cash down payment. Equity increases from both the increase in value and the paying down of the mortgage balance.

Cash flow is the income after paying all the costs to operate the property and taxes, insurance, management, reserves and debt service, but not depreciation.

The rate of return on equity is figured by dividing the property's annual cash flow by its equity. For example, say an investor owns a property with $250,000 in equity and a cash flow of $30,223. The return on equity is 12 percent (30,223 divided by 250,000). This is often called cash-on-cash return.

It is the paying down of the mortgage balance that causes the equity to increase proportionately faster than cash flow. Cash flow and value increase proportionately the same, (assuming value is based on the same capitalization rate). But the decrease in the mortgage balance increases equity whether or not there is an increase in cash flow and value. If there is no debt there is no difference in the proportionate change in cash flow and equity.

Following are examples showing how the return on equity goes down in a real estate investment and what to do about it. This requires that I calculate operating numbers for two hypothetical buildings. I have included here only the essential numbers, but you can see my work sheet where these numbers were derived by going to this story on adn.com.

Let's say the building I mentioned above with $250,000 in equity was worth $1 million, and during the next 10 years its revenue and expenses increase at 3 percent annually. The property will then be worth $1,344,000. The equity will increase to $843,000, an increase of 337 percent.

At the same time the cash flow after debt service will increase from $30,223 to $64,615, an increase of 214 percent. That is less than the percentage increase in equity of 240 percent. Equity has increased proportionally more than the cash flow, and as a result the return on equity will have declined from 12 percent to 7.7 percent.

This problem is solved by reducing equity. Lower equity with the same cash flow will increase the return on equity. The equity can be reduced by either selling and buying a higher-priced property or refinancing with a larger loan to extract equity, which is used as down payment on an additional property.

Refinancing might work, but there can be problems. Refinancing might not be available or only be possible at unfavorable terms. There might be tax consequences. Or the existing loan might have provisions that prevent paying it off as part of a refinance.

Selling and buying another property is a lot of work and expense. It is natural to want to avoid all that and keep the current familiar property. But the opportunity cost of not selling and buying a larger property might be very high.

If the owner of the above property does nothing and just goes along for say another five years with the same 3 percent growth in rent and expenses, cash flow and equity will increase but the return on equity will fall to 6.7 percent. During the five years, total cash flow and increase in equity will total $1,593,000.

Instead the owner could sell the property and buy a larger replacement property. By using the sale proceeds from the first property as a down payment of 25 percent of the purchase price (assuming a tax deferred exchange and ignoring transaction costs), the owner will buy a $3.4 million property. With the same performance characteristics as the first property, the replacement property will have a 12 percent return on equity.

Five years later with the same assumptions as above, the return on equity will have fallen to 8.9 percent, but that still would be better than the 6.7 percent from the first property. Also during the five years, total cash flow and increased equity over the original building will total $2,246,000. This is $652,300 more than having done nothing -- good pay for going through the selling and buying process.

The above is only an example to demonstrate the effect that disproportionate growth in equity and cash flow has on a property's return on equity. Do your homework and you might find that a change could pay very well.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every fourth Friday.

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