Buy, (improve) and hold (BIH) OR BIH & SELL when your ROE is low?

Question

Again, just a newbie here, but I have been reading a lot and watching a lot of videos and I have flight of ideas with all of this info coming in... I am also producing a ton of ideas and questions and I am curious to know what others think!

My question is in regards to continue to own the property even when the ROE (return on equity). In the beginning both ROI and ROE are great, but then, as the principal gets paid, a lot of your wealth is tied down to a house... and when it's completely paid off, not only is your wealth anchored to the property, but now you have to pay a 1/3 of the cash flow in taxes (before it was all going to equity assuming you break even with rent/expenses+mortgage). So, not only the ROE is a lot less... but also you are now losing a 1/3 of what you were making before in taxes!!

On the other hand, I could refinance and extract the equity this way, but I really don't want to always owe a variable percentage on ALL my properties at ALL times to extract the equity on all of them, as the risk is bigger for me in case I have too many vacants and because nobody will lend me more money if I owe money on everything I have...

How have you guys solved this problem? Is there a way around it? Or you just have to deal with this and accept the low ROE and increase in taxes down the road?

Thanks for your help!

Hugo Castellanos · Answer

@Brent Coombs , thanks for your reply!

I think I didn't transmit my idea correctly. I am not boo-hooing about making more money and having to pay more tax. It would be like saying: "oh I don't want to make 200k a year in my job, I only want to make 100k so I pay less in taxes!"... that was truly not what I was saying...

What I am saying is, the more mature your mortgage gets, the more money you have tied down to a single property to get more or less the same yearly return out of that property. So your money is working less efficiently for you!

Let me use a real life example:

I just bought a townhouse for a $192k (value $200k) with $4k seller's assist for closing,  with 25% down and 3.5% interest @15 yrs. Taxes are $3200 and insurance $400 (HOA takes care of external) and HOA 130$/month.

Mortgage $1030 (P&I)

T&I             $300      ==

HOA           $130           \

Total Expenses  = $595

Managem.  $83             /

Vac%Rep   $165     ==

---------------------

Total        $1625

Rent         $1650 => Cash Flow = $25 (I even think this would be taxable, but I omitted that)

1st yr:

ROI: $7731 (Principal paid+cash flow)/$50k (down payment and omitted closing)= 15.462%

ROE: is the same as ROI in the first year as the down payment and equity should be the same in my opinion (unless you take into account the under market value at which you bought, the appreciation for 1 yr and don't omit closing costs, but it still doesn't change the concept; I omitted all of these things for simplicity).

2nd year

ROI: $7997/$50k = 15.994%

ROE: $7997/($7731(1st yr)+$7997(2nd yr)+$50k (down))= 12.167%

7th year

ROI: $9466/$50k = 18.932%

ROE: $9466/$107913 = 8.772%

12th year

ROI: $11216/$50k = 22.4332%

ROE: $11216/$162468 = 6.903%

16th year (1 yr after mortgage paid in full)

ROI: ($12660-$4304 due in income tax)/$50k = 16.712%

ROE: ($12660-$4304 due in income tax)/$200k = 4.178%

As per my example you can see that, once you are close to paying the mortgage off, your ROE is significantly lower than it was before. In the beginning 50-70k of equity were making me 7-10k a year, in the latter years 120k plus were making me about the same a year and when you pay it all off, now you have no mortgage to pay, so all the money after expenses is taxable as part of your income tax as far as I understand (I could be wrong), which in my case is already 34%.

So at the later years I am using a lot of money to make around 10k a year and after the mortgage is paid I am using all my equity to make even less, around 6k!! So this question is truly not about taxes, but about how to make my money work more and more efficiently for me. If I have to pay more taxes, so be it! as long as I am making more money, who cares?!

One idea I had was, always refinancing so you keep a debt of around 40-10% on each property, and then refinance again, so all your properties are working at max capacity and somewhat "controlled risk", as opposed to tying all that money down, for so little a year and then having to pay a third in taxes out of it.

I hope this helps illustrate what I am asking in a better way... I am sorry for the length, I don't know how else to express it, but with numbers.

Thanks!!

PD: also thanks for your advice... I own a house already, I am under agreement for a second one, and I have an offer put on a third one... I am getting full into this, doing the best I can with the best of my knowledge... I need to work on the deal part still, I think I am still not buying "under market enough"!

Brent Coombs · Answer

@Hugo Castellanos, you sound like you are a member of the I'd-better-not-earn-a-lot-in-case-I-have-to-pay-more-tax Club (which has a high membership cost, but that's FANTASTIC, because you will find a way to make it tax deductible)!

Not sure I agree with all your premise. After all, it's not YOU who are paying it down! Equity becomes a FREE asset! Paying tax on your free profit? Boo Hoo...

My advice: never do a deal, or never not do a deal, solely based on tax considerations!

Yes, have a good tax Agent, but go! Go find some great deals! Go!

Jeff B. · Answer

Most of us use the term Cash-On-Cash:  NOI / Down payment (your initial equity), we just don't see a lot on Return-On-Equity.  IMO, tracking that year over year for the declining mortgage adds little and end up spending more time with the numbers than managing the facility.  It's your time / effort, so go for it :)

Hugo Castellanos · Answer

Thank @Brent Coombs!

Excuse my ignorance... what is BRRRR? I know I read it somewhere... buy, rehab... rent and resell? or something like that

Is this what you do?

Thanks again!

Brent Coombs · Answer

@Hugo Castellanos, ah. Yes, I think you have reached the right conclusion: Low return on equity is WASTED equity! That's why many are choosing the "BRRRR" strategy.

First, I agree, you DO need to buy "under market enough"!

Congrats on your progress so far! All the best...

Buy, (improve) and hold (BIH) OR BIH & SELL when your ROE is low?

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