When I ask property owners what their return on equity is, I often get the wrong answer. Not surprisingly, many think that return on equity is the cash flow their building produces each year divided by the amount of cash they originally invested in the property. If you purchased an investment property recently, this would be true. However, if you have owned the same property for any length of time, it is likely not.

1031 EXCHANGE CASE STUDY: (Part I) 

Recently I represented the sale of a duplex in Cole Valley for $1,229,500. My client purchased the building in 1993 for $430,000. At that time he put down $86,000 and got a new loan for $344,000. When I first started talking to him about his property, he, like most others, thought his current return on equity was his current cash flow ($25,000) divided by his original $86,000 down-payment. He thought he was getting a 29% return on equity. Not true! At the time of sale, he had $900,000 in equity, not the original $86,000. Even though his annual cash flow after paying all expenses, including debt service was $25,000, his current return on equity was 2.8% ($25,000/$900,000). With his $900,000 in equity, I was able to assist my client with a 1031 Tax Deferred Exchange into a larger commercial property as part of a Tenant-in-Common (TIC) that produced a 7.5% average first year rate of return. He now has a more secure property without any management responsibilities and has increased his annual cash flow from $25,000 to $67,500, a 170% increase.

1031 EXCHANGE CASE STUDY: (Part II) TIC for TIC

Recently, I represented a client in the sale of a vacant three-unit building in Noe Valley. When the seller first came to me he was thinking about fixing up the units and renting them at the market rate. I immediately explained to him that in my opinion this might not be his best move. Firstly, he owned a 100% vacant building which he could now sell to a TIC partnership who could afford to pay him an extremely aggressive price for his property (reasons being: lower down-payment, pooled resources, better financing, owner-occupancy.) If he rented up his units he would no longer have this option. Secondly, and more importantly, even if he did rent up his units he probably could only get an average of $2,000 per unit or $72,000 gross income per year. After expenses and debt service we agreed that his total net income was approximately $30,000 per year which he, like most owners, felt wasn't bad considering what he put down originally for the property. His net income did not even take into consideration the time and energy he spent away from work managing and maintaining the property.

Here is where I was able to get his attention. His buildings was worth $1,310,000 ($513.21 per foot.) After paying off his loans, transfer tax and commissions, he was left with $1,100,000 in equity (a 2.7% return.) I was able to assist my client with a 1031 Tax Deferred Exchange into a Commercial TIC that produced an initial 7.5% year-one cash-on-cash return. This equated to a new net income of $82,500 per year. A 175% ($30k vs. $82.5K) return on equity increase! Additionally, he now no longer had the challenge of fixing up the up the units to get them ready to be rented and he no longer has the day to day responsibility of managing his building.

If you are interested in learning more about how to maximize your true equity, please contact me.