You Are Valuing Your Rental Properties Wrong Here’s How To Fix It

I have been valuing my rental portfolio wrong for years. As someone who consistently researches and analyzes personal finance information, I was dumbfounded when I realized that I was valuing my rental properties wrong.  With my rental properties I pay attention to 2 numbers: total cash flow and cash on cash returns.

When I bought my first rental house I figured that the math was fairly straight forward:  If I have $30,000 of cash invested in this property and I net $6,000 per year, then I am making 20%.  If I keep earning that $6,000 every year, then I am always making a 20% return on my investment.  Of course the total dollars mattered as well, because the numbers for financial independence have nothing to do with percentage returns, that math is based on actual numbers.  If my total financial freedom number is $60,000, then a $6,000 net income property is 10% of my total goal; Build to 10 and I’m all set.

Why This Is Wrong:

This is wrong for 2 primary reasons:

The first reason is that as time goes on, we need to inflation adjust the numbers.  $6,000 of income in 2018 is not the same as $6,000 of income in 2024, and that is certainly not the same at $6,000 of income in 1995.  To have the same 20% cash on cash return from 2018 (Because I invested $30,000 of 2018 dollars), I would really need to be earning $7,600 today. What if I bought the property in 1995 and maintained the same $6,000 cash flow?  It would still be 20% cash on cash return, but not adjusted for inflation.  $6,000 in 1995 is the same as $12,550 today, so if the property was purchase with $30,000 in cash in 1995 to maintain an ACTUAL 20% cash on cash return, the property would need to earn $12,550 per year in net cash.

The second reason this is wrong is that it doesn’t take into account the increased value of the property.  I paid cash for this property in 2018 and initially made $6,000 in cash per year from it.  What happened to home values over the last 6 years?  They have increased greatly, especially on the lower end.  That $30,000 house could sell today for $90,000. It also doesn’t take into account mortgage pay down for properties with a loan.  Every month, especially on a 15 year mortgage,  hundreds of dollars are added to the equity of the property through the required principal portion of the loan payment.

For the purposes of today, I have 2 options:  Sell the property and take $90,000 in cash, or continue to rent it out.  If I were still earning $6,000 in cash, my return on equity would not be 20%, it would only be 6.7%. (6,000 / 90,000) That is not as good.  Even if I adjusted the rents up $200 a month to be at market rate today, then I would have $8,400 in cash flow, still only a 9.3% return on equity, way off from the desired 20% “return” I was chasing. Return on equity makes much more sense to use as a KPI (Key Performance Indicator) Than cash on cash returns.  Return on equity is measuring in current dollars and looking at the current situation, while cash on cash returns are looking across time historically.

If my goal is to maximize my cash return on equity, even on a paid off house, selling the property may make more sense than continuing to rent the property for this reason.  The real important piece of this is that we must pay attention to both the change in the value of our real estate and the change in our total equity position over time.

How This Changes The Plan:

My plan was always to hold these houses forever, get them all paid off, then live comfortably off of the rental income in early retirement.  That plan doesn’t fully make sense when I am holding properties that are giving me a sub 10% cash on equity return.

It makes far more sense for me to sell some of these properties and 1031 exchange them into properties that can yield a higher cash on equity return.  As an example, properties like the 7 unit I just picked up.  I paid $36,000 for this property and getting it stabilized will likely produce cash flow per year in excess of its purchase price.

A 1031 exchange is the tax process of selling a property and using the proceeds to invest in another property without paying capital gains taxes currently. Those capital gains get deferred and lumped into the next property. 1031 exchanges can be difficult to pull off.  100% of the proceeds must be reinvested AND the property the proceeds are being reinvested in must be identified within 45 days. Depending on the situation selling and paying the long term capital gains tax still may be preferable to holding.

Selling stabilized property and reinvesting in non stabilized property that will produce higher cash on equity returns and higher return on equity.

The Refinance Solution:

Another option for houses that have significant equity is to do a cash out refinance every so often and redeploy that equity.  This is much easier on higher dollar houses, because closing costs aren’t as high of a percentage of the property. This is also much easier when interest rates are stable and low.

As an example, I owe $21,000 on a house that is worth $110,000 and I have net income of $8,500 per year.  I am all in on the property $50,000.

• My return on my initial investment is 17% ($8,500 income / $50,000 investment)
• My cash on cash return is 34% ($8,500 income / $25,000 of cash investment, the other 25K is the debt)
• My cash on equity return is 9.5% ($8,500 income / $89,000 equity)

The bank will allow me to owe a maximum of $88,000 debt on the property, meaning that a cash out refinance will give me an additional $67,000.  I then need to pay roughly $5,000 in closing costs, meaning I will only receive $62,000 in cash, while effectively adding that $5,000 onto the new mortgage.

What’s more is that with the increase in rates I would be trading the $21,000 of debt at 3.75% for $88,000 of debt at 6.75%. I would also be trading a mortgage that is 6 years into a 15 year amortization for a new mortgage that will be starting a fresh 30 year amortization.  This is where the current market makes things very tricky for a real estate investor.  My interest expense would increase from $800 per year to $5,900 per year, so my net income would decrease from $8,500 to $3,400.

My new situation would then be:

I have $62,000 of cash that can be deployed, plus

• My cash on cash return is infinite because I pulled more cash out of the deal than I had invested originally. ($3,400 income / -$37,000 of cash investment, (62,000 loan proceeds – initial 25,000 cash)
• My cash on equity return is 15.4% ($3,400 income / $22,000 equity)

These numbers get far better with the next rent increase. We have kept rent on this property steady for the past 3 years.  The next increase will be $100/mo which would result in the cash on equity increasing from 15.4% to 20.1%.

I would need to deploy the $62,000 into assets that would generate at least $5,890 of net income per year to break even with the cash on equity return I was getting on this property. The advantage here is that I would retain the future upside in this property.

My Strategy Going Forward:

Refinance 2 properties with low debt and high equity: 

The two properties described above will be our targets for refinance.  Combined, we should end up with around $130,000 of cash from them.  Swapping from 15 year to 30 year loans also takes a lot of the sting out of having a larger amount of debt by reducing the total payment.

With the proceeds from this we plan to invest in new properties. Currently we have an eye on a commercial property that we could do a significant value add on.  Some of the proceeds will also go towards finishing stabilizing our 7 unit building, which does not have a loan on it.

Sell Under Performers:

I plan to sell my 3 lowest performing single family houses. I am not sure yet whether I will 1031 exchange them or if I will pay the taxes and temporarily pay down our heloc with the proceeds and wait for the right reinvestment opportunity. I don’t want to rush into buying something.

These 3 properties are all in Benton Harbor City. A big reason for their under performance is that the tax assessments of the city are very high, as well as the tax rate.  The high cost of property taxes makes it difficult for these properties to perform. These properties are all relatively low on cash flow, but they do have some decent equity in them.

I plan to sell these slowly. The first option to purchase has been extended to all the tenants and we plan to sell all 3 of them off over the next 18 months.  2025 is a high income year for us, so it would be better if I could push the sales into 2026 and MAYBE 1 of the sales into 2027.

How do you evaluate your rental properties? Do you look at return on equity?