Return on Equity: When to Refinance or Sell a Rental Property
Book: Real Estate by the Numbers: A Complete Reference Guide to Deal Analysis Authors: J Scott and Dave Meyer Chapter: 37
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Most investors track cash flow. Many track cash-on-cash return. Fewer track return on equity, or ROE. That’s a shame, because ROE is one of the most useful metrics for managing a real estate portfolio over time.
Chapter 37 covers what ROE is, why it matters, and what to do when it starts to drop.
What Is Return on Equity?
Return on equity measures how much annual cash flow each dollar of your equity investment is generating.
Formula:
ROE = Cash flow / Equity value
Two inputs:
- Cash flow: The annual income the property produces after expenses and debt service.
- Equity value: How much your ownership stake is worth. Property value minus any liabilities (usually the loan balance).
Equity value = Property value - Liabilities
Example: Stephen buys a $400,000 property. He puts 20 percent down ($80,000) and borrows $320,000. The property generates $8,000 per year in cash flow.
At the time of purchase:
- Equity value: $400,000 - $320,000 = $80,000
- ROE: $8,000 / $80,000 = 10%
That means for every dollar Stephen has invested in this deal, he’s earning 10 cents per year in cash flow. Or, put another way, his equity is generating a 10 percent annual return.
Why ROE Changes Over Time
Here’s the thing that makes ROE so important: it doesn’t stay constant. Both inputs change.
Cash flow can change when rents rise (good) or expenses climb faster than income (less good). If you manage the property well, cash flow should trend up over time.
Equity value changes in two ways:
Appreciation: The property rises in value. If a $400,000 property is now worth $450,000, the equity has grown by $50,000 (assuming the loan balance is the same).
Amortization: Each mortgage payment pays down a little principal. That principal reduction is equity building quietly in the background.
The problem is that equity can grow faster than cash flow. When that happens, ROE drops, even though the actual dollar returns have improved.
Let’s continue with Stephen’s example. Five years in:
- Property value has risen to $450,000 (appreciation)
- Loan balance is now $290,000 (amortization)
- Cash flow has grown to $10,000 per year (good management)
- Equity value: $450,000 - $290,000 = $160,000
- ROE: $10,000 / $160,000 = 6.25%
Stephen’s cash flow grew 25 percent, which is great. But his equity doubled. Each dollar of equity is now producing less cash flow than it was before. ROE dropped from 10% to about 6%.
Is this bad? Not exactly. Stephen is clearly doing well, his equity doubled. But it raises an important question: is his money working as hard as it could be?
ROE vs. Cash-on-Cash Return
The book draws a useful distinction here.
Cash-on-cash return (COC) is great at purchase time. It measures how much cash flow you’re getting relative to the cash you put in upfront (down payment, closing costs, rehab). It’s a good snapshot of first-year returns.
ROE is better for evaluating long-term portfolio performance. Here’s why.
After five years, Stephen’s COC would have actually gone up, because his cash invested hasn’t changed but his cash flow has. But COC ignores the $160,000 in equity he now has. If he sold the property, he’d have $160,000 to work with, not just the $88,000 he put in originally.
ROE accounts for that. It asks: given everything you have tied up in this deal, including built-up equity, how efficiently is it generating cash flow right now?
That’s the right question to ask when managing a portfolio over time.
When ROE Drops: Two Options
When ROE starts declining, there are two main strategies to consider.
Option 1: Sell
Selling frees up the equity and lets you redeploy it into deals with better returns.
If Stephen can find a deal where $160,000 would generate $17,600 per year in cash flow (ROE of 11%), that’s better than the 6% he’s getting now on the current property.
Even better: he could split his equity across two deals. Diversifying into two properties might achieve similar or better total ROE, while also spreading risk.
The drawbacks of selling: commissions, closing costs, potential tax implications, and you lose a property you may have worked hard to find. Selling isn’t always the right move, especially if the market is down or the property has strong long-term appreciation potential.
Option 2: Refinance
If selling doesn’t make sense, a refinance can reset the ROE without giving up the property.
There are two kinds of refinances:
Rate-and-term refinance: You swap your existing loan for a new one with a different rate or term, without pulling out any cash. This can increase monthly cash flow if you lock in a lower interest rate. But it doesn’t change your equity and isn’t a great way to improve ROE.
Cash-out refinance: This is the powerful one for ROE management. You replace your existing loan with a larger loan, and the difference comes out as cash.
Here’s how it works for Stephen.
After five years, his property is worth $450,000 and he has $160,000 in equity. The bank will lend up to 80% LTV ($450,000 × 80% = $360,000). The new loan is $360,000. His old loan balance was $290,000.
The difference: $360,000 - $290,000 = $70,000 cash out.
After the cash-out refinance:
- New loan balance: $360,000
- Required equity retained: $90,000 (20% of $450,000)
- Cash in hand: $70,000
- New cash flow (slightly reduced due to higher mortgage): $9,000/year
- New ROE: $9,000 / $90,000 = 10%
His ROE is back to where it was at purchase. He’s also got $70,000 in cash to put to work in another deal.
The trade-offs:
- His new mortgage is bigger, so monthly payments are higher and cash flow is a bit lower than it was before the refinance.
- He’s resetting the amortization clock, which means the early payments are mostly interest again.
- If interest rates have risen since the original purchase, the new rate will be higher, making those downsides worse.
Despite these trade-offs, a cash-out refinance is often the right call for investors who want to build a portfolio without selling their existing holdings.
The BRRRR Connection
The book points out that cash-out refinancing is one of the four R’s in the BRRRR strategy: Buy, Rehab, Rent, Refinance, Repeat.
In a BRRRR deal, you typically inject a lot of equity upfront. You buy a distressed property, pour money into a rehab, force up the value through improvements (forced appreciation), and then rent it out. At that point, you have a lot of equity and a somewhat lower ROE.
That’s where the cash-out refinance comes in. You pull the excess equity out, leaving just enough to keep the loan at 80% LTV. Then you take that cash and do it again on the next deal.
It’s a deliberate system for recycling equity.
The Annual ROE Review
The practical takeaway from this chapter: once a year, sit down and calculate ROE for every property you own.
Compare each property’s ROE to what you could get elsewhere, either by refinancing or by selling and redeploying capital. If a property’s ROE is significantly lower than what the market is offering, it may be time to act.
This doesn’t mean you should always be trading. Some properties have strategic value beyond current ROE: strong appreciation markets, hard-to-find assets, tax situations that favor holding. Context matters.
But without calculating ROE, you’re flying blind. You might be holding onto equity that could be generating twice the return somewhere else, and you wouldn’t even know it.
Dave, one of the book’s authors, shares a story here. His first deal was a fourplex in Denver, purchased in 2010 for $467,000. Over eight years, ROE dropped from 16 percent to about 10 percent as equity built up. He eventually sold, used a 1031 exchange to roll into a new rental, and put the remaining proceeds into a short-term rental. The two new deals averaged about 17 percent ROE and increased total cash flow by 35 percent.
He was sad to let go of the deal that started his investing career. But the math made the case.
The Simple Summary
ROE tells you how hard your equity is working for you.
It changes over time as appreciation and amortization build equity faster than cash flow grows. When ROE drops too far, you have two main choices: sell and redeploy, or do a cash-out refinance.
Each has costs and benefits. The right answer depends on the market, your tax situation, and your goals. But making that decision based on data is always better than making it based on inertia.
Calculate ROE. Review it every year. Act when the math calls for it.
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