Let me begin this discussion by stating that owners of income-producing property have two basic financial objectives: maximize their property’s cash flow and future appreciation. Of course, there are other financial objectives, but these two are usually high on anyone’s list.

Many investors are content when their building is performing well and there is good cash flow. An important question that is often not asked by those same investors is, “What is the yield on my property’s current equity?” Cash flow and yield are two different performance measurements, with different calculations. We feel that investors should know the yield on their property’s current equity in order to make informed decisions regarding investment alternatives in the market.

Most people understand the concept of yield on current equity when it comes to money in the bank. For example, let’s say you are planning to deposit $100,000 in a Certificate of Deposit. You would shop around to see which institution gives the best rate (yield) on the money (equity). If Bank #1 was offering 3% and Bank #2 was offering 3.5%, you would buy the CD from Bank #2. You would receive 3.5% yield on your funds (equity). The cash flow would be $3,500 per year. If you deposited $1,000,000, the cash flow would be $35,000 and the yield would still be 3.5%. The yield remains the same, but the cash flow changes when the amount deposited (equity) changes.

Now let’s shift to that investment property that you own in Santa Monica. Do you know what your yield is based in the property’s current equity? You certainly know what your cash flow is because you collect the rents, pay the bills, and what’s left is yours (the cash flow). We find that many investors still calculate the yield on their property based on the original down payment, rather than the current equity. Unlike the Certificate of Deposit example above, we do not directly control the equity of a property in the same manner as the deposit (equity) into the CD. That is because the equity of a property fluctuates (grows or declines) based on market factors, good or bad management, income growth or decline, and the principal reduction of making loan payments.

Let’s look at an example of what we mean by a property’s yield on current equity. Suppose you bought a $400,000 property for a $100,000 down payment and a $300,000 loan. At the acquisition time your cash flow (total income less all the expenses and debt service) is, say, $6,000. Your yield on equity (often called Cash-on-Cash return) is 6%. The math is $6,000 divided by the $100,000 down payment. Now let’s say that the property has tripled in value and is now worth $1,200,000, and the loan is paid down to $150,000. Your current equity is now $1,050,000 ($1,200,000 - $150,000). Through good management, you have raised the cash flow over fourfold to $25,000. That’s a 25% yield on the original equity. That is great…right? Life is good! Why would you ever consider selling?

Using the new numbers, let’s calculate the yield on current equity. By dividing the $25,000 by the current equity of $1,050,000, the result is 2.4%. That is your true yield on current equity, not the 25% cited above or even the 6% yield you originally achieved. What happened? Well, the property’s equity grew faster and greater, on a relative basis, than the cash flow. The nice 6% return (yield) that you once had has now shrunk. You did not necessarily do anything wrong. Under optimum circumstances, you can only raise rents so much for existing tenants, and market rents generally do not keep up with the kind of significant price appreciation we have seen in the last five years. Of course, you are getting more money (cash flow), but your money (equity) is not working as hard and giving you the yield it should and that you deserve. In fact, you were probably more diligent in checking the yield and managing your choices when you were shopping for a Certificate of Deposit that we discussed above. If your $1,050,000 was earning the 6% yield you were receiving on your original equity, your current cash flow would be $63,000. That is a $38,000 difference! That’s tuition at a private college for a year.

What should you do? Well, you have two alternatives:

•Ignore this article, think of it as “fancy numbers,” and do nothing. Thus, by doing so, you decide to accept a potentially low yield on your current equity.

•Contact a real estate professional who is an expert in your market and let them assist you in determining the true yield on the current equity of your property. Next, let them explain some alternatives in the market that would best serve your interests.

In conclusion, keep all of your current equity working hard for you. There is a BIG difference.