Real Estate Equity Build Up Rate

There are many calculations in real estate investing and it can be very confusing to try to remember them all.  Its good to understand how all of them work and decide which ones you want to use.  Equity Build Up Rate is one of those calculations that you want to understand so you can decide if you want to use it for your next rental property.  

Equity build up rate often gets thrown to the side in favor of cash on cash return, rental yield, or for those with a rental property calculator, return on investment or internal rate of return.  But for those who understand equity build up rate, it is well known that it should be used side by side with year 1 cash on cash return.  

To understand why that is, here is an explanation of how equity build up rate is calculated.  Equity build up rate is calculated by dividing mortgage principal paid in year 1 by initial cash invested in the property in year 1.  The reason that this should be calculated is that principal, although a required part of a mortgage payment, is not considered an expense.  This is obviously because it gets credited to the equity of your real estate investment.  Since this is the case, it should be factored into a year 1 rate of return calculation.  

Mortgage Principal Paid in Year 1

To calculate mortgage principal paid in year one, look to a mortgage calculator to help make this calculation for you.  Any number of mortgage calculators should break your payments out into principal and interest via an amortization schedule or table.  If not, a fixed interest mortgage calculation can be built in excel fairly easily for finance minded individuals.  

Initial Cash Invested in Year 1

To calculate initial cash invested in year 1, this equals the down payment on the property plus any other cash investments in year 1.  This should only include one time cash expenses such as renovation expenses, brokerage fees, or appraisal fees.  This should not include year to year operating expenses such as property taxes or property insurance.  

Here is a formula for how equity build up rate is calculated.

Equity Build Up Rate = Year 1 Mortgage Principal Paid / Year 1 Initial Cash Invested 

 

Pairing with Year 1 Cash on Cash Return

Equity build up rate pairs perfectly with cash on cash return because they both calculate a source of returns in year 1.  Cash on cash return calculates a return on cash flow while equity build up rate calculates a return on principal payments.  When you add these two together, a total return in year 1 is the result.  

These also pair well together because they are both only meant to be year 1 calculations and are not to be used in subsequent years.  The reason is that they don't factor in the time value of money in the following years.  

Conclusion

Equity build up rate for real estate investments is an important calculation because it allows a total return including principal payments to be calculated in year 1.  Be sure to get accurate numbers when determining mortgage principal payments and initial cash invested in year 1 and consider pairing this calculation with year 1 cash on cash return.  Ultimately, equity build up rate and cash on cash returns are one metric that should be used to compare mutually exclusive or competing real estate investments.