1. Cash Flow
If you’re holding real estate as an investment, you will have tenants. Each month they will pay you rent. Let’s say that you own a rental house and get $1,500 per month in rent. Over a year, that is $18,000 in income.
Subtract out your expenses, which include things like your taxes, insurance, property management, vacancies, turnover expense, allowances for repairs, etc. (this doesn’t include your debt).
For purposes of this example, let’s assume that your monthly average expenses are $150 a month. Your cash flow on operations then would be $1,350 per month. That is what is known as your Net Operating Income (NOI).
Out of your NOI, you pay your debt service. Let’s assume for this example that you have a $250,000 property with a $200,000 loan at a rate of 4%. That’s a debt payment of about $955 a month.
So, that would be rental income of $1,500 minus $150 in operating expenses minus $955 in debt service, equaling $395 in cash flow. That times 12 equals $4740 in cash flow per year. That $4740 divided by your $50,000 equity stake would equal a 9.5% cash-on-cash return.
Moving on to the next profit center…
2. Amortization
Amortization is the paying down of your debt service. Each month, when you make your debt payment (or rather your tenant makes your debt payment) out of your NOI, a portion of that goes towards paying down your principle on the loan.
Because your tenant is paying rent, and that rent is covering the debt payment, the principle pay down included in that debt payment is actually profit for you.
With our $200,000 loan from above, and in the first year of the loan, you’d be paying $7,938 in interest and $3,523 in principle. As the loan matures, the interest amount goes down each month and the principle amount goes up. But we’ll use these numbers for now.
That $3,523 is profit to you. It’s true equity in your property.
If you add this $3,523 to the $4,740 in operating income, you now have $8,263 in income for the year, a 16.5% return on your $50,000 invested in this property. Plus, your interest payment is often tax-deductible, but check with your tax advisor to be sure for your specific case.
Already, you’re crushing average stock market returns and there are still two more profit centers to look at.
3. Depreciation
The basic concept of depreciation is that your investment property is made up of two parts, the land and the improvements on the land, i.e., your house.
Appraisers will assign percentage values to your property based on these two parts. For this example, 20% of the value is the land and 80% of the value is the improvement. Over time, the house will deteriorate, the government (check with your tax advisor to make sure you qualify) lets you write down that 80% value over a certain number of years depending on the type of real estate. For residential homes, it’s 27.5 years.
So, your $250,000 property has $200,000 that can be depreciated over 27.5 years, which equals $7,273 per year. This amount is listed as a loss of income, even though no money is coming out of your pocket.
Let’s assume you are in a 30% tax bracket. That means you’re applying 30% to your depreciation of $7,273, nets you $2,182 in annual tax savings.
Adding that $2,182 to our existing income of $8,263, we now have $10,445, a 20.9% return on your cash of $50,000.
4. Appreciation
This is the tip of the iceberg. Most of my clients don’t invest in real estate for appreciation. Most are cash flow investors. But most do appreciate the appreciation.
Let’s assume you have a conservative appreciation rate of 2.5% a year on average for you $250,000 property. That equals $6,250 per year in value added to your house.
Add that to your $10,445 and you have $16,695. That’s a 33% return on your $50,000 capital investment in your $250,000 property. And that blows investing in the stock market for the long-term out of the water.
Increase Your Real Estate IQ
These types of returns are achievable by anyone, as long as they understand how to find the right deal and run the numbers correctly. And it takes a high financial IQ.