I’ll be using an example property with the following purchase price and loan terms to illustrate the returns:
• $400,000 purchase price
• $100,000 down payment
• $300,000 loan (4.5% interest rate, 30 year amortization)
Now, let’s look at the returns:
1. Cash flow (cash on cash return): Cash flow is the income generated each month in excess of what is needed to pay for all property expenses and debt service (loan payment) on the property. Say you received $7,000 in cash flow over the course of the year on this property. Your cash on cash return would be: $7,000/$100,000 = 7%
2. Appreciation: Of course short-term fluctuations in property prices can vary, but historically, property values go up over time. Just think back to the house your parents might have owned when you were growing up. We look back and laugh at how low the prices seem in retrospect, right? Historic appreciation rates over many years, although regional, have been around 3-4% annually. It’s important to point out that your returns in this category are increased by using leverage (i.e. a mortgage) to purchase the property. The appreciation returns reflect appreciation on the entire $400,000 price of the property not just a percentage gain on the part you put down. In our example case, let’s say your $400,000 property appreciates by approximately $5,000 in one year. Using leverage as in the above example, the return from appreciation would look like this: $5,000/$100,000 = 5%. If you did NOT utilize a mortgage to pay for this property, your return from appreciation would look like this: $5,000/$400,000 = 1.25%.
3. Principal pay-down/Loan Amortization: When you purchase property using a loan, the rental income is utilized to not only pay the monthly expenses of the property but to also pay down the loan with the monthly mortgage payment. Essentially this means that the tenants are making the loan payments for you and paying off your property over time. Each payment increases your equity in the property independent of market conditions or even rent growth. Let’s take a look at what kind of return that generates. Based on the above example of a $300,000 loan at 4.5% interest amortized over 30 years, the loan payment would be $1,520/month. Of this $1,520 payment, approximately $400 is applied to the principal of the loan each month (over the first year; more is applied in subsequent years as the loan is paid down). Therefore, at the end of the first year, a total of $4,840 has been paid down on the loan principal through the monthly loan payments. Again, this is all paid by money coming from rental income BEFORE your cash flow return. The return from this part looks like this: $4,840/$100,000 = 4.84%
4. Tax Benefits: The tax benefits below, although technically things that create a benefit through tax reduction, are still worthy of considering when factoring in the “returns” from real estate ownership. The benefit from these areas will depend on your individual circumstances – tax bracket, type of property owned (and subsequent depreciation schedule), amount of loan and thus mortgage interest, etc. However, with an example tax bracket of 33% it is easy to see how these benefits can contribute to you keeping thousands of dollars more per year of your rental property income.
• Depreciation: Although depreciation is considered an expense for tax calculations, this is not an expense that comes out of your pocket each month. However, because of this expense your property might generate a “loss” on paper when tax time comes even though you have received monthly cash flow throughout the year. For this reason you may end up with no tax due on the cash flow you have received over the year. Try that with your W2 job!
• Mortgage Interest Deduction: Like depreciation, the mortgage interest deduction helps to reduce any amount of rental income that you are potentially taxed on each year.
• Passive income vs. earned income: Another tax benefit is that rental income is considered passive income instead of earned income. As such, it will not be subject to payroll taxes like earned income, thus lowering the overall tax rate on this type of income.
• Other tax benefits include 1031 Exchange and cash out refinance. Each of these allow for tax savings while still offering the opportunity to pull out equity in a current property (cash out refinance) or roll equity into another property (1031 Exchange). Money from a cash-out refinance is considered a loan and not income, so no tax is due on that money. A 1031 Exchange allows you to roll profits from one property into the purchase of another rental property and defer taxes at the same time. For more information on 1031 Exchange, see our previous article at www.physicianrei.com/7-points-to-remember-for-a-successful-1031-exchange/.
Just from the actual returns above, you can see how your cumulative returns from owning real estate can easily exceed 15% per year. In the above example, the cumulative returns are approximately 16.8%, not including any tax savings benefit. Even with the conservative projections used, those are pretty healthy returns.
Hopefully this has helped illustrate how to look at your returns from real estate investments. As a reminder, I am not a tax professional (thank goodness!) and any illustrations here are given for educational purposes only. I strongly encourage anyone interested in investing significantly in real estate to find a tax professional that is well versed in areas of taxation that pertain to your real estate investing to maximize your tax savings opportunities.