I am planning to purchase my first rental property this coming winter using conventional financing. While I save for a downpayment I have been analyzing properties for practice. When looking at properties and the return they will generate, should I account for rent paying down the mortgage and building my equity in the property while doing my analysis? Is this something that is just nice to know, or should I be factoring it to my decisions?
It depends. If you're trying to figure out how much cash the property will put in your pocket each month, then no. An old saw for real estate is "you can't eat equity".
If you're trying to figure out the full value of your investment, then, yes, include the "principal paydown" in your calculation. On commercial deals, the resulting return, including principal paydown is called "total return".
If you plan to purchase properties and hold them for a relatively short period of time, perhaps less than 5 years or so, then I probably wouldn't factor in the principal paydown in your upfront analysis. My line of thinking for this is because I wouldn't want to make a decision based on capturing the equity in a property, then realize that the property has declined in value by more than the equity that I assumed I would "capture" over that period of time by simply paying down the loan balance. For example, you assume that over 5 years of ownership you will pay down the principal balance by $10k, but then when you sell the property you receive $10k less for the property than what you bought it for.
I know that we would like to think that RE values don't fall, but I think that recent history has shown that is not necessarily the case, especially in the short run.
@Sean Mills I factor in my pay down, but not in the normal way. I usually only get 15 year loans with a 5 year ARM. Since my market is not that good on rentals anyway this means that I do not cash flow well. If my purchases make their own payments, taxes, insurance, and have a little left over for vacancy and repairs. It is a struggle to do things like put a new roof on or replace that bad sewer line $7K expense that pop up every once in awhile. I often work on fix up properties myself as well as replace a water heater, or paint a room or 2. I even spend more time on the roof than any of my helpers when replacing one. Not a smart use of my time, but it helps keep things going. I usually show a small profit at the end of the year despite trying to break even on taxes. Making lots of money means paying lots of taxes. While I am digressing a bit, what I am trying to emphasize is that pay down is my main return on the short financing properties. I will definitely retire in 13 years and if I have a stable of a dozen properties free and clear it will look a lot more inviting than living off of social security.
HI All- Sorry for the delayed response. Haven't been on in a while! This is all great perspective. Overall my goal is generating long term cash-flow for early/better retirement. @Jon Holdman it's the first time I've heard that saying but I like it. "You can't eat equity". Sounds like for my situation it's best to stick with using cash-flow as my measure and any potential increase in equity is just icing on the cake.
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