Including Principal Pay Down in Your Calculations

8

With a big question mark surrounding what kind of appreciation investors will achieve in the coming years, most investors look at yearly cash on cash returns as the primary metric for evaluating investment property. I see a wide array of advertised returns from various investment property marketers, and it seems like everybody has slightly different assumptions and formulas for this calculation. One of the most commonly overlooked factors when calculating the return from an investment property is the principal pay down (i.e. the principal portion of the mortgage payment that reduces the balance of the loan).

This is one of the greatest benefits of investing in real estate, and yet so many investors neglect to factor this into their calculations. A rented investment property should not only pay for the cost of the debt (interest), it also pays down the principal balance of the asset and increases the equity. Most investors calculate the yearly cash on cash return by dividing the net profit for the year by the total cash out of pocket. For example, let’s say you bought a $100,000 investment property and put $20,000 down. You also spent $4,000 for closing costs and another $1,000 in miscellaneous costs (including repairs, leasing fee, etc). At the end of the day, you had $25,000 of actual cash invested to buy this $100,000 property.

Now, let’s say your monthly numbers look something like this:

RENT: $1,000/mo

Principal and Interest: $441 (30 year loan on $80,000 at 5.25%)

Taxes: $150

Insurance: $50

Property Management: $80

Vacancy Factor: $50

Maintenance Factor: $50

TOTAL EXPENSES:  $821/mo

 MONTHLY CASH FLOW: $179 (Rent  – Total Expenses)

YEARLY CASH FLOW: $2,148 (Monthly Cash Flow * 12)

Most investors would calculate the yearly cash on cash return by dividing the yearly cash flow ($2,148) by the total cash out of pocket ($25,000) for a yearly return of 8.5%. Compared to most investment vehicles, this is a very good return. However, this does not include any increase in value of the property or the fact that the outstanding loan balance was reduced by the principal portion of the mortgage payment.

In the above scenario, the mortgage payment of $441 per month pays interest, but also pays the principal balance of the loan down by $1,128 over the course of the first year (and by nature of amortization schedules, this amount actually increases every year). As an investor, why would you consider this principal pay down an expense? If you take into consideration the fact that your total expenses are slightly inflated by this amount, your returns look even better. In the above scenario, if you add $1,128 back to your yearly cash flow of $2,148, you have a yearly cash flow of $3,276. Your yearly return now increases to 13%!

I know this seems somewhat technical, but it’s important for investors to accurately calculate returns. As you can see in this example, this slight change in calculation is the difference between an 8.5% yearly return and a 13% return!  This is a huge difference! Even better is the fact that the longer you pay on this mortgage, the more that gets applied to principal (based on a typical amortization schedule)

Using leverage to buy properties is one of the most effective tools we have as real estate investors. Understanding how this leverage provides a return on investment is critical to becoming a successful investor.

About Author

Ken Corsini

Ken Corsini G+ is the host of the Deal Farm Podcast (on iTunes) and has 10 years of full-time real estate investing experience. His company, Georgia Residential Partners buys and sells an average of 100 deals per year and has helped hundreds of investors around the country make great investments in the Atlanta market. Ken has a business degree from the University of Georgia and a Master Degree in Building Construction from Georgia Tech. He currently resides in Woodstock, Georgia with his wife and 3 children.

8 Comments

  1. This is a great post. It is extremely important to look at the entire picture when investing. Your focus is also extremely important. I am focused on long term results. Understanding your risk tolerance to debt is also an important factor. I personally only finance properties with a 15 year mortgage. They still must cashflow comfortably. This fits in with my goal to retire at 40 and just invest and manage my properties. I’m 25 now and this ahould set me up nicely to have several properties paid off naturally at 40 and a couple more with very low balances that would allow me to pay off as I approach my target age in order to lower risk and increase cash flow as I transition from normal “employment”. Great post, hopefully more will see this aspect of investing and allow investors to achieve great results with a lower leverage rate.

  2. Charlie McDermott on

    Great post. It’s true, there are a confusing amount of numbers advertised with properties and most of them don’t tell ‘the rest of the story’.

    “Understanding how this leverage provides a return on investment is critical…”

    I understand it. But I wonder if a retired person with lump sum cash and no income can get a bank interested in lending money based solely on potential cash flow.

    Do you know if this is possible?

    Thanks,
    Charlie

  3. Thanks so much for explaining what “cash on cash” is. Everytime a seminar comes to town, the “New” wholsalers are spewing this term out. Never been to a seminar. So, I didn’t know what they were talking about.
    Don

  4. Too bad, adding principal, is really, adding invested money to your investment, yielding more investment for the same return out, which ACTUALLY reduces your ROI. (because you have now added MORE money to the investment.
    Trickery with numbers at its best right here.
    So when the house is almost paid off? Did I just double my investment? Or reality, continually add money to the investment.
    No one considers their yearly RRSP contribution an investment profit increase, i wish.

    • Yohan, I appreciate the post. The question is whether I “added invested money to my investment” (as you put it) … or whether my tenant added money to my investment. The beauty of real estate investing is that the tenant living in the property is paying down my principle, not me.

      For example, if my investment in the property was 20% down and my tenant lives in the property for the next 15 years and pays the remaining 80% balance off for me … wouldn’t that be a return on my initial 20% investment?

    • Yohan:
      Since the investor borrowed the money and the Tenant is repaying the money by virtue of making rent payments to the investor, the principal portion of the payments constitutes a ‘return of’ investor’s money to the point where the investor has received all of his investment back and the excess then constitutes ‘return on’ his investment.

  5. Wesley Jones

    Great post Ken! I know this post is a little dated, but I am new to the site and just found this post. I have been using this same calculation for my rental and have always wondered why the cash-over-cash valuation was so dominant. I definitely enjoy seeing someone else adding equity to my investment.

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