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