The 4 Types of Return on Investment Real Estate
There are 4 different types of return on real estate, and you HAVE to consider them all.
If you only focus on cashflow or purposely ignore any of these factors, you won't be able to accurately calculate your return or correctly analyze an investment's potential.
The four types of return are:
- Debt Paydown
- Tax Benefits
Let's start with the most obvious return, cashflow.
This is the money your investment property makes minus all the costs and expenses of ownership. If you have a property renting for $2,000 a month and your mortgage, vacancy, repairs, maintenance, everything altogether costs you only $1,800 a month, then you are getting a cashflow return of $200 a month.
A majority of investors don't calculate cashflow correctly. They will purposely leave out expenses in order to make their numbers look better. For example what if the example above didn't include paying a property manager? Well... turns out they usually charge 10% of rents, so that $200 in cashflow that I thought I was getting is now $0.
Cashflow is everyone's favorite return because it's the money you get to realize immediately. Just make sure you account for all of your expenses.
When you buy a property and it goes up in value, your property has experienced appreciation.
One of my favorite benefits of appreciation is that, unlike cashflow, this results in an increase in your equity and net worth and you aren't taxed on it unless you sell the property. Don't consider this tax or investment advice, I'm not a tax professional and you should certainly talk to one, but cashflow is typically considered income and is taxed the year your earn it. Appreciation is taxed as a capital gain, only when you realize the gain, for example by selling the property.
The tax benefits of appreciation over cashflow are not talked about nearly as often as they should.
Additionally, appreciation has the massive benefit of being somewhat controllable.
Meaning, unlike stocks, you control the asset and can drive the price up or down. You can force appreciation by improving your real estate, such as making repairs, renovating properties, and sometimes even just by increasing the profitability or net income a property produced.
And I haven't even mentioned that appreciation generally just happens over time. You don't have to do anything if you don't want to. Historically, properties have tended to appreciate a small percent every year.
3. Debt Paydown
If you couldn't tell, I love appreciation. But let me say this, debt paydown is by far the most underappreciated yet impactful return on real estate investments.
Where cashflow and appreciation rely on market rents and market values of property, your debt paydown is a return you can calculate the minute you get your loan's amortization schedule. It is a predefined agreement that tells you how much principal is paid off from your loan balance with every loan payment.
Let's revisit our scenario from the cashflow section above, where we rent a property for $2,000 a month. Where cashflow investors might focus on that $200 a month cashflow return, the best investors will consider the debt paydown as well.
Of our expenses of $1,800, our mortgage payment is probably our largest expense. Let's assume our mortgage is around $1,400 a month.
Because each payment covers principal, interest, and possibly other escrow expenses, we can break down the specific amount that goes to our principal based on the amortization schedule of the loan. The amortization schedule is a spreadsheet that outlines every mortgage payment and exactly how much of the payment goes toward principal and how much covers interest. Familiarize yourself with this document.
So we know our payment is $1,400 and according to our amortization schedule, our next payment will be broken down into $700 towards principal and $700 towards interest. Hang on, we're almost there.
So our $200 a month cashflow might not be significant, but if we also consider the fact that every month our debt goes down by about $700 a month then our total net worth actually goes up by almost $900 a month.
Even if we add in the hypothetical property management cost and have $0 cashflow, our net worth still goes up $700 a month!
As you can see, debt paydown can be incredibly powerful.
And sometimes can get you a significantly higher return that cashflow.
And the best part? You don't pay taxes on debt paydown!
4. Tax Benefits
Last but not least, the tax benefits of real estate.
There are a lot of them and this should be something you think about often. But due to the nature of taxes, these can be difficult to forecast accurately. Every county, state, and country has different tax laws and they tend to change a lot over time.
Get a good tax advisor on your team that can help you navigate the world of taxes.
Also, make sure they specialize in real estate and ideally even own rental properties too. Any general tax specialist likely doesn't know the intricacies of investment real estate and is more likely to not consider all of the deductions and rules available to investors. For example, some tax professionals think depreciation is an optional write-off but the reality is you have to take it. It's not a choice.
Again, get a tax professional who knows this stuff!