Real Estate Returns - More than Just Cash Flow
Introduction
Everyone seems to focus on Cash-on-Cash Return as a metric for how well rental units are performing, but they ignore the other factors that play into making rentals solid investments. This post will help you appreciate those other factors so you know what your true return is through an Adjusted Cash-on-Cash Return.
Why This Matters - My Sob Story
I just acquired a house that on first blush isn't a slam dunk. I had wanted to resell it either on a Wrap or a Lease Option, but the market in this area just doesn't support that. It also doesn't work as a Mid-Term Rental because that market is saturated, and a race to the bottom (cheapest price) isn't going to get me the returns I want. There are no tourist attractions here, so a Short-Term Rental won't work, either.
I'm stuck renting this out as a Long-Term Rental for a measley 6.5% Cash-on-Cash Return. My target is at least 11%.
But after factoring in the other contributors of real estate wealth, you'll see my adjusted return is closer to 28%! That's phenomenal and way better than any stock market can do!
The Four Factors of Real Estate Wealth
Net monthly cash flow is only one factor, albeit the one that gets the most attention. Here are three others:
- Asset Appreciation. Your property increases in value over time (most often, on average).
- Equity Accrual. Your tenants pay down your principal (and interest) as they cover your mortgage, adding equity to your bottom line.
- Depreciation. Tax savings due to depreciation mean a penny saved is a penny earned - or here, more like a few thousand dollars!
Don't Let the Math Scare You
To calculate the cash-on-cash return for a long-term rental while factoring in asset appreciation, increase in equity due to mortgage payments by tenants, and straight-line depreciation, you need to follow the steps below. None of them are particularly difficult. Just follow along with my real example.
Start with the End
First, let's start at the end. Here's what we're trying to calculate factoring in all four factors:
Adjusted Cash-on-Cash Return = (Annual Cash Flow + Annual Appreciation + Annual Equity + Tax Saving) / Initial Investment
1. Know Your Initial Investment
In order to calculate any return, you need to know what's coming in and weigh that against what went out.
For me...
This was a pre-foreclosure that we stopped the auction on literally the day before. Here's what my expenses looked like:
- $23,000 in Arrears and Legal Fees
- $10,500 in Closing Costs
- $29,000 in Renovation
- $5,000 Assignment Fee (for my Wholesaler)
- $4,500 in Holding Costs (to operate the house before renting it)
My total Entry Fee (or All-In Costs) for this is $72,000. I'm honestly not proud about this at all.
2. Calculate Cash Flow
The next step is probably the easiest because it's the one everything thinks of - cash flow.
Simply put, it's income minus expenses. Be sure to set aside allowances for future expenses.
For me...
I can get by on this property keeping CapEx and Repairs low because, well, I just renovated it. Here's what I'm assuming as Operating Expenses:
- 4% Vacancy
- 2% Capital Expenditures
- 2% Maintenance and Repairs
- 8% Property Management ... even if I do it myself, since I should pay myself
My monthly net cash flow is $413 per month or $4,956 per year.
3. Asset Appreciation
I'm assuming my asset is going to appreciate 6%, which is well above inflation. It's located in an area that's developing rather quickly and has seen solid growth over the past four years. When I see what similar houses (comps) have sold for from last year and a few years ago, I feel confident to extrapolate that data to reach my 6% appreciation rate.
Your mileage may vary. But do your due diligence, look to see how your market has behaved over time, and use that as your basis for assumptions.
For me...
my house is $275,000. 6% of that is $16,500.
4. Equity Accrual
As your tenant pays your mortgage for you, they are paying down your principal. This gains you equity each month, which is like cash ... that's tied up in your house. But that money is still just as real as the cash flow that goes into your pocket!
The easiest way to figure out how much equity you'd gain in a year is by looking at an Amortization Schedule that shows you how the monthly payments get split between principal and interest. Early in the loan, the bulk of the money goes to interest, but over time the balance shifts to where, by the end, it's mostly principal.
For me...
Because I acquired this house as a pre-foreclosure and took the house over subject-to (i.e., I acquired the house subject-to the existing mortgage being in place at a sweet 3.5% rate in a landscape where new mortgages are closer to 7.5%), the loan was already four years into the amortization schedule. So it's paying a bit (not a lot but still decent) more toward principal.
I'm also a bit of a geek and created my own Amortization Schedule using Google Sheets. If you sum up the Principal Paid column for the next 12 months, it comes to $4,523.
5. Depreciation
The IRS allows for residential real estate depreciation over 27.5 years. Calculate the annual depreciation expense. (This is called Straight-Line Depreciation and is different from Bonus Depreciation or Cost Segregation, which will be covered in a future post.)
Basically, take your asset's value, subtract out the land value, then divide that by 27.5. Multiply that result by your tax bracket and there you have your tax savings
Annual Depreciation Expense = (Property Value−Land Value) / 27.5 * Tax Bracket
For me...
($275,000-$35,000) / 27.5 * 25%
$240,000 / 27.5 * 25%
$8,727 * 25%
My tax saving is $2,182
Put it All Together - Adjusted Cash-on-Cash Return
Time to plug and chug, and see what comes out the other end of the equation.
As a reminder, the equation we were solving for is this:
Adjusted Cash-on-Cash Return = (Annual Cash Flow + Annual Appreciation + Annual Equity + Tax Saving) / Initial Investment
My Adjusted Cash-on-Cash Return =
($4,956 + $16,500 + $4,523 + $2,182 ) / $72,000
$28,161 / $72,000
39.1%
That's WAY better than 6%, right?
Let's say my assumption was off on Asset Appreciation, and it only goes up 3% instead of 6%. We can adjust that very easily.
($4,956 + $8,250 + $4,523 + $2,182 ) / $72,000
$19,911 / $72,000
27.7%%
Conclusion
By following these steps, you can comprehensively account for the various factors influencing your rental property's return and arrive at a more accurate cash-on-cash return calculation.
Leave a comment below if you've found this helpful or if there are any other metrics you'd like to understand better to evaluate real estate investments.
