Rates of Return – Real Estate Investing – Part 11
This is Part 11 of my Real Estate Investing Series. You can view the first 8 Parts here:
Now we are going to look at one of my favorite ways to evaluate a real estate investment - Rate of Return. There are actually several ways to calculate Rate of Return. The easiest and most important for the small investor are called Rates of Return for the First Year. I find this an odd name it does not really apply easily to the first year. Your first tax year of having the property will probably involve a pro-rated return since you will probably only be invested part of the year. If it refers to investment year the issue is that it will probably stratle two tax years. Your investment is dynamic and the results will vary from year to year. However, Rates of Return for the First Year is a good way to take current circumstances and project results. It is also good for evaluating results when you complete your taxes.
First you may want to go Download the Latest Investor Calculator that can be used with all of these chapters.
Rate of Return for the First Year comes in two forms; both are very easy to figure. The first one is for Before Tax Cash Flow:
Before Tax Cash Flow/Cash Invested = Before Tax Cash on Cash Rate
Using the example we have been working with it would look like this:
$2,183.63/$40,000 = 5.46%
You can do the same formula for After Tax Cash Flow:
After Tax Cash Flow/Cash Invested = After Tax Cash on Cash Rate
Now are example using the After Tax Cash Flow method:
$2,012.45/$40,000.00 = 5.03%
I know someone is asking where the $40,000.00 figure came from. That is your down payment. You would also include any out of pocket closing cost and rehab cost before you could rent the property. Don't beat up the numbers. If you figured your Rehab cost into your expense you should not include them in out of pocket expenses on the purchase. If you put them into the expense column they should be assumed to be offset by rents. As a rule of thumb if you can depreciate it leave it as part of your initial cost (Cash Invested); if you are taking what ever you spend as an expense for that year let is be an offset against your Cash Flow. If you have a lot of First Year Expenses it might lower the investment return the first year.
This may not sound like a great return. We live in an instant culture where everyone hears about someone making a quick fortune in the stock market or flipping a home. There is money to be made in flipping homes; however it is not as easy as everyone thinks and these may not be the best approach for a first time investor with limited funds. Compared to banks and other investments this is a good return. My figures and examples are all conservative; I think a smart investor could do better. Another huge consideration is that the value of your investment should appreciate over the long term; so you have growth and income from the same investment. Furthermore, if you have a fixed rate loan on the property your income from rents should climb, while your expenses are staying relatively fixed.
More on Rate of Return on my next post - so subscribe below.