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Real Estate Investing - It's All About the Cash!

By
Real Estate Agent

Real Estate InvestmentWith continued elevated inventory levels and interest rates at generationally low levels, I have conversations about the viability of real estate as an investment on a regular basis. Now, for those of you who recall my earlier post about homeownership, I do not consider residential real estate an "investment" if you plan to live in the property (I consider that a lifestyle choice vis-à-vis renting or living with your parents). However, real estate can be an investment (and a very lucrative one) if done based on the return it can provide relative to one’s invested capital.

I routinely provide data to prospective investors as to the estimated return on investment a particular property could potentially provide (disclaimer time: past performance does not guarantee future results….).

Real Estate Investment ROIThe illustration to the left (click for a larger image) provides a summarized version of a synopsis for a prospective investment property. This is a simplified version for illustration purposes. My more detailed analysis also provides an estimated taxable income versus cash flow analysis along with depreciation schedules, re-capture provisions as well as an overall IRR at the point a property is sold. For the purposes of this blog post, this summary will suffice.

The illustration is based on a property purchased for $200,000, which is the median sale price in Davis County for calendar year 2010 (it’s $208,000 for Salt Lake County). The analysis then makes certain assumptions as to down payment, closing costs and rental rates for this property. Where I see beginning real estate investors make a mistake is how they determine their return on investment (ROI). Many compare their gain/loss to their purchase price rather than their invested capital (e.g. down payment, cash closing costs, etc). This leads many to believe they cannot make money on real estate investments.

Using this simple illustration, you will see that when you compare your gain/loss against invested capital, the return is actually quite reasonable given current market conditions. This result does not even factor in the overall return based on the equity accumulation from the renter, any potential appreciation over the course of the holding period or even the value of depreciation on deferring tax liability on positive cash flow. However, even this simple illustration demonstrates the principle most successful real estate investors understand: the power of leverage to produce a viable ROI.

Historical Interest Rates 40 yearsInterest rates on the other hand can eat away at your return on investment much faster than changes in acquisition prices. The example utilized a 4.75% interest rate, however, if I increase the interest rate to just 6% (still historically low), the rate of return is completely wiped out (basically a break even proposition without consideration to tax and equity advantages). Many would be investors have been holding off waiting for the market to hit that mystical "bottom."  This can be devastating from an investment perspective. If you’re leveraging 80% of the acquisition, just a 1% increase in interest rates will completely wipe out an acquisition price decline of 10%. In fact, your cash on cash ROI would be less than paying 10% more at the lower interest rate.

The concept of leverage and actual cash on cash ROI is something successful investors have figured out and is a wealth building concept they take full advantage; especially in economic down cylces such as this which feature lower priced inventory coupled with exceptionally low funding costs. If you are thinking about real estate as an investment, you really can’t ask for a better opportunity to engage that process than the economic conditions we are experiencing now.

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Craig Frazer, Realtor, CRS, CDPE, GRI, CLHMS
RE/MAX Metro

Cell & Text: (801)699-6046
Email: cfrazer@remax.net

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