Real estate investing is a big piece of my financial pie. The way I think about real estate investing in the same way, I think about public markets investing…I look at it within the context of our life goals, savings plan, and the hopeful expected return on our investments.
I'm going to give you a breakdown of The 5 Critical Components of Real Estate Investing Returns, so you can ensure the property you're looking at will meet your goals.
Before we dig in, for all of you audio/visual folks out there, here is a video version and a podcast version of this article.
The Buy, Rent & Hold Strategy of Real Estate Investing
Before I get into the list, I want to establish upfront that you should generally approach real estate investing with a “buy, rent & hold” strategy: buy it, then rent it out, and hold onto it as an investment. That's not to say that you have to hold onto it forever, but “betting on excessive appreciation” is not a long-term strategy.
As a rule, any investment property you buy needs to be relatively self-sustaining as a rental. This way, if you go through a rough patch in the market and the house loses value, you can hold onto it comfortably until its market value rebounds.
That said, even though you invest in it as a “buy, rent & hold,” if a period of significant appreciation powers up your return, you can sell and reevaluate what you want to do with that equity. That's smart real estate investing in a nutshell. Easy, right?
What You Need to Know About the Compound Annual Growth Rate
Real estate is one potential piece of your asset allocation pie, so you should think about and compare its potential results against the same benchmark the finance industry compares its results: the 7-10% CAGR (compound annual growth rate)— which I discuss in my Big Picture of Investing post.
When it comes to my own real estate investment returns, I try my best to forecast the probability of meeting or beating that hopeful public market return of 7-10% CAGR mentioned above. Also, since real estate can take up more of my personal time and effort than public market investing, it makes sense to factor that in as well.
It's important to understand that whether you invest in the public markets or in personally owned real estate, you are ultimately still just trying to meet or beat the public market's 7-10% benchmark. It's not necessarily easy to do this in either the public markets or in real estate—but for me, it's been easier in real estate investing.
Now, being the diehard proponent of bookkeeping that I am, I've spent a lot of time adding up and analyzing our real estate investment returns.
I want to get a crystal clear picture of whether or not they are making money and if they're beating that 7-10% CAGR benchmark. I have a method by which I do this in Quicken, which I will eventually share with you in more detail in an online course, but for now, I'll try to keep it concise.
The 5 Critical Components of Real Estate Investing Returns
When trying to predict what that CAGR might be, you will utilize these five critical drivers of your real estate investing returns: cash flow, principal pay-down, appreciation, tax effect, and renovation costs.
These five categories are combined to produce your net profit. Once you have that number, you can run it through a CAGR calculator, along with your initial out-of-pocket cash investment and the length of time you were in the property, and that will yield your CAGR for comparison.
1 Cash Flow (Cash on Cash)
Cash flow can be positive or negative and is basically the monthly financial net result of your property's general income (rent received) and expenses.
You collect rents, and out of that, you pay the PITI (principal, interest, taxes, insurance) on your loan, then pay any management fees (if you are using property management), then pay any expenses that come up like repairs and/or maintenance—and what's leftover is your net cash flow.
Hopefully, this will be positive, but sometimes it can be negative if a big expense comes up. It also is determined by the stats of the property you bought.
2 Principal Paydown (Amortization)
Every month as you cover your PITI, the “P” goes toward paying down your loan principal, so your principal balance is almost always going in the right direction…down. While this money doesn't hit your actual bank account until a sale or refi, it is, in fact, income to be realized down the road.
There are some cases in which your principal would go up, like in the case of a cash-out refinance, if you choose to do one. (I'll talk more about refinancing in a minute.)
Throughout the timeline of a property's ownership, its value in the open housing market may go up or down. Like the stock market, the housing market has a long recorded history of performance.
As you can see in the chart below, which was based on information from the US Census Bureau, it has appreciated by about 5.57% per year from 1963-2016. Now that’s less than the stock market's rough average of 10%, BUT with real estate investing, you have the other categories making you money, and you also have “leverage” working for you if you have a loan (more on that below).
4 Tax Effect
The US government offers a host of tax advantages to owners of real estate. These advantages translate into potentially significant real money that further lines your pockets. I (half-jokingly say) that “the government is largely a set of rules, made by the rich and powerful, for the rich and powerful” (the rich and powerful own a lot of real estate, in case you didn't know). The good news is that in America (along with many other countries), the average person can get in on it too!
Let's look at some ways you will experience tax benefits. Each year, you can not only deduct any net loss on the property (rent minus expenses), but you can also depreciate the value of your property and add that to your expenses—which often puts your property taking a paper loss—which will result in overall tax savings now.
That said, you are actually just kicking those taxes down the road because all that depreciation will have to be added to your profit when you sell the property.
This brings me to the other aspect of Taxes. When you sell, you pay tax on the gain you made on the property itself. You should always factor in potential sale tax when evaluating a property, BUT if you reinvest your proceeds into another rental property via a 1031 exchange, you can kick the entire tax down the road again. This will have a significant positive impact on the CAGR of your investment at the time of sale, of course!
If you can postpone paying these taxes while you're in your highest-earning years to a time when you're earning less and are in a lower tax bracket, it's always preferable. You could essentially keep kicking it on down the road all the way to your death if you want while still having a revenue stream from the property!
5 Capital Expenditures (CapEx) & Renovation Costs
While also known as “capital improvements,” here's what it includes: the money you spend improving your property that is not part of the usual “expenses and maintenance” of cash flow.
In some sense, this is a subcategory of cash flow because it’s potentially “cash out of your pocket” at the time of doing it. But, because it's also voluntary, I don't count it there. I keep it in its own category and track it as such.
Wait, Don't Forget the Refi!
There's one additional item I mentioned earlier that you might run into, which you'll need to track as well: Refinancing.
I'm sure most of you are aware of this term, which basically means that you take out a new loan on your property while at the same time paying off your existing loan to glean some additional benefit.
This usually comes in the form of a better interest rate and/or tapping some of the equity that is trapped in the house and putting it to use—or in your pocket!
We track this because 1) there are usually closing costs involved, which you want to track as an expense, but also 2) the cash you might take out is basically giving you back some of your initial cash investment, which in turn affects your CAGR. So you want to be sure to factor that incorrectly.
It's All About the Leverage
We all hear about the “magic of compounding,” which is how percentage growth, year over year, creates exponential growth. Well, leverage is just a banking term for using borrowed money, and it's like pumping steroids into compounding!
Here's how leverage works: You buy a house for 100K with 20% down (or only 20K out of pocket). Now, even though you only spent 20K to get into the house, the appreciation of the house applies to the home's total value (not your cash investment).
So, if after one year your house is worth 105K, you have now made 5K on your 20K, or a 25% return on your money. You had 80% leverage on the house, and that multiplied your return by a factor of five!
Whoa! Now for clarity, that math doesn't factor in closing costs on the purchase or sale, but you get the gist.
Negative Cash Flow in Real Estate Investing
Now, let's specifically take a look at the cash flow factor in this case study for a minute. Notice how in half of the years, I had negative cash flow on this property.
Some of that, in the beginning, was due to lower rents and also large expenses that popped up. I did have to come out of pocket quite a bit in some years, and in others, I made some extra cash.
Ultimately, you have to assume that your real estate will cost you extra cash in some years and generally break even in others.
You'll need to be able to absorb that when necessary. BUT, the longer you hold the house, you can continue to raise the rent, and the law of averages on repairs will eventually be on your side.
Why I Like Real Estate Investing Over Public Markets Investing
OK, so all of the above probably sounds like a lot to take into consideration, but it’s relatively simple math. It really comes down to making the effort to do the “bookkeeping” so you can understand the results. Actually, one of the things I like most about real estate investing vs. the public markets is that it's fairly straightforward.
Houses are something we all understand because we all live in them! In a home, there are a handful of major systems at work (plumbing, electrical, HVAC, etc.) that you need to keep running, but at least we know their gist. You just collect the rent and pay your bills (often with help of a property manager). Ultimately, it's pretty simple.
Real estate investing is also a great business because it's a product everyone in the world needs—housing! The public markets, on the other hand, are riddled with trap doors, puppet masters, layers of fees, and businesses we don’t understand. There is a level of uncertainty there that I have a hard time accepting.
Another benefit (especially for me), is that real estate is not easy to get in and out of quickly! You might think that sounds like a bad thing, but in my case, it stops me from making quick (and often bad) emotional decisions around my investments. Maybe you can relate?
Selling a house involves paperwork, signatures, notaries, and multiple moving parts. Public stocks, on the other hand, can be traded with the click of a button! When the markets tank, it requires an individual to be able to just calmly watch their wealth evaporate before their eyes and NOT sell, simply because they have faith in the system. I've found I do NOT possess this ability.
Real Estate Investing Returns Analysis of an Actual Property We Owned
Now, let's take a look at a real-life example of a real estate investment returns analysis. Below is a spreadsheet of one of the properties my wife and I sold. There's more detail about the house in its case study if you're interested.
Again, this is an actual property we owned and sold, and the numbers are accurate. (There's one caveat to mention in that the tax savings are “close.” It’s hard to exactly capture the tax savings because of the ways the deductions can skew your tax rate and so on, so I just took the actual expenses and actual deprecation and then multiplied it by a common tax rate. But, as I said, this is very close.)
As you can see, the CAGR outpaced my hopeful target of 7-10% at a very good 12.05% over 8.85 years. Furthermore, by using this convenient S&P 500 returns calculator, you can see that for the same period, the S&P only returned 6.42% (inclusive of reinvested dividends).
To put it into numbers…this is the financial result of the difference. It's a huge difference!
$39,356.62 growing at 11.74% for 8.85 years = $107,724.07
$39,356.62 growing at 6.42% for 8.85 years = $68,261.15
The significant drivers of the returns for this property were principal pay-down, appreciation, and the tax benefit I was getting along the way. This spreadsheet also shows that the ongoing cash flow and the minor renovations we made were both negative.
I utilized a 1031 exchange to transition this investment's equity to another real estate investment in a less expensive city and paid zero tax on the gains!
Through a combination of residential and commercial “buy & hold” investments, including my residences, I’ve achieved a (time and amount invested) weighted average return of over 40% per year on invested capital, with reinvested gains.
(If you would like to see how I try to project these returns in advance for actual investments, take a look at my youtube video)
I realize this post is somewhat of the broad strokes of the analysis, but I wanted to give a general overview before taking you through a very detailed analysis.
When it comes to forecasting the potential profit of a real estate investment, you can use The 5 Critical Components of Real Estate Investing Returns based on the numbers you know and also reasonable averages.
If you know you plan to invest in real estate, rest assured you will be able to get more elaborate details in future posts.
If you'd like to read more about other aspects of real estate investing, check out these other posts…