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Four Pillars of Investment Return in Real Estate

BY TEI KIM, CFA, CPA. PARTNER AND INVESTMENT ANALYST AT LEVINE CAPITAL MANAGEMENT

Today, we are going to explore the four critical elements of returns from an income property:

  1. Cash Flow Returns
  2. Appreciation
  3. Principal Paydown
  4. Tax Benefits

Not every investment property will bring in these returns in an equal degree. Since each property is unique by nature, it will most likely manifest the four sources of returns differently. For example, one property may be suited to generate stable cash flow while another may reward you more with a handsome check upon the sale of the property than with cash flow. Therefore, it’s imperative that your personal investment philosophy and goals be congruent with the benefit of these returns when making an investment decision. Let’s take a dive into each of them.

Cash Flow Returns

Simply put, cash flows embody how much came in and how much went out in a similar manner to a checkbook. Cash income is the money you collect on a periodical basis from your property investment. In a typical scenario, your cash flow calculation will look something like this:

Gross Income (rents, storage, amenities) – Operating Expenses (maintenance, repairs, taxes, property management, insurance, etc.) – Debt Service Cost (mortgage principal and interest) – Capital Reserves (long term capital investment projects or future capital expenditures) – Asset Management Fees (if any) = Cash Flow

Appreciation

Every real estate investor may hope to receive a reliable cash flow from his or her investment property. However, as stated before, not all properties deliver considerable cash flow. For those that don’t, this is where appreciation comes in like magic.

The formula for appreciation is as straightforward as below:

Appreciation = Resale Price – Original Purchase PriceBroadly speaking, there are two kinds of appreciation:

  1. Market-driven and
  2. Forced.

Market-driven appreciation mostly results from increases in population and jobs, greater demand than supply, and general economic inflation.

Forced appreciation could be more fascinating as it is achieved in a way that is under control of the owners intending to boost net operating income (NOI = Gross income – vacancy and credit loss – operating expenses) by increasing income, decreasing expenses, or a combination of the two. Any physical improvements to the property that bring about increased income and/or reduced expenses will lead to forced appreciation. The better management of the property can also help enhance the income stream through reduced vacancy losses by attracting and keeping desirable tenants. You may not reap the benefit of appreciation until you sell the property, but the value of such benefit can be sizable when the sale day comes. As briefly demonstrated in the example below, small changes can make a huge difference!

Let’s say we have a 50-unit building with a 6% cap rate (i.e. NOI / Property value). Each year, we increase rents by $25 per apartment. At the end of Year 4, we will have increased the property value by a whopping $1 million!

Four Pillars of Investment Return in Real Estate 1

Principal Paydown (or Loan Amortization)

In most situations, you would draw a mortgage loan to purchase the investment property. Tenants would give you the rental income needed to pay the monthly mortgage linked to an income property, thereby reducing the outstanding loan principal balance. In effect, they help you increase equity in the property each month.

Tax Benefits

Despite an increase in property market value, the assumption can be made that the building (not the land) deteriorates and becomes less valuable over time. This “phantom” decline in the value of your property is called depreciation and qualified for a tax deduction. Depreciation (a.k.a. cost recovery) allows a residential property owner to depreciate the property value over a 27.5-year time span. The owner is permitted to deduct 1/27.5th of the value from current income each year. This may offset a substantial portion of the current income, especially in the early years of ownership. For instance, let’s assume you own a rental property that nets $1,000 and your depreciation totals $800. Then, the net taxable income should be $200. If you are in the 35% tax bracket, you would pay $70 in tax. However, comparing the $70 to the rental income of $1,000 leads us to see an effective tax rate of merely 7%. Additionally, the return of capital (i.e. receipt of original investment) is not considered to be income or capital gains from the investment, thus not triggering a taxable event. And, appreciation is taxed at capital gains tax rates, which come lower than income tax rates. For more tax benefits applicable to your situation, it may be prudent to consult your own CPA.

The Bottom Line

With the right strategy suited to your situation and financial goals, real estate can be a highly lucrative investment vehicle and it offers many avenues for generating income. A myriad of real estate concepts and calculations hinge on the aforementioned components of investment return. Now that you have laid the groundwork and foundation for real estate investing, you have taken a step further to building up your wealth for the future.

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