What to do when the Bears come calling? CRE Of course!

[Christopher Perez]

Stock market investors are often so focused on growth that many do not realize how the leverage, cash flow, and tax-deferral of real estate investing can combine to produce potent returns. And when mixed with the power of compounding, real wealth can be generated from a relatively modest investment.

The real return on real estate is not always easy to see, which is perhaps why investors do not pursue it as actively as investments in equities or fixed-income instruments. Also, professionals do not always agree on the best way to calculate the ultimate return on real estate. Below is an approach that takes into account cash flow, tax-equivalent yields, and depreciation, both combined and separately, and can make the case for why you might consider investing in real estate. Throughout this example, we’ll take some shortcuts that make our numbers more conservative. If this case study was real, the actual return would likely be higher than what is presented here. These shortcuts will be pointed-out as we go along:

Now let us consider our happy, fictional couple, the Smiths, who purchase a four- unit apartment building in their hometown for $292,500. Their down payment is $75,500 (or 25%), and their closing costs are another $6,822, for a total cash investment of $82,322. Their total mortgage balance (with one point on top) is $219,170, financed with a 6.26%, 30-year mortgage.

During the first year of ownership, the Smith’s building delivers the following financial performance:

Total Rental Income $ 40,780 Less Mortgage Payments $ 16,210 Gross Income $ 24,570 Less Operating Expenses $19,836 Net Cash flow $ 4,734

(Here is the first of the shortcuts: the above mortgage payments of $16,210 include the principal as well as the interest. The interest expense alone is less than the $16,210, meaning the net income and the investor’s return is actually higher than what we will shortly calculate. We will revisit this later.)

At the most fundamental level, the investor’s return is 5.75%, (consisting of $4,734 cash flow divided by the $82,322 total equity investment). Scholars might quibble over whether or not closing costs ought to be part of this calculation. If not, the return goes up to 6.27%. However, for those who actually had to come up with the cash to get to the closing table, it’s easy to look at these expenses as part of your equity in the property.

True, a return of 5.77% is not such a bad thing, but at the same time it is not a very compelling return. Yes, it will double in 12 years, but that’s a very long time. However, 5.77% is not the end of the story. If we consider depreciation, 5.77% is only the beginning.

Most rental property can be depreciated over a lifespan of 27.5 years. Therefore, the $292,500, net of the land value of $5,100, carries an annual depreciation expense of $10,451. This is a non-cash expense, which is the best kind to have, since it will significantly boost the Smith’s return. Why? Because on an economic basis, the Smith’s property actually lost $5,717 ($4,734 operating income minus $10,451 depreciation). Therefore, the $4,734 that went into the Smith’s pocket is sheltered from taxes by the depreciation on the property.

For the Smith’s to put $4,734 in their pocket from wages, tips and salary, they would have to earn $7,283 in a 35% tax bracket. Therefore, the so-called tax equivalent return is 8.85%. ($7,283 divided by $82,322). Now the Smiths are getting somewhere! And once again, this figure understates the return because it does not take into account the sheltering of income against state and local taxes which might occur.

But there’s more: the Smith’s still have an economic loss of $5,717, which is the depreciation expense net of the operating cash flow ($4,734 minus $10,451). This loss will help the Smith’s shelter $5,716 of other income. Specifically, if the Smiths are in the 35% tax bracket, the $5,716 loss on their property will result in $2,001 of avoided federal income taxes. If this avoided expense is viewed as income, it represents an additional 2.43% return ($2,000 divided by $82,322) in addition to state and local taxes which may have been avoided as well.

As an aside, the opportunity to avoid taxes through real estate investments can be tricky. Specifically, if you are not a real estate professional (i.e., it is not your career), the federal government places a limitation on how much of your passive loss from an investment on something such as real estate can be deducted against your ordinary income. Specifically, a married couple filing jointly may offset up to $25,000 of passive losses against their “active” income (i.e., wages and salary). Furthermore, the deduction is phased out for adjusted gross incomes between $100,000 and $200,000.

And while we are on the subject of taxes, it is worth noting that some of the deferred income taxes will come out in the wash in the form of higher capital gains taxes, if and when the property is sold. This will happen because the depreciation expense decreases the owners’ basis in the property, which will increase their gain upon sale.

In the case of the Smiths, neither limitation applies. Accordingly, the Smiths’ return is 11.28%, which is comprised of their 8.85% taxable equivalent yield plus the 2.43% yield from avoided taxes. While this figure takes some work to arrive at, there’s nothing illusory about it. You would have to generate interest income of $9,286 on an investment of $82,322 to come out the same after taxes.

There is one other element to the return worth taking into account: the monthly mortgage payments consist of both interest and principal. During the first year of operation, the Smiths pay $13,647 of interest while making $2,563 in principal payments. There are several ways of looking at this $2,563. One way would be to add it to the equity base of $82,322, since principal payments add to owner’s equity. This has the effect of decreasing percentage returns, since additions to equity increase the denominator of return calculations.

But this, however, is not the appropriate way to consider this new sliver of equity. The reason has to do with pockets. Specifically, since the mortgage is a self- liquidating liability, funded by tenants’ rental payments (assuming, of course, at least “break-even” cash flow), this new equity never came from the owner’s pocket. It came from the tenant’s. Therefore, it’s not unreasonable to think of this $2,563 as a gift, which at 3.11% of the initial $82,322 investment, is not an insignificant one at all. If it could be efficiently extracted from the property, this $2,563 could also be viewed as a return of principal, which reduces the owner’s equity investment from $82,322 to $79,759. This, in turn, will increase the effective return to 11.28%.

If there has been any appreciation in the value of the property, the owner’s equity will increase even faster than the rate at which principal is “gifted” to the owners by the tenants.

Of course, real estate investing is not as cut and dried as this article would make it appear. Owning a building where others live is a real responsibility. Things do go wrong, and maintenance is required. But if you’ve got the temperament for it, the very real return on real estate can be well worth your time and attention.