How do you quantify 4 ways an investment property makes a ROI?

Question

Buy and hold investors (like myself) know that an investment property produces a Return on Investment (ROI) in 4 ways:

1. Cashflow (acknowledging a property could potentially have negative cashflow)

2. Equity building (the tenant is essentially paying off the mortgage for you)

3. Tax advantages (deductions for both "depreciation" and for dollars paid in interest on a mortgage)

4. Appreciation (potentially, but not guaranteed.  A property could also go down in value pending market conditions)

How do we calculate these four sources of return to quantify the total ROI for a particular investment property?

1. ROI from Cashflow is calculated by taking the Cashflow (Income minus expenses) and dividing it by the amount of cash invested in the property (usually in the form of a down payment).  This will produce a decimal that can be represented as a parentage to indicate the APY (Annual Percentage Yield) due to cashflow.  An example would be a property with a $20,000 down payment that produces a positive cashflow of $100 per month would have an APY of 6% ($100 per month x 12 = $1,200 per year divided by the cash invested as the down payment of $20,000.  $1,200 divided by $20,000 = .06 or 6%)

My question for the other investors out there is:  How do we quantify equity building and tax advantages in terms of ROI and/or APY.  These ones (equity building, and tax advantages) are a little more difficult to quantify probably because they are dependent on the individual investors circumstances (loan terms for equity building, and tax bracket for tax advantages for instance), and thus they don't get discussed as much, but I am interested to hear what methods can be used to quantify these sources of ROI from an investment property.

It is important be able to quantify the ROI of an investment to ensure we, as investors, are achieving the highest and best use of the money we invest.  In order to do this we need to be able to compare the rate of return (usually in the form of APY or IRR) of an investment to another potential investment (Including stock dividends for example).

The first three returns are realized while owning the property, but the forth (appreciation) can only be realized by selling the investment property.  After selling it is very easy to calculate the ROI due to appreciation by simply comparing the purchase price to the sale price.  What I am really interested in discussing is methods to calculate an APY for returns from equity building and returns (in the form of tax savings) from tax advantages from owning an investment property.  I look forward to hearing your ideas.

Buddy Holmes · Answer

@Ryan Sasscer, I can send you a spreadsheet perhaps but..

You are correct on the first term of cash flow in your rent less:

P (below) principal and interest per month

less Insurance per month

less real estate taxes per month

less reserve for rental vacancy (perhaps 1 month per year? or ~8% or rent

less reserve for repairs, perhaps 5% of rent

less Capital Expenditures reserve, perhaps 5-10% or rent.

Multiply by 12 months to put on a yearly basis.

That cash flow divided by you down payment and closing costs = ROI or cash on cash return

Next you need to know how much 12 months of mortgage payments actually pays down the principal on your loan.

Loan, L - B = first year's principal pay down.  see formulas below.

P = L[c(1 + c)n]/[(1 + c)n - 1] = monthly payment of principal and interest

B = L[(1 + c)n - (1 + c)p]/[(1 + c)n - 1]

B is principal remaining after n monthly payments. for first year, n=12

L is your original loan amount

c =monthly interest, yearly interest rate/12

p= monthly payment for Principal and Interest

Now your next calculation is you ROI based on tax savings.

Your depreciation allowance is the purchase price + a few items of you closing divided by 27.5 years. check IRS for how to determine you initial Basis or value to be depreciated.

Now you can calculate how much of your rental income is taxable

the net cash flow from first calculation above + first years principal pay down(you only deduct interest paid)+ Capital reserve (hopefully you will not spend this the first year) = your best guess at taxable income from your rental.  (This assumes you used you estimate for vacancy and repairs.)

No determine your tax rate for Federal and State from last year.  Say it is 30%

multiply the taxable income from the rental by you tax rate to get the next tax saving or tax expense from this calculation.  Add this tax (+/- )number to the net cash flow and divide by cash invested for

after tax ROI

Next step is consideration of principal pay down.  The first year is the smallest number of your rental investment, so;

Add the principal pay down to the tax savings/expense and the net cash flow.

divide again by your investment to get the ROI at this level.

Lastly decide what appreciation you might expect.  multiply that by the purchase price to get a yearly value.

Add this value to the last sum of cash+tax+principal pay down to get a yearly return estimate then divide by investment for total expected ROI.

Easy to set up on a spreadsheet, difficult to talk through!

Cheers,

Buddy