Once you have established the value of your investment property, your next concern is to determine the anticipated annual return on invested capital.
Initial Investment
Since we consider the purchase of a property an investment, we refer to the down payment as the “initial investment.” The initial investment is the amount of capital that investors use to purchase an investment property. Remember, the bank finances the rest. When determining our return on investment, we must first determine the size of that investment.
EXAMPLE
Throughout this chapter, we will use the following property information to calculate the return on investment. In this case, the investment consists of a 20% down payment.
Property Price: $400,000
Initial Investment; $80,000
Return on Investment
Your annual return in real estate will be composed of four elements;
1. Cash Flow
2. Equity growth by amortization.
3. Equity growth by appreciation, and
4. Tax shelter benefits.
Using the property in the example above, we will calculate the return for each of these four element. On page 15, we will put each of the individual returns together and produce a simple ROI statement.
Cash Flow
Cash = Rental - Operating
Flow Income Expenses
Rental income includes all the rent a property produces. Operating expenses include all the expenses a property incurs. This includes mortgage payment(s), property taxes, insurance, utilities, upgrades, and repairs.
EXAMPLE
Yearly Rental Income $36,500
Yearly Operating Expenses -34,200
Yearly Cash Flow $2,200
Equity Growth by Amortization.
Equity growth by amortization is the amount of principal paid off each year on your mortgage loan. This phenomenon of growth income assumes that the value of real estate remains at least constant over time. Our data indicates this to be valid assumption.
To illustrate, let’s examine the equity growth by amortization for the first year of this chapter’s property.
NECESSARY FORMULA
Yearly Equity Growth Monthly Principle
by Amortization = Payment x 12 (months)
Property Price: $400,000
Initial Investment : $ 80,000
Mortgage Loan Balance: $320,000 Mortgage Interest Rate: 5%
Monthly Interest Payment $1,333.33
Monthly Principle Payment: $ 384.50
Total Monthly P & I Payment $1,717.83
Calculation $384.50 x 12 = $4614 (Yearly Equity Growth
By Amortization)
Equity Growth by Value Appreciation.
Traditionally, well located properties have an average annual increase in value of 5% to 9%. The increase results from two factors: (1) inflationary appreciation and (2) demand appreciation.
Inflationary appreciation is the upward dollar value of assets resulting from the decreasing value of the dollar. The appreciation rate is related to the general inflationary rate in the economy. In this way investing in real estate is a hedge against inflation.
We believe this hedge against inflation is an essential safeguard, particularly for those in their retirement years. Every once in a while inflation skyrockets (like it did in 1978-81 when it increased 43 ¾%). When this occurs, a person on a fixed income can suffer financially.
For example, let’s say a person’s retirement nest egg remains $250,000 and inflation jumps 25% in 3 years. The value of the $250,000 is now 25% less. Unfortunately, those in or near retirement are traditionally less likely to recover economically. The results can be devastating.
For the person, however, with investment property, inflation can be a good thing. For example, let’s say you invested $50,000 to purchase a $400,000 property. When such 25% inflation occurs, property, from inflationary appreciation alone, is highly likely to increase your earnings $100,000! Of course, in such situations, the more property you own, the better off you’ll be.
Demand appreciation is the upward value of property resulting from its limited supply and large demand. Well located properties (for example, those in areas with great weather, a strong job and rental base, and which are relatively close to major airports and nice beaches) have strong demand appreciation.
EXAMPLE
Let’s examine this chapter’s property. Let’s assume a low appreciation rate of 5%.
Original Property Price: $400,000
Yearly Equity Growth by
Value Appreciation (5%): $ 20,000
Tax Shelter Benefits.
Outside of a property’s operating expenses, there are three major tax shelter benefits: (1) the use of the capital gains tax, (2) the tax-deferred exchange and (3) depreciation.
The use of the capital gains tax is not something we can speak precisely about in this guide because the laws concerning it are constantly changing. We can say, however, that the benefits of using the capital gains tax are increasing. Professional accountants are generally authoritative sources for tax information. A good agent, however, follows the capital gains tax laws closely and should be of much help.
Since profits from investment property are considered investment income, you are taxed at the capital gains rate. This is beneficial because normal income is taxed at much higher rates and can be, up to a point, subject further to self-employment/social security tax. Therefore, the use of the capital gains tax can significantly reduce your tax liability.
The tax-deferred exchange is a feature of the tax code which enables you to defer paying any capital gains tax by exchanging, instead of selling, your investment property. We will not attempt, here, to explain the “behind the scenes” details of a tax-deferred exchange. That is because, for all practical purposes, it is simply the process of selling one investment property and purchasing another.
We will however, mention three key details for deferring tax through an exchange. First, when you “trade” your investment property, you must purchase another investment property. Second, the property you trade into must be of equal or greater money value. Third, all of the profit from the sale of your current property must be used to purchase the “upleg” property.
Depreciation is a tax deduction for investors of “improved” property. Remember, improved property is that which has some sort of building(s) on it. We will not attempt, here, to explain the theory behind it, for, as it relates to real estate, it is an arbitrarily contrived theory anyway. For now, simply understand it for what it really is: a special tax break for real estate investors.
Before calculating your depreciation tax deduction, you must first understand a few details. First, you need to understand that the total value of every improved property is comprised of two independent parts: (1) the value of the land and (2) the value of the “improvements” (that is, the building[s] on the land). Second, whenever a property is bought, the County Tax Assessor “re-assesses” it, determining for you the value of each part. For tax purposes, these assessed values, generally, remain constant for a long as you own the property.
With that said, depreciation is calculated by dividing a property’s improvements value by either 27.5 (for buildings with 1-4 residential units) or 39 for (commercial/manufacturing buildings or those with 5+ residential units).
To get your actual tax savings, in real dollars, you multiply your depreciation deduction by your combined (federal, state and local) income tax rate.
EXAMPLE
Let’s examine this chapter’s property to determine the size of its depreciation tax deduction. We’ll assume a combined tax rate of 25%.
Necessary Formulas
Depreciation Improvement Value .
Deduction = 27.5 or 39
Actual Dollar = Depreciation Combined Income
Savings Deduction x Tax Rate (%)
Improvement Value (assessed) = $192,000
Calculations
$192,000 ¸ 27.5 = $6981.82 (Depreciation Deduction)
$6981.82 x 25% = $1745.46 (Actual Dollar Savings)
Simple Yearly ROI Statement
$2,200 Cash Flow (from page 11)
$4,614 Equity Growth by Amortization (from page 11)
$20,000 Equity Growth by Value Appreciation (from page 12)
$1,745 Tax Shelter Benefits (from page 14)
$28,559
$80,000 Initial Investment (from page 11)
$28,559 Total Return
35.7% Return on Invested Capital (%)
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