Each investment property is unique. When new investors, such as private sector and first response retirees, are considering whether a real estate investment in a particular market is likely to yield a significant profit, it’s important to calculate the property’s return on investment, or ROI. According to Jason Hartman, income property ROI is driven by four major pillars: appreciation, cash flow, principal reduction and tax benefits.
A basic formula for calculating ROI begins with determining the annual gain from the investment. A different calculation than profit, investment gain establishes how much is returned from the property annually. The next step is to subtract all investment related expenses from this number. This cost of investment is then divided by the total cost of the investment.
But as Jason Hartman says, income property is a multidimensional asset, and more elements factor into its return on investment than, say, stocks or other kinds of commodities. The first and most obvious of these elements is appreciation: the “buy low and sell high” principle. And appreciation can be increased with leverage – borrowing money to increase profits. Fixed-rate mortgages that fix the cost of borrowing for terms of 30 years can amplify the appreciation of the investment.
The second pillar in this ROI framework is cash flow. A positive cash flow from the property clearly demonstrates a return on the investment. But even a negative cash flow, which can occur in the early years of owning a property or in periods of vacancy, may not be a drawback if taken in the context of other aspects of the framework such as tax benefits, which can offset that negative income.
Principal reduction also drives the ROI. If an income property is purchased on a fixed-rate mortgage, that loan can be paid down over time by rents from the property’s tenants. One additional factor that contributes to the reduction of loan principal is inflation in the general economy – during periods of inflation, a given amount of money is worth less. Because this is true, not only are tenants paying down mortgage debt, the debt itself becomes devalued.
Finally, the many tax benefits pertaining to income property play a major role in determining that property’s return on investment. With deductions for virtually every aspect of repairing and maintaining the property as well as any activity or travel associated with it, current tax laws favor property investors. These tax breaks, which include depreciation, ongoing maintenance, and capital improvements, can offset temporary periods of a negative cash flow.
No two properties are equal, and the best way to build a viable income property is by diversifying into as many markets as possible. The ROI for each property is driven by its unique performance relative to each of the four pillars in Jason Hartman’s framework for establishing not just the return on investment, but also the return on inflation. (Top image: Flickr/pnwa.)
The Heroic Investing Team