Cash flow is NOT everything when it comes to analyzing rental properties and real estate investing. Yes, it's important, but if you're only looking at cash flow, then you're missing a few very important pieces to the puzzle. This post covers:
- The four ways you make money in real estate investing.
- Defining your true total initial investment to accurately measure your ROI.
- Using a powerful visual aid to calculate the four returns to determine your complete ROI.
- Two real-world Denver rental property analyses and their ROIs.
Most likely, it'll be a different property analysis perspective than you've learned elsewhere. As the title states, cash flow is NOT everything!
This post is part of the Investment Property Analysis Course. The course teaches you how to analyze a rental at purchase and how to review it annually to optimize your returns.
Three Learning Options:
- Listen to episode "#118: IPAC #1 - The Four Returns in Real Estate: Cash Flow is NOT Everything" on the Denver Real Estate Investing Podcast
- Watch the YouTube video at the bottom of the page.
- Read the blog post.
What is Your ROI (Return on Investment?)
I'm an active investor-friendly real estate investing agent who works with veteran and new investors. Typically, within the first few minutes of talking with someone, I can tell if they are a veteran investor or new investor. The veteran investor can clearly and concisely articulate what type of return they are looking for, where newer investors typically can't.
Here's a typical conversation:
Investor: "I want a property with a 'good' return. Can you help me find one?"
Me: "Maybe... what's a 'good' return to you?"
Investor: "You know, a 'good' return!"
Me: "No, I don't know what a 'good' return for you is. Can you quantify it?"
Investor: "Uhhh... like 7%, I want to beat the stock market."
Me: "7% of what? What return metric are you using?"
See the problem here! If this is you currently, don't be embarrassed. This is how every investor, myself included, initially started.
If they are looking for a 7% return on their money, I can throw a rock on the MLS and get that return for them, but they probably mean something else. You might be scratching your head at that last comment. Continue on and you'll see why I say that and can back it up with numbers!
Defining Real Estate Investment ROI
There are two parts to understanding return on investment (ROI) with real estate investing:
- Define and understand the real estate investment returns (plural, not singular) AND...
- Define and understand your true total investment in the rental property.
The Four Types of Returns from Real Estate Investing
Real estate investing, unlike many other investments, has four ways to make you money. The four ways are:
- Cash Flow
- Debt Pay Down
- Tax Benefits (Depreciation)
You may know some or all of these. We'll discuss each one in detail, but first we need to define the true investment.
Defining Your True and Total Real Estate Investment
Many investors and agents use the down payment required to buy the rental property as the total investment. That's incorrect! If you buy a $400,000 rental property with a 25% down payment, then you're putting down $100,000. But there are other costs associated with buying the property.
There's a cost to buying and selling real estate. It's not insignificant like the transaction costs of buying a stock market index fund. Typically, one can invest $100,000 into an index fund for a $0 to $10 transaction fee. Compared to the total investment of $100,000, those are insignificant transaction costs.
There are three main categories for real estate transaction costs:
- Acquisition costs
- Home inspector
- Property insurance premium for one year
- Transfer taxes
- Title insurance
- Recording fees
- Closing fees
- Plus more!
- Loan costs
- Underwriting fee
- Processing fee
- Point buydown (optional)
- Origination fee
- Rent ready costs
- Initial repairs to make it rentable or get top dollar
- Tenant placement costs
- Carrying costs, if the property will be vacant for an extended period.
Unfortunately, there is not a fixed price or percent for an amount. For many of our Denver transactions, these costs range from $2,000 to $15,000. There are many variables unique to the investor and the property that will impact the total investment amount.
Total initial investment = downpayment + acquisition + loan + rent ready costs.
This is why you can't just look at the downpayment! Including all of these costs gives you a more accurate return on the rental property that you're buying. It also gives you a better comparison for investing the same amount of money into other investments, such as the stock market.
If it really takes me $110,000 ($100,000 downpayment + $3,000 acquisition + $1,500 loan + $4,500 rent ready costs) to buy the $400,000 rental property, then I need to compare investing $110,000 to $100,000 investment in the stock market. Real estate has a high cost of doing business, and we should expect a higher return!
The Real Estate Investing Return on Investment Quadrant™
Now that we've defined, at least from a high level, let's dive into the details on the four ways you make money with real estate. The Return on Investment Quadrant™ is a great visual guide for showing the returns.
I wish I could take credit for creating this great visual, but I can't! This is the brainchild of James Orr, who is an investor and real estate broker in Fort Collins, CO. He's gracious enough to allow me to use the Return on Investment Quadrant™.
Let's jump into the details on the four types of returns.
Appreciation is how much the property value increases over time. Many investing websites out there say something along the lines of "buy for cash flow, don't worry about appreciation. You may or may not get some and if you do, it's a cherry on top."
I don't agree with that sentiment. It's too simplistic and doesn't use any data to back up it up. Let's look at the historical data for appreciation:
- According to Case-Shiller, real estate has appreciated at about 3% a year at a national level over a 100+ year time frame.
- In Denver over the last 45 years (1974-2018), homes appreciated at 6.5% annually and condos appreciated at 5.5% annually.
Keep in mind, that this is the average appreciation per year. Some years saw worse (even negative!) and some years saw better. Most people agree with me that they should expect appreciation in their rental properties.
Now, the million-dollar question, "What appreciation rate should I use for modeling investment properties here in Denver?" I don't have a crystal ball! The majority of investors that I know (and respect their opinions) use somewhere between 3% to 5% for annual appreciation. I have yet to meet anyone who thinks Denver will NOT appreciate over the next 30 years. With our population and job growth, I'm betting Denver will see price appreciation.
Real Estate Cash Flow
Out of the four ways of making money, people are most familiar with cash flow, so this section will be brief.
Cash flow = Rent - Expenses - Mortgage payments.
If you have a property that rents for $1800 (rent) - $500 (expenses) - $750 (mortgage payment) = $550 is monthly cash flow before taxes.
Debt Pay Down
You only get the debt pay down if you finance your rental property. If you pay cash, you won't get this return. Very few rental property investors buy properties with cash, because the returns are higher when using leverage (debt.)
Below is an amortization table. It shows the first few payments on a typical $400,000 mortgage at 4% over 30 years. The first column, "Payment" has the same amount every month. The next two columns," Principal" and "Interest", change monthly because as you pay down the loan, your balance decreases. Each month you'll pay a little more towards the principal.
Paying down the principal is actually building more equity in your property. Equity is like money in your "real estate piggy bank." Every time you pay down the principal and build equity in your property, you're getting a return.
It gets even better. Who paying down your loan? Not you, it's your tenant! With no cash from your pocket, your tenants are buying you more of your property by building your equity.
Obviously, you have to make your monthly payments to get this return. If you don't make your payments, you don't get the monthly principal reduction.... and will have bigger problems on your hands.
The debt paydown return goes away after the loan is paid off.
Real Estate Tax Benefits (Depreciation)
Disclaimer: I'm not a tax professional. Make sure you consult a CPA or tax professional.
Depreciation benefits are based on federal tax law. Personal residences do not receive these tax benefits, only investment properties do. Depreciation can generate significant tax savings, which indirectly puts money back into your pocket.
When you purchase a rental property, you're buying the land and the structure (known as "improvements.") The land does not depreciate, but the improvement does.
The last rental property I purchased is a fourplex in Westminster. I'll use this as an example to differentiate between land and improvements. According to the assessor section on Adams County's website, here's how they value my property:
- Land assessed value = $4,970 (14%)
- Improvements assessed value = $30,070 (86%)
- Total assessed value = $35,040 (100%)
I paid way more than the $35,040 value! It's important to understand that's their calculation for property tax purposes, not the actual value of the property. I purchased the rental property for $850,000.
A way to estimate your depreciation benefit is by using the percent valuation from the assessor's office. Adams County values the improvements (aka, the building) at 86% of the total value.
86% x $850,000 = $731,000 for a total estimated improvement (structure) value.
The government allows you to depreciate the property over 27.5 years. Don't ask me how they came up with that number.
$731,000 / 27.5 years = $26,581 for my annual tax benefit. For owning an investment property the government is giving me a $26,581 tax deduction for the next 27.5 years!
How much this tax deduction benefits you ultimately depends on your personal tax situation and tax brackets. This is why you must talk to a CPA. Every person will ultimately receive a different benefit on their taxes.
Here's an example of how your tax bracket will impact your actual tax benefit (I'm using round numbers for simplicity):
- Investor A is at a 50% tax bracket: 50% x $26,581 = $13,290
- Investor B is at a 25% tax bracket: 25% x $26,581 = $6,645
Generally speaking, the higher your tax bracket, the bigger the benefit.
Since the IRS gives you 27.5 years for a residential property, the tax benefits go away after 27.5 years.
Note: If you got lost in this example, don't sweat it. I wanted to highlight the amazing tax benefit from real estate. You certainly don't get this in the stock market.
Speculative and Uncertain Returns
Appreciation and cash flow depend on the conditions of the market. Therefore they are uncertain and to an extent, speculative. Every investor will say that immediately about appreciation, but very few will say that about cash flow. How good is your cash flow? As good as last month's deposited rent check!
Cash flow is easier to predict than appreciation, but it is in no way guaranteed. The important point is to understand that neither is guaranteed! We can take our best guess at modeling them but not with 100% certainty.
More Fixed and More Certain Returns
The only guaranteed things in life are death and taxes. But the bottom half of the quadrant is pretty damn near guaranteed. It does not depend on market conditions or property performance. These returns are much easier to predict and model.
Regardless of what the property value does, you're getting the same tax benefits based on your original purchase price. As long as you pay your mortgage every month, you're getting that return.
Cash Now Side
Cash flow and tax benefits are considered "Cash now," because you realize the benefit every year. Generally speaking, cash flow is looked at on a monthly basis. Depreciation is realized every year you file your taxes. Does that mean you'll get a check back from the IRS for the exact amount of your realized tax deduction? No, but you should realize the tax benefit as part of your refund or as it offsetting taxes you owe on other taxable income.
Equity Side - Cash Later Side
While you're making a return from appreciation and paying down your debt, you're not getting cash deposited into your bank account. However, you're building equity in your property which is like your "real estate investing piggybank."
In reality, you can't tap into your piggy bank or equity on a monthly basis, but once your property gains enough equity, you have three main options for getting it:
- Sell the property
- Get a HELOC (Home Equity Line of Credit)
- Do a cash-out refinance
Getting into those details and putting your equity to its best use is covered in the Return on Equity Course (COMING SOON.)
To get your complete real estate investing ROI, you simply need to add up each return. Fortunately, you don't need to do this manually as our rental property analysis spreadsheet can do the work.
Remember, The Return on Investment Quadrant™ analyzes the return for the first year. It's a powerful way to see if the property makes sense as an investment now.
The rest of this course will walk you through a couple of examples. Hopefully, you have the conceptual idea down on the four ways you make money in real estate. Now, let's plug in a few example properties.
Example: Aurora Rental Property
The first one is a real rental property that I helped a client purchase in 2019 for $190,000. It's a 3 bedroom, 2 bathroom condo in Aurora that we found on the MLS. Generally speaking, these are some of the best cash flowing properties we're seeing in Denver in 2019.
The screenshots are from our rental property spreadsheet. In this blog, I won't give you a line by line breakdown of the spreadsheet. For those details, review the rental property analysis spreadsheet course. Rather, I'll highlight certain parts.
The cells that add up to your total investment are highlighted in the red dashed line. This is the total cash required to buy this property and get a tenant in there. It's the total initial investment that is used to calculate all four returns.
Calculating Total Initial Investment:
$47,500 (downpayment) + $2,500 (acquisition) +$1,540 (loan) + $1,000 (rent ready costs) = $52,540 (Total Initial Investment)
Below is the second screenshot from the spreadsheet that shows expenses and assumptions for vacancy, appreciation, and effective tax rate (used to estimate depreciation benefits.)
Income and Expense Summary
Annual rent income: $22,200
Less non-mortgage expenses: ($8,481)
Net Operating Income (NOI): $13,719
Less mortgage payments: ($8,897)
= ANNUAL CASH FLOW BEFORE TAXES = $4,822
It's a positive cash flowing property!
First Year Returns with Traditional Investing Metrics
Before jumping into calculating the total ROI, let's review three common metrics for calculating rental property returns:
- Cash-on-cash return: 8.2%
- Cap rate: 7.0%
- Gross rent multiplier (GRM): 103
If you don't understand or know what these are, that's fine. I'm sharing them for people that are familiar with them to help put the total return into context.
Return on Investment Quadrant™ Results
What is your guess for the total return on your initial investment? When I teach this class, people guess between 4% to 15%.
Look below at ROIQ™ for the return from the four ways to make money in real estate:
Can you believe the first-year return on investment is projected at 33.2%? Yes, you read that right, 33.2% return on your initial investment!
Take a minute to really read the numbers and understand the math behind it. It's a mind pretzel for most people the first time they see it! The 18.1% appreciation return does not mean it's at an 18.1% appreciation rate. No, it's the return appreciation comparted to total initial investment.
Let's look at total dollar returns rather than a percent return:
Each quadrant is showing the projected return in dollars after owning the property for one year. Let's look at Appreciation: The property was purchased for $190,000, and we assumed a 5% appreciation. Therefore $190,000 x 5% = $9,500.
The percent return is calculated by dividing the dollar return by the total initial investment of $52,540. The appreciation percent return calculation is $9,500/$52,540 = 18.1%
I'm sharing this, because people often don't believe the numbers. Look at the math yourself in the example below. Once you understand the math, you'll understand why so many people rank real estate investing as their #1 investment!
Is your sticker shock on complete real estate investing ROI over? Good. Let's discuss some key takeaways:
- Cash flow return is the same as cash on cash return of 8.2%
- Look at the bottom half of the quadrant with debt paydown and depreciation. It's a 6.9% return! Where else can you get an almost guaranteed close to 7% return? I don't know of any places.
You don't agree with 5%. That's fine! Here's the Return on Investment Quadrant™ with a 3% appreciation assumption on the same property.
Geeze, only a 25.9% return with the 3% appreciation assumption! Sarcasm aside, if you don't agree with any of my assumptions, then download our rental property analysis spreadsheet to plug in your own assumptions. I'm not here to tell you what numbers you should model with. The goal of this course is to teach you how to understand the ways you really make money with real estate investing.
Example: Nomad™ Property in Arvada
Nomad™ properties are properties where the owner buys the property as their primary residence with the goal of moving out after one year to convert it to a rental. It's a powerful and simple way to acquire rental properties for two main reasons:
- Low down payments - These are owner occupant properties. People typically put down 3.5% to 5% - much less than a 20 to 25% downpayment on investment properties.
- Lower interest rates - You get lower interest rates if it's your primary residence compared to investment properties.
If you want more details, then check out our Denver Nomad™ and House Hacking Overview course.
Below is a real property that I closed on in 2019 for a client. It's a 5 bedroom, 3 bathroom single-family home in Arvada purchased for about $430,000. A couple with two kids purchased this future rental property.
The total initial investment was $26,000. You'll notice the acquisition costs are a negative $5,210. It's negative, because the spreadsheet is designed for investment properties and we needed to offset the incorrect, auto-calculated higher loan costs. UPDATE: The newer version (6.1+) of the spreadsheet now calculates this correctly.
Income and Expense Summary
Annual rent income: $30,000
Less non-mortgage expenses: ($10,000)
Net Operating Income (NOI): $20,000
Less mortgage payments (including PMI): ($24,459)
= ANNUAL CASH FLOW BEFORE TAXES = -$4,822
It's a negative cash-flowing property. Does that mean it's an automatic pass? Well, it depends on the context of the real estate investment. Remember, this investor put only 5% down. Review the Denver Nomad™ and House Hacking Overview course for a full breakdown on these properties and why we consistently buy them, even with negative cash flow.
First Year Returns with Traditional Investing Metrics
Before jumping into calculating the total real estate investing ROI, let's review three common metrics for calculating rental property returns:
- Cash-on-cash return: -17.1%
- Cap rate: 4.7%
- Gross rent multiplier (GRM): 172
Return on Investment Quadrant™ Results
Will the return be higher or lower than the Aurora rental property example?
It's higher! Does that surprise you, since it has negative cash flow? Look at the total dollar returns:
We're seeing a higher overall return on this Nomad™ over the rental property for two reasons:
- The power of leverage. This client put less money down, so he has move leverage. The more leverage, the higher your return (and the higher your loss - it cuts both ways!)
- It's a more expensive property. A 5% appreciation of a more expensive asset will always return more than a less expensive asset. He also gets a higher debt paydown and depreciation benefit.
Let's take a look at the math again:
You gotta love the power of leverage!! Yes, a large part of the real estate investing return is coming from appreciation, but if you dial it back to a 3% appreciation rate, then the return is $13,050 which is a $13,050 / $26,000 = 50% return. Still not shabby!
As I mentioned earlier, this example is scratching the surface for house hack and Nomad™ properties. Make sure you review the Denver Nomad™ and House Hacking Overview course for all the details and how we can manipulate the numbers to make it a positive cash flowing property!
Hopefully, this course opened your eyes to a different way of analyzing rental properties and for comparing it to other investment classes. This is a deep topic that has a learning curve to it. Continue on with the course, attend classes, and ask your questions in the comments below.
- Overview: Investment Property Anaylsis Course (IPAC.)
- Module #1: The Four Returns in Real Estate: Cash Flow is NOT everything
- Module #2: Rental Property Analysis Spreadsheet Tutorial
- Module #3: Return on Equity: Playing Adult Monopoly
- Module #4: Refinancing Your Primary Residence to Purchase Denver Investment Property
- Module #5: Tapping into Your Primary Residence Equity Updates - Part #2
- Module #6: Case Study: Investing $100,000 from a Primary Residence Cash-Out Refinance