Cash flow refers to the amount of cash on a monthly basis that is left after the cost of expenses on a property. It is generally referred to as before-tax cash flow. If the expense of taxes is taken into consideration it is referred to as after-tax cash flow. Cash on cash return is the cash flow divided by the required equity investment.
Return on Investment
Return on Investment is the actual earnings from the investment. This does not represent any return that repays the principal that was invested.
Inflation and Appreciation
Inflation is the decline of purchasing power of the dollar over time. Real estate is generally considered a good hedge against inflation. Appreciation is the rate at which the value of property increases over time. See disk 1 for an EXCEL worksheet that will calculate expected appreciation. It is, however, not a given fact that your property will appreciate. Appreciation can vary tremendously and should not be the only consideration for purchasing property. The following table is provided on the disk and the initial value can be changed to find values of appreciation.
Depreciation – Tax Deductions
Concerning Federal Income taxes, the IRS allows you to depreciate the cost of property as an expense even though your property may increase in value. This depreciation schedule is created by taking the price you paid for the property minus the value of the land, divided by 27.5 years. This will give you the yearly depreciation to offset against your rental income. In some cases, if you sell, you will be liable to pay back taxes on this depreciation expense. You can also depreciate the cost of appliances and other items over shorter periods of time. Consult a tax attorney for further details.
Real Estate is known for producing a loss as far as tax purposes are concerned while often having a positive cash flow. This is due to certain tax deductions and credits. Reducing taxes is a form of investment income. As always, consult a tax consultant before making any decisions.
A capital gain in real estate occurs when a property that is held for investment use is sold and generates a profit. Adjusted basis is the original cost of the property adjusted for depreciation and capital improvements. You will be taxed on the adjusted basis with the capital gains tax. In some cases, this tax may be lower than your income tax. You can also use a 1031 tax exchange to defer capital gains taxes. Consult a tax attorney for more information.
Leverage is using borrowed money to magnify returns. You are controlling a large dollar value, while only investing a small portion. Using financial leverage also magnifies risk, as you may not profit as much after expenses, due to increases in financing costs. Suppose that you bought a building for $100,000 cash that produces a net operating income of $12,000 per year. Your annual income is $12,000 giving you an annual return of 12%. If you had used a loan of $80,000 to buy the property, your cash investment would have only been $20,000. For simplicity, assume the loan is interest-only payments of $8,000 (10% interest). Your cash flow is still $12,000 minus the debt service of $8,000 leaving a profit of $4000. Leverage has thus increased your return to 20% ($20,000 divided by $4,000).
They ain’t makin’ any more of it! Real estate is a finite commodity, there isn’t going to be any more produced over time, so it will only go up in value over time