What is the Real Return on My Investment?

Math is hard.  It’s why the abacus was invented by… Well, we don’t know who invented that.  Fortunately for us, we have risen from the abacus, to the calculator, to the computer, to the handy-dandy investment spreadsheet I’ve made for you.  Before you download it though, we should probably talk about what all the numbers and terms mean.

My caveat here is that this spreadsheet is based on quick a snapshot also known as a “cash on cash” analysis which is designed to let you know if a property is even worth the first gander.  The extra savvy investor is going to extrapolate numbers over all the years he/she holds a given property, taking into account increases in rental income and costs over their holding period.  I do include an index for the increase in resale value, so in that way it’s somewhere between the “cash on cash” method and the “internal rate of return” method.  The crux of the matter is that this is a good decision making tool.  Extrapolating those extra numbers for IRR over time is almost always going to make the return look even better.

Okay.  Enough small print.  Let’s talk turkey.  Once you’ve downloaded the spreadsheet [click here] and opened it, you will see that it’s broken into color coded sections.  I have the costs in red, the income in green, and the final evaluation points in blue.  I’ve entered numbers for a property my investment partners and I looked at (although I entered a fictitious address).  You’ll notice that some of the cells have thicker black borders around them.  These are result cells and you should not be entering any numbers into them.  The rest of the cells are where you plug in your own data.

The magic answers for evaluating any property’s value as an investment are at the end and we’ll cover that after I explain how we get there.  Let’s begin with the first section of costs:

This section outlines the upfront, one time costs associated with purchasing your property.  The items are pretty self explanatory and I’ve even included a link to a closing cost calculator that Bank of America provides.  This section will represent the total amount of money coming out of your pocket before you start earning income on your property, although it is possible that, in purchases that require repair, some of your monthly costs happen before you can earn money back.  In that instance, I just add the amount into the “Other” cell.

Our example here is based on a small townhouse unit with a purchase price of $200,000.  The down payment is a standard 20%.  You’ll find the cell to input the purchase price at the top right of the sheet, after the address.  Next we look at the costs that will be there month to month.

Once again, I put a link in for you to help figure out estimates.  The mortgagecalculator.org site is a convenient, free tool for you to use.  I know some people like to wrap the property taxes into the mortgage. You can do that here and just enter $0 for taxes, or change that cell to “Other” and put things like PMI or anything else you might need in there.

My numbers for vacancy, repair, and property management are based on averages that my partners and I have found to be reliable.  Most any property will have some period where it’s vacant before you lease it again and it’s generally reliable to consider 5% of the life of a residential holding to reflect that.  Numbers will vary for office, warehouse, and other type space.

The reserve for repair was set to 5% on this example because it was a newer building and in very good shape.  You might want to bring that number up to 7.5% or even slightly more for older buildings.

Lastly, property management reflects standard rates in the area of this property.

Now, let’s look at the happy part of the worksheet.

This is as simple as it gets.  What’s the total rent?  Are there other income sources?  Like a building on a busy street might generate revenue from a billboard on it’s roof.  Maybe there’s money to be made with extra parking space for a contractor in need of a spot to leave trucks overnight?  Whatever that might be, it goes in “Other.”

One note for you here: If the property you are looking at doesn’t have an existing rental history, the Zillow estimates for property rent values is actually pretty good.  I wouldn’t, for a minute, consider their sale price estimates, but their rent price is a decent guide.

Resale income is where we have to do some divination.  Obviously markets bubble and crash, but over longer periods of time, it is fairly safe to expect certain amounts of growth per year.  In the area of our example, 2% is a good, conservative estimate and that’s what we entered.  I always like to figure on the high side with costs and low side with income.  The other numbers here express how long you will keep the property before selling and what your realtor fees will be for making the sale.

Our last income category is one that newer investors usually know nothing about.

26 USC 167 provides real estate investors with tax breaks for property they own.  I strongly recommend you speak with an accountant about how to best set things up so you take advantage of these benefits in the right way.  For the purposes of our sheet, I have a simple calculation to represent the two factors you’ll need to know for the value in your investment.

“Time Multiplier” is a number based on the tax code and represents how many years you get to depreciate your investment.  For residential holdings, the period is 27.5 years.  Offices, warehouses, et. Al. have different periods.  You can also depreciate some improvements outside your building.  The period for that is much shorter.

The meaning of this number is quite simple.  You just take the price of your property (in our example it’s $200,000) and divide it by the time multiplier.  Here it is $7273, which is how much income you get to take off your tax return.

In the next cell, I have an entry for “Your Tax Bracket.”  This is important for my final, “Mark’s Quick ROI” calculation, because the entire tax benefit doesn’t go in your pocket.  Your actual financial benefit here is that depreciation total multiplied by your tax bracket.

Whew!  Still with me?  Let’s get to the goods.

Here are the four numbers that you will base your decisions on.  The first is the most simple number and is often used in commercial real estate to express the quick overview value of a property.  It is quite simply an expression of the yearly income from the property as a percent of the total purchase cost.  Our example is pretty high at 13% and means that you will have gross earnings of 13% of the total property value in just one year.

The second number, “P&L Ratio” is probably the single most important number that I use.  This number represents the ratio of monthly income over monthly expenses (including the estimated expenses for repairs and vacancy).  If you are studying real estate investing at all and watching/reading interviews with wealthy investors, you will almost always hear them speak about not investing in a property unless it’s at a 1.25.  This means that you want your monthly income to be equal to real & estimated future expenses and then 25% more on top of that.  Any number lower than that and you expose yourself to unnecessary risk, especially if problems occur early in your holding period.

“Cash On Cash” is our next number and it is a good quick comparison tool when considering your investment versus putting cash into other vehicles like stocks.  Here we are looking at the amount of money you took out of your pocket to get the property (all from the “initial costs” section) and your pre-tax income for the first year.  In our example, we can see that we earned 10.84% on that investment.  Pretty darn good.

Lastly we have what I have so humbly dubbed, “Mark’s Quick ROI.”  As I mentioned above, in an extremely granular “IRR” analysis, we would take all of our numbers and do an annualized spreadsheet that shows increases in rent and costs, interest and equity, etc.  I want a quick number, however and this figure takes all the income from the annual rental profits (without increases), the profit from the resale price of the property (divided by years held), and depreciation benefits in real dollars.  When you take that number as a percentage of your initial investment, it begins to show you why 90% of the millionaires in this country got there with real estate.

As always, if you have any questions or comments, please feel free to reach out to me.  I’m always happy to chat!