Real Estate Investing - Rate of Return
Rate of Return is one of the best ways for a Real Estate Investor to evaluate the profitability of an Investment Property. There are actually several ways to calculate Rate of Return on an Investment Property. The easiest and most important for the small Real Estate Investor is called Rates of Return for the First Year.
I find Rates of Return for the First Year an odd name as it does not really apply easily to the first year. The Real Estate Investor’s first tax year of having an Investment Property will probably involve a pro-rated return since the Real Estate Investor will probably only be invested part of the year. If it refers to investment year the issue is that it will probably straddle two tax years.
The Real Estate Investor’s Investment Properties are financially dynamic and the results will vary from year to year. However, Rates of Return for the First Year is a good way to take current circumstances and project results. It is also good for evaluating results when you complete your taxes.
Rate of Return for the First Year comes in two forms; both are very easy to figure. The first one is for Before Tax Cash Flow:
Before Tax Cash Flow/Cash Invested = Before Tax Cash on Cash Rate
Take an Investment Property that generates Before Tax Cash Flow of $4,367.26 on an out of pocket cash investment of $40,000.00:
$4,367.26/$40,000 = 10.92%
You can do the same formula for After Tax Cash Flow:
After Tax Cash Flow/Cash Invested = After Tax
Cash on Cash Rate Now suppose the After Tax Cash Flow is $4,024.90
$4,024.90/$40,000.00 = 10.06%
I know someone is asking where the $40,000.00 figure came from? That is the Real Estate Investor’s down payment. The Real Estate Investor would also include any out of pocket closing cost and rehab cost before you could rent the Investment Properties. Don't mix up the numbers.
Compared to banks and other investments this is a good return. My figures and examples are all conservative; I think a smart investor could do better.
Another huge consideration is that the value of Investment Properties should appreciate over the long term; so the Real Estate Investor will have growth and income from the same Investment Properties. Furthermore, if the Real Estate Investor has a fixed rate loan on the Investment Properties the income from rents should climb, while the expenses are staying relatively fixed.
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