Calculating First-Year Return on Equity for Real Estate Investments
Many real estate investors are involved in multiple properties and use leverage in their purchases. When deciding on the viability of an investment, one of the measures used is the expected Return on Equity in the first year.
If two properties are similar, the one which will produce the best first-year return may be the better short-term investment. To find out, you must determine the Cash Flow After Taxes (CFAT). For this example, we'll assume a CFAT of $11,000. The cash invested in acquiring the property, for instance as a down payment, represents the next piece of the equation. Let's say the buyer put down $170,000. We must then divide the CFAT by the cash invested to calculate the return on equity:
$11,000 / $170,000 = .065 or 6.5%
You might use a real estate financial calculator to check the math for this and other calculations when buying a property.
Rental property investing is a great tool to build wealth. The rental property investor wants two things primarily: 1) monthly positive cash flow, and 2) value and equity appreciation.
Rental Property Trends
The demand for rental housing has been growing as have rents and in 2018, more people in the U.S were renters than homeowners. That trend is expected to continue. Millennials, the likeliest first-time home buyers, are delaying the start of families and homeownership because they are still paying off record levels of student loan debt after graduating into a recession that stalled their earnings.
The biggest challenge now is to find bargains, especially if looking for ready-to-rent properties. As rental demand increases, it's possible to raise rents, resulting in better cash flow.
Cash Flow & Benefits
Real estate investment has some advantages not afforded to the stock market or bond market investor. Mortgage interest, taxes, and insurance are deductible against rental income. Also deductible are operating expenses such as repairs, maintenance, trash collection, water and sewer, management fees, taxes, insurance and more,
The Tax Cuts and Jobs Act (TCJA), which took effect for the 2018 tax year, places restrictions on deductible interest for homeowners. These changes, however, do not affect rental real estate, unless it is owner-occupied. There's still an annual write-off for depreciation calculated over 27.5 years. What's more, the TCJA allows up to twice the Section 179 deduction in the first year, if these deductions don't create a net loss on the investment. The 1031 Tax Deferred Exchange can be used to push forward capital gains taxes if the rules are followed for selling one property at a profit and rolling the money into another property.
Equity and Debt Pay-down
History has proven that in the long run, the odds are that a property's value will increase. As you pay your mortgage down, you're building equity as well, That means when you decide it's time to sell, there should be a reward on that end, too.