Appreciation, tax advantages, cash flow, leverage and equity build up each contribute to the rate of return on rental real estate. If that sounds confusing and it’s keeping you from investing in rentals, try looking at it a different way.
Most homeowners, based on their familiarity with their own home, should feel more comfortable with a rental than personalternative investments. A conservative strategy is to purchase slightly below average price range homes in a predominantly owner-occupied neighborhood. Collect the rent, pay the bills and make necessary repairs.Consider this, look at only cash flow and equity build-up to determine whether to buy the property. They are easy to calculate and their outcomes are both reliable and predictable.
A cash on cash rate of return is determined by dividing the cash flow before taxes by the cash invested in the property. It considers all of the “real world” income and expenses related to the property.
The equity build-up occurs from the normal process of amortization with an increasingly larger portion of each payment applied to reduce the principal loan amount.
In this hypothetical example, the combination of the Cash on Cash and the Equity Build-up is almost 12% which is considerably higher than certificates of deposit and bonds and nowhere near as volatile as stocks or mutual funds.
In most of today’s markets, rents are expected to continue to rise and due to a low inventory of homes for sale coupled with growing demand, prices will continue to rise. Even though there is value in appreciation, tax advantages and leverage, they could be considered an unexpected bonus to this basic rate of return.