Hello, my friends and welcome to another episode of Ask Marco where I answer your investing related questions.
Today’s question is a great one and it comes in from Kramer and he says, Hey Marco, quick question for you. It’s really more of a viewpoint that I’d like you to address for me. Maybe there is something I’m not seeing or considering if I’m going to buy a $100,000 investment property where I have to put $20,000 of my own money down for it and my cash flow is going to be around $200 per month based on several properties listed on your site. I’m having a hard time getting excited about that. It would take just over eight years to recover my initial investment through the property’s cash flow in quotes. More to the point I’m having a hard time considering it cashflow when I already had $20,000 in my bank account.
Does that make sense? It reminds me of the concept of an annuity except I’m not earning interest unless I raise rents every year, but even then, how much can I reasonably raise rents without losing tenants. It seems like the real reward or gain comes from the price appreciation and equity accumulation over time, which I could then use to either cash out for a windfall or 1031 for more property, 1031 being the tax-deferred exchange. Perhaps at that point, the cashflow would see more attractive. Is this about right or is there something I’m missing from the concept of the near future cashflow? Thanks for reading. I love the podcast and plan to work with you.
Okay, so Kramer, this is a great question. Yes, you are overlooking something very basic and fundamental, but I can see how this would trip up a lot of people.
So I’m going to break it down for you and I’m going to begin by saying that in order to change your viewpoint on this, you have to understand that your $20,000 that you currently have probably in a savings account at the bank, is not money that is actually being spent. You’re simply investing it and you’re investing it by moving it and putting it to better use. So you’re taking it out of the bank in the form of liquid cash, and you’re using that as a down payment towards the purchase or investment in a piece of real estate. In this case, a rental property. So that liquid cash now becomes equity. It’s still yours. It’s still on your personal financial statement. It’s on your personal balance sheet. It’s under the asset column. But now instead of being listed as cash, it is listed as equity in the form of property.
So your quote-unquote recovery is not eight years. It’s not any years. There is no recovery because that $20,000 is still yours. It’s still on your balance sheet. You still own it. But now instead of losing money in the bank because your purchasing power is being eroded every year from the effects of inflation, you are now actually getting a real rate of return in the real world because you have real assets that are generating real returns for you. Real cashflow. So that’s the major viewpoint. That’s the hopefully the aha moment here is again, you’re not spending that $20,000 a year investing that $20,000 by simply moving it out of the bank and into real estate. And that means that you’re simply turning liquid cash, which by the way is inflated away into the real estate, which will hopefully appreciate for you. So hopefully that changes your understanding and your viewpoint.
So you understand that you are making money from day one, you are generating a return. So let’s break that down and use some real-world numbers here. So first of all, in order to break this down, you have to remember that real estate is the ideal investment. Now I say that half-jokingly, it really is an ideal investment. In fact, it is by far the best investment, but I use the word IDEAL because it’s an acronym I D, E, a, L and those all represent something different. So that represents income depreciation appreciation, which is equity growth, the amortization, which is equity gain from the mortgage being paid off, and the L in the word IDEAL is leverage. So the first four are actually forms of returns, different types of returns, but returns nonetheless, the L or leverage is your ability to take a little amount of investment capital, your cash in this case and turn it into a larger investment where you get all the benefits.
Let’s break this down. I could do an entire episode on this, and by the way, I have done an entire episode on this, which I will put in the show notes. But for the sake of this short ask Marco episode, when you look at the income, you have to ask yourself, first of all, what is the return on the $20,000 you have in your savings account in the bank? I will bet that it’s almost zero. It is probably very, very low. And when you factor in the real rate of inflation, not the nominal rate, which is what the government reports all the time, and that’s probably somewhere around two, two and a half percent right now, you will see that you are losing money every year on that money, on your cash. So in your example with uh, your property example, above that, you cited the cash on cash return by itself.
Just income based is 12% how did I calculate that? Simple. The $200 per month cashflow times 12 months is $2,400 per year. If you divide that by the $20,000 investment that you made from the cash in your savings account, the math is pretty simple. It’s 12% if you really want to be more conservative and just say, let’s call it $22,000 because you had a couple thousand dollars in closing costs, you can take that same $2,400 divided by $22,000 and now you have 11% that’s an 11% immediate cash on cash return. That’s an 11% annual cash on cash return note also that the $200 that you cite above is true net cashflow. And what I mean by that is you are budgeting for, even though you may not have spent, but you are budgeting for probably 5% in vacancy, future vacancy or towards future vacancy and another 5% for maintenance and repairs.
So right off the top you’re taking 10% off of that cashflow. So that $200 a month is more like probably 240 to $260 real spendable cash in your pocket. Cash flow. I don’t recommend you do that, but let’s just call it $200 to be conservative and that’s your net cash flow. So I took an example off of our website. This is a available as of today, and this is a property that’s on our website for $110,000 so close to the a hundred thousand dollar example that you’re giving that rents for $1,150 a month. So right around a 1% rent to value ratio. And what I did is I actually took the numbers from this in order to record this podcast episode. So looking at those numbers, the net cash flow is $303 per month. So over the course of a year, that’s $3,635 per year. Again, doing the same math is what we did.
In your example, the cash on cash return, which is immediate cash flow is 14.2% that is a great rate of return and hard to find in many other investments short of having your own business, it’s pretty hard to find that. So that is the income part of IDEAL. Now let’s look at the D. the depreciation allows you to take the improvements, basically everything but the dirt and depreciate that over 27 and a half years. And just to keep this ask Marco episode, pretty simple. We’re going to take that hundred and $10,000 property and assume that 20% is land, 80% is the improvements. So we have $88,000 that you can depreciate over those 27 and a half years. Well, do the math and that works out to $3,200 a year that you can depreciate and put towards your passive income. Now remember, this allows you to lower your taxable income on your passive income without having to spend a single penny.
This is what they call a paper loss. It looks like a loss on paper, but in actuality, you haven’t lost anything. You haven’t spent anything in order to get that depreciation. So talk to your CPA or your tax advisor about how this plays into your personal tax situation. But as a general rule of thumb, that applies straight towards your passive income. And if you’re a professional real estate investor, which has a classification, you can actually apply that to active income, not just passive income. So that’s the D in IDEAL. Now the A or the appreciation. Actually let’s do this the other way around. Let’s look at the amortization, which is the equity portion of it. That’s the E and so what happens is you have a return from the increase in equity. Now, keep in mind, this is not spendable money. It doesn’t go into your pocket because it’s a locked up in the property in the form of equity, but the reality is is that equity is still a gain even though it hasn’t been realized and put into your pocket.
But when you look at the gain over the first year, if you actually look at what is amortized on your mortgage in the first year, it’s $1,298 your tenant is paying you rent every month and that rent, a portion of that obviously goes to pay the debt service, which is your mortgage. Now your mortgage payment every month pays down. The principal, a part of it goes to interest and a part of it goes to principal. When you look at the part that’s paid down every year in terms of the principal, you could measure that or look at that as a rate of return. So in year number one, you’ve paid down $1,298 in principle, when you take that number and divided into your original investment, that 20,000 or in this case it’s $22,000 in my example, you have a 5.9% return on that equity if you will. So in other words, you’ve gained $1,298 in principle, which is now equity in the property.
And when you compare that to what your original investment was of $22,000 you have almost a 6% return. And I went ahead and just check the math on years two and three. So in the second year, you’re paying a little bit more towards principal because that increases each and every year. So in year two you have $1,365 towards principal, which is a 6.2% return. And in the third year, you have 14 and $35 towards principal, which is a 6.5% return. Again, we’re measuring this against your original investment of $22,000 in this particular property that we have in Pennsylvania or the Pennsylvania Metro. Here’s an interesting little fact. If you looked at a 30-year mortgage and you actually averaged out that rate of return every year over the 30 years, the average return on that equity increase is 13.3% that’s assuming you let the 30-year loan amortize without paying it off early or accelerating any payments.
What you would have as a 13.3% return on your investment on average over the course of that 30-year loan. So that’s the return on the amortization of the loan. So the A is the appreciation in the word IDEAL and the way that works is simple. Let’s just say you have a 4% average rate of appreciation per year. Now I know some years are going to be more, some years are going to be lasted. It does change, and we’re making an assumption here, but it is not atypical to see a 4% average annual rate of appreciation in healthy markets and in good neighborhoods. In fact, it’s often higher, but not always, and again, there’s no guarantee, but let’s just take 4% which is a fair number to work with. So at 4% on this $110,000 property that you just invested in at the end of four years, at the end of that fourth year, your equity in the property would have increased by $21,000 I’m rounding off here, but it’s approximately $21,000 that means that you have equity in the property, additional equity that you can tap into for investment purposes.
These are real spendable returns that you can pull out of the property to reinvest, but I’m going to get more to that here in a second. If you were to do the same calculation based on a 6% appreciation rate, you would achieve that $21,000 increase in investable equity at the end of three years. So at the end of year number three, you have about $21,000 in increased equity in this property. Now again, this is investible money because it is equity that you can tap into. So let’s look at the last piece of the IDEAL equation and then bring it all together. The L is leverage and that simply means that you can take 100% of the income from this property, take 100% of the depreciation, take 100% of the appreciation and keep 100% of the amortization in this property, all four of those things, all 100% from a 20% investment in this property.
So you’re leveraging your investment capital, five to one 20% down payment and you get 100% of all those benefits. You don’t share or split that with anybody. And that’s the power of leverage is you can magnify your returns and take that investment capital that you have and invest in more properties, as many as you want to invest in or as many as you can get. Now, let’s wrap this altogether. What is your total return on investment? Because you started this question with, you know, I can’t get excited about a rate of return that you were actually looking at in the wrong way, but you actually have a great rate of return right from the get-go. Would you call near future cashflow? And you also have great returns after each and every year. So tying this all together, your total ROI is simply your cashflow plus your equity plus your amortization or appreciation.
I guess the equity would be the amortization, the appreciation. So those three things together. If we take this example that I have this $110,000 property on our website in Pennsylvania, we have $3,635 in cash flow. Add that to the $1,298 in equity growth from amortizing the loan in the first year plus $4,400 in appreciation, which is just a simple 4% growth in the property’s value. At the end of that first year, you have a total of $9,333 both in realized and unrealized gains. Okay? This is your total return on investment. Well, do the math, 9,333 divide that into the $22,000 investment at the beginning of that year. And you will see that is a whopping 42.2% total return, 42.2% that is pretty incredible. It’s hard to do that with other investments. So the other thing too about this is that the cash flow itself, the annual cash flow is sheltered in whole or in part by the depreciation on this property.
So at the end of the year, you may not be paying any taxes on this. In fact, you may show a paper loss and carry that forward to other passive income that you currently have or in the future, uh, to shelter that income. Again, check with your CPA or tax advisor. I’m not a tax professional, but I’m just telling you the possibilities of what is possible here with investment property. So I hope that is enough to get you excited because for most people looking at the possibilities and the return, this can get you very excited. And last but not least in three years or four years at a 4% or 6% rate of appreciation. Yes, you are correct in that your comment about price appreciation and equity accumulation over time can be used to either cash out for your windfall or you can do a tax-deferred exchange and essentially sell the property and scale-up, leverage up your portfolio.
Or the other option, which you didn’t mention is you can do a refinance, a cash-out refinance, which allows you to refine that, that property, pull that equity out, a portion of that equity out, and use that equity to purchase your next one or two or however many properties depending on what you’re doing it on. So yes, it starts to grow and then it starts to snowball. So if you’re in growth mode, this is a great way to start building your portfolio. And the faster you can actually build your portfolio in the beginning, the faster it grows. It starts to mushroom or snowball. As the years go by and you’ll see it every four to five years. You can do this where you take a chunk of equity and you leverage that into more property. So anyway, I went fast. I hope I didn’t confuse anybody with the numbers, but this is actually a pretty simple concept to understand, so I hope that helps.
I’m not just you Kramer, but everybody who’s listening to this, so thank you for the question and if any of you have a question about real estate investing or finance that you’d like me to try and answer on this show, I’m going to get to as many as I possibly can. Just go to passiverealestateinvesting.com click on the ask Marco button or you can go to AskMarco.com it takes you to the same place. Remember to subscribe and remember to share this show with other likeminded people. It would be great to share this great information and these questions that are coming in with other people who are also interested in this topic. Thank you for listening. I will see you on our next episode.
———————–
Are you having a hard time finding great investment properties? Unfortunately, the best deals are rarely found locally successful investing begins with the right properties in the right markets. Norada real estate provides everything you need to invest in the best deals across the US. Our simple proven system will help you create real wealth and passive monthly cash flow. Get your free copy of the ultimate guide to passive real estate investing at www.NoradaRealEstate.com/guide.