Updated: Dec 10, 2019
In our last post, we summarized the 4 types of returns most commonly reported in real estate investments, cash flow, amortization, appreciation, and depreciation. We also looked at how some of those returns are calculated. In this post, we are going to use that knowledge to do a deep dive into a theoretical acquisition and sale on a 20-unit apartment building.
Now that you know the terms, lets look at an example of how this all plays out on the purchase of a 20 unit apartment building held for 10 years before refinancing. Let's say the purchase price is $1,000,000 and you get a loan for 75% of the price. You and a partner form a Limited Liability Company (LLC) to make the down payment of $250,000. The property produces $60,000 per year of income before the mortgage payments. This is also known as the Net Operating Income (NOI). The mortgage payments total $20,640 each year.
So what will be our return if we hold the property for 10 years and then refinance or sell? To get the full picture, we need to calculate the expected 4 types of returns discussed earlier; cash flow, amortization, appreciation, and depreciation.
Cash Flow is the cash remaining after the financing is paid. We subtract the financing from the NOI to get $39,360 per year in expected cash flow.
$60,000 NOI - $20,640 financing = $39,360 annual cash flow
$39,360 annual cash flow X 10 years = $393,600 cash flow
Amortization is the principle pay-down on the loan over the 10 years. Assume a 20-year amortization period and 5.5% interest rate. Then pull-up an amortization calculator like you can find on bankrate.com. After 10 years, the amortization schedule shows a balance remaining of $475,383. Subtract that amount from the original loan of $750,000 and that indicates that your tenants have increased your equity by $274,617!
$750,000 loan - $475,383 balance = $274,617 equity
Appreciation is the anticipated increase in the property's value over the 10 year holding period. In this case study, we are not planning on forcing any appreciation through making improvements, extensively raising rents, and/or reducing operating costs. Conservatively, lets assume appreciation just keeps pace with inflation at 3% each year. At the end of year 10, the property we bought for $1,000,000 would be worth $1,343,916, an increase of $343,916.
$1,343,916 future value - $1,000,000 purchase value = $343,916 appreciation
Depreciation on this residential rental property will be what's called "straight-line" which means the IRS expects you to evenly depreciate the value of the building, each year, over 27.5 years. Each new buyer of the property gets to start the depreciation schedule over again. We can only depreciate the building or improvements, not the land itself. Oftentimes, the improvements constitute 90% of the value of the property or $900,000 in our scenario.
Divide the $900,000 by 27.5 years to get an annual depreciation deduction of $32,727. That deduction reduces the annual taxable income of $39,360 to only $6,633! At a 25% tax rate you would have paid $9,840 ($39,360 * 25%) in taxes on that income, but instead your partner and you only pay $1,658. That adds up to $81,820 over 10 years.
$9,840 tax bill before depreciation - $1,658 tax bill after depreciation = $8,182 tax savings
$8,182 tax savings X 10 years = $81,820 tax savings
How does real estate investing compare to the stock market?
A couple of common ways to compare investments is by calculating the Return on Investment (ROI) and Internal Rate of Return (IRR).
To calculate ROI, take the total cash gain divided by the initial cash outlay. Since depreciation is a savings and not a cash gain, we are leaving it out of the total. Also, we are just going to refinance this property, so we need to leave 25% of the equity in the investment as our new down payment.
+ $393,600 Cash Flow
+ $274,617 Amortization
+ $343,916 Appreciation
- $335,979 Down Payment
$676,154 Cash Gain
$676,154 Cash Gain / $250,000 Initial Down Payment = 270% ROI
To calculate IRR..... use an Excel formula. IRR is a subject of another post, but for now just think of it as the annual return you can expect from an investment which also accounts for the time value of money.
Excel IRR formula = 20% IRR
The S&P 500 has historically returned 9.8% annually. We used a conservative real estate investment scenario in our example and expect a 20% annualized return. So this real estate investment appears to be a superior allocation of our capital.