There are four elements of return associated with investment property. They are:
(1) cash flow,
(2) equity growth by amortization,
(3) equity growth by value appreciation, and
(4) tax shelter benefits.
Cash Flow. The formula for cash flow is rental income minus operating expenses. Operating expenses include mortgage payments, property taxes, insurance, utilities, upgrades and repairs. Usually, investors who require significant cash flow will significantly decrease their profit in the other three elements of return.
Equity Growth by Amortization. This occurs as the principle is deducted from your mortgage loan balance. Typically, mortgage payments are the same each month and are paid by the rental income. These payments usually cover both principle and interest. As you make payments, you pay of the principle which increases your equity.
Equity Growth by Value Appreciation. When properties increase in value, you gain equity. There are two kinds of appreciation: (1) inflationary and (2) demand. Inflationary appreciation is the increase in property value due to the reduced purchasing power of the dollar. Demand appreciation is the increase in property value due to the limited supply of property.
Tax Shelter Benefits. Outside of a property’s operating expenses, there are three main tax shelter benefits, which include: (1) the use of deferred capital gains tax, (2) the tax deferred exchange and other tax deferral strategies, and (3) depreciation on improvements. By selecting a property with high tax shelter benefits, investors can significantly reduce their federal and state tax liability.
YOUR TOTAL INVESTMENT PLAN
The single and most important consideration in selecting investment property, financial planning in general and probably the most frequently overlooked, is a total investment plan. Any plan, however how meager, is better than no plan at all. And, we have found that the more detailed your plan, the better. Any good investment real estate agent should be equipped to develop a customized, detailed plan for you. We estimate your chances of success in investment real estate are improved by a factor of 100 if you simply have a plan.
As an investor, the two most important aspects of an investment are its value as an asset and its return on invested capital. In other words, you will invest your money in real estate and (with improved property) obtain an annual return on your invested capital until you sell the property.
When you sell, you will expect to recover your original invested capital plus profit from equity growth by amortization and value appreciation. It is said that you make money in real estate when you buy, and in our experience this has proven to be true. So buying below or at fair market value will ensure that you will be able to recover your original invested capital plus profit at the time of the sale. If you overpay for a property at the time of purchase, your overall return on invested capital will be reduced.
The purchase of investment property will probably be the largest dollar investment that you will make in your lifetime. Unfortunately, there is no “Bluebook” for establishing the value of used property. In addition, each property is unique in value. So, how do you, as an investor, determine whether or not your property is worth the asking price? This and more will be covered in article 3 of this series.
Mr. Scott W. Burch is a licensed commercial real estate agent, a private real estate investor, author and Registered Investment Advisor. Due to his experience and background, Scott is able to help clients successfully locate, analyze and acquire suitable investment properties. As a principal himself, Scott is able to bring a unique perspective to his work, understanding the needs of the seller, and the process of the buyer through which a new property is analyzed and acquired.