Owning income-producing real estate can be a lucrative investment. But have you ever stopped to think about how and where your money is actually made? One of the big advantages of owning income-producing real estate is that it allows an investor to receive a return from three different sources.
Three Ways to Make Money
Let’s say you own a single-family home and rent it out. What is the first thing that comes to mind as your moneymaker? Of course, you would think, “Well, the rent.” But that is not the real moneymaker. In order to make money by owning a rental, you must have a net profit after expenses, and you need to maintain a positive cash flow. So, your moneymaker isn’t the rent, it is your Net Cash Flow.
What’s the second way to make money? Appreciation. However, there’s something to note here. Most people think about appreciation as a moneymaker when the home goes up in value. But unless you have a crystal ball, you never know what the value of your home is until you sell it. So, appreciation is essentially irrelevant until you sell the property, although it might make you feel good prior to the sale. A lot of money has been made and lost on speculation of appreciation. As with life, it is all in the timing. There are ways you can protect yourself, but ultimately, if you get lucky by selling at the right time and are able to enjoy a lot of appreciation, consider it a bonus.
The third way to make money isn’t always apparent to investors. What is it? The monthly Principal Paydown on your loan. This paydown needs to be factored into your overall return. If you have leveraged your property, you will have increased your return by investing less cash, and you will benefit from having someone else pay down your loan every month.
Three Ways to Measure Your Money
Now that you know the three ways to make money, there are also three ways to measure what you make.
The first is Cash on Cash. If you have $100,000 of your hard-earned cash in the property and you net $10,000 in cash flow at the end of the year, you have a 10% Cash on Cash return.
The second way to measure your earnings is through your IRR or Internal Rate of Return. This can be estimated, but it is not a true IRR until you sell the property. (It is similar to the appreciation in that aspect.) You can guess what it might be, but until you sell, you don’t know what it will be. IRR is one of the best overall measurements because it takes into account the timing of your cash flows. This is especially important as most cash flows aren’t very consistent.
The third way to measure your return is based on your equity, and is commonly called Return on Equity. To calculate this, you take the principal paydown on your loan each year and add the property’s net cash flow. This will be a higher return than your Cash on Cash return. However, it is important to practice caution on this measurement because it is not fully realized until the property is sold. If for some reason your property is worth less than what you owe, this measurement is essentially worthless.
So, what does this mean for investors?
Bottom line, err on the safe side. Buy properties that are income-producing from day one, and if the economy takes a cycle downward, make sure those same properties can continue to produce income even if you net a small loss. You have to be able to survive downturns to live to invest another day.
That’s exactly what we do with Guardian, our fund that owns mortgages on starter homes in the Midwest. We offer investors income-producing properties with no speculation on appreciation and the ability to weather long downturns in the real estate cycle if need be.