Investors often examine the cash flow a property generates, that is, rental income, minus operating expenses (property taxes, insurance, maintenance, and utilities), less mortgage payments to arrive at the monthly or annual cash flow profit from the property. While this is an important metric, are you considering the three other sources of return on investment?
A second source of profit from owning real estate is “appreciation”. As the value of property increases, so do the investment returns. Simply, if a property is purchased for $1 million and later sold for $1,250,000, the investor makes money. On the surface, the ROI (Return on Investment) is 25%; that is the property value increased by 20%, going from $1,000,000 to $1,250,000.
What if the property is financed by a loan from a bank? For example, if the property is purchased for $1,000,000 and the bank finances 75%, or $750,000, the actual amount of cash invested is $250,000. If the property then goes up in value by $250,000, the ROI is not 25%; the return on dollars invested is a whopping 100%.
If the property value increase was only 4.5% per year, in 5 years the property value would reach $1,250,000. While the investor had to wait 5 years, the annualized return on dollars invested is an impressive average of 20% per year.
Let’s take a look at another, more modest example. In this example, a property is purchased for $100,000 and the investor puts down 25% or $25,000. After one year, the property increases in value 5% to $105,000. While the outside world would look at this as 5% appreciation, or a gain of 5%, the $5,000 increase, as measured against the investors $25,000 actual cash investments is an impressive 20%.
This chart demonstrates how equity growth is compounded by modest annual market value increases combined with paying down the mortgage over time.