Welcome to the second post in the series of evaluating real estate deals. You can see the previous post that discusses what are the sources of return here.
Today we will learn how to know if the investment is a good investment looking at its returns. This is not a comprehensive ‘how to analyze deals’ post. People could write whole books on this topic. Instead we will take a look at some basics of investment returns. I will explain the following terms:
and teach you how can you can use them when evaluating real estate in the Irish real estate market.
Are you left with cash (or money in the bank) after all the expenses and taxes are paid? Then you have positive cashflow. If the mortgage payments, expenses and taxes together are higher than the income, then the cashflow is negative. You have to send additional money to keep your property afloat.
Is negative cashflow a problem?
It doesn’t have to be - because you can make great deals that have negative cashflows, but it has its downsides.
One big downside is that it will limit how many properties you can have. If you have one property and it loses you 100 euro per month, you can cover the missing cash with your disposable income. But if you had ten such properties then they would require a 1000 euro per month to keep your portfolio afloat. Since you are spending money on your portfolio, you won’t be able to save up as much money as you could otherwise. This can prevent you from being able to get enough cash for down payments for other properties.
But, the above is not that bad - the situation can become much worse. What if you have a longer than expected vacancy and have to pay the whole mortgage? Or if you have to make a big repair… it can become a steep sum. It is a drag on your personal finances and you might have to lose the property if you can’t afford the mortgage.
But if the property is cashflow positive it amasses more cash in its in account. You can take that cash out and spend it on your lifestyle or buying more properties or use it as future reserves. For example when you need to pay the mortgage, while the property is vacant.
How to compute cashflow?
You can compute the cashflow monthly or yearly. You would compute the monthly one by computing yearly cashflow and dividing it by 12. There will be some yearly expenses that don’t show every month - but then they you shouldn’t be surprised by them. You need to budget for things like vacancies and repairs and maintenance by adjusting your projected cashflow . Another thing to remember is that you should think about your tax bill. It might be one of the biggest factors in you cashflow. In certain markets you can decrease your tax bill through depreciation. In Ireland this is much more limited unless it’s an industrial building.
You can find a good example of how to compute a cashflow in the Irish market here https://www.informeddecisions.ie/blog33/
The bad news is that most properties in Dublin will be cashflow negative if you are taxed at 52% tax rate and if you have a mortgage.
How to increase cashflow?
There are two main ways of improving your cashflow, increasing the income and decreasing the expenses.
You can raise rent. In many places, you will be limited in how much you can do that, due to rent pressure zones. But even in a zone like this, you might still be able to raise the rent by 4% every year. That can be quite significant over time.
The other option might be to decrease vacancy. Vacancy means that your property isn’t rented and you aren’t receiving any income. You can think about why isn’t it rented? Are you not advertising the property correctly, e.g. poor photos, waiting for too long? Is rent to high? Maybe by lowering the rent, you will lower your vacancy? Are you picking wrong type of tenant and having a lot of tenant churn? Is the location poor? Does your property need a renovation to attract more potential tenants?
Probably the biggest drag on your cashflow is the mortgage payment. There are many ways to decrease the mortgage payments.
For example if you borrow less, your payment is lower. You might even chose not to have a mortgage at all and have a zero payment. This will greatly increase your cashflow, but might decrease your total return on investment.
You can also get lower interest rate - this will decrease the amount of interest you will pay, decreasing your payment. Or you can have a longer term of your mortgage, for example the payment will be much higher on 15 year mortgage compared to 30 year mortgage. But if you chose longer term mortgage you will pay more interest over the lifetime of the loan.
Apart from the mortgage payment there are many other expenses and some of them can be reduced. For example, if you hire a property management company they will charge you a significant fee - usually 10% of your rental income. You might decide not to hire them and manage yourself. Be creative when thinking about your expenses, some of them are unnecessary or you can make some changes to make them that way.
Can you lower the taxes you pay? There doesn’t seem to be a magical solution for this. But there are different ways you can be taxed, e.g. as an individual or as a company. The marginal tax rate for an individual depends on the income level, it can be above 52%. As a company you will be taxed at 25% - but it doesn’t mean you can easily access it. If you pay the profits out as a salary to yourself, it will be taxed again. Regardless, make sure that you maximize your tax deductions that are available for you: see the revenue website. But remember, you shouldn’t increase your expenses just to increase your tax deductions! You will still spend more than you can deduct from your tax bill.
Will the future cashflow be the same as it is in the first year?
If the rent increases, but the mortgage stays flat, then it will have a positive influence on the cashflow.
However with time, as you pay off your mortgage, the principal part of the payment will increase and the interest part will decrease. Because you will pay less interest in that year (which is a tax deduction), you will have a smaller tax deduction and this way pay more tax. This will decrease your cashflow.
If look at your cashflow using a very long time horizon. At some point you will pay off your mortgage completely. This will hugely increase your cashflow, because you will be free of the mortgage payment.
If you used to pay high taxes, because of your high paying job and then you quit or you lose your job, you might end up being in a much lower tax bracket. You might end up drastically improving your cashflow, because your tax bill will be much smaller.
The older is the property, the more things then to break there. Which might mean that your cost of maintenance will increase over time.
Those are all very interesting factors and you cashflow might either improve or get worse with time. You need to analyze the situation carefully to predict what will happen to it with high confidence.
ROI - Return on Investment
Return on investment is total amount of money made divided by the total amount of the investment. The total amount of money made for a given year would be cashflow plus equity growth (through the loan repayment). Some people don’t include the principal paydown, but I think you should. This is an important component of building wealth in real estate.
Cashflow and ROI are related, but a good cashflow doesn’t mean good a ROI and vice versa. What is similar is that they have the same relationship with the rental income and expenses. The more you rent a place for the more cashflow and better ROI you will get. The more expenses you have the worse cashflow and also ROI.
The cashflow and ROI have a different relationship to the amount invested in the deal. If you have higher equity in the deal, then your cashflow will be better, because the mortgage payment will be lower. However, the more you invested compared to the income you are getting, the worse return on the investment you will have.
For example if you have no mortgage, most likely you would have great cashflow, because the mortgage payment will be zero. However compared to 30% down, having 100% down will mean that you put much more money into the deal, so you return on money invested will become worse.
See some more examples of computing the ROI in the investopedia article.
ROE - Return on Equity
Return on equity is a different way of looking at the deal than ROI. Equity here means: the value of the asset minus outstanding debt.
ROE becomes a useful metric if the equity and the amount of investment become significantly different. This can happen if:
- you bought the property for a price below its value,
- property appreciated (e.g. either due to time or due to you adding value to it)
- you paid off the significant amount of the loan down over time
Most likely, the trend will be that the ROE will be falling over time. If you look at your ROE and it is low, it is a good signal that your money might be able to work harder somewhere else. You can unlock the equity by doing a refinance or by selling the property. Then you can use the capital on deals with higher ROI.
Other ways of looking at real estate returns
Is this all? No! There are many more ways of looking at returns of real estate. The common other ones are:
- CAPRATE - unleveraged rate of return (imagine ROE when the property is fully paid off)
- Cash on cash return - pre-tax cashflow divided by the cash invested. This could be good - but with the Irish reality, I would expect the pre-tax cashflow to be much better than the post-tax cashflow. This is because the taxes and the amount of cash invested are high for typical deals. I’m not sure how useful this metric really is in the Irish market.
What is a good rate of return?
We can probably all agree that it shouldn’t be negative! Apart from that, it depends on what are your alternatives and what is the associated risk or amount of effort. It is also worthwhile to look at the returns using long term perspective. Are the cashflow and ROI improving over time? Do you think you the area will significantly appreciate?
Apart from comparing the returns between different real estate deals, you can compare the returns and risk with other ways to use your money. How about keeping it in cash, buying Irish Bonds, stock market investments or paying off the debt ?
Cash is losing value due to inflation, but when you need to access it it provides a great cushion. Irish Bonds… well that is a really low bar for the rate of return. Currently 10 year bonds give you annualized rate of return of 1.5%. The stock investments usually look the most attractive, but how certain will those returns be?
Since I have a mortgage on my house, the absolute lowest bar I use for the post-tax return on investment is related to my mortgage. The ROI has to be higher than the interest on my mortgage. Paying off the mortgage is zero risk with guaranteed return of the interest rate.
Sometimes, even if the return is lower than the ROI expected from some other asset class, you might still decide do invest for the benefits of the diversification. For example I invest both in the real estate and stock market.
So, is 5% ROI good enough, is 10%, is 20%? Do you need the cashflow to be positive? You have to decide for yourself.
Now you know about different ways of looking at rates of return, but this is just a beginning. Do you know how to properly estimate rent, expenses and taxes?
You can take another look at the https://www.informeddecisions.ie/blog33/ article to see an example of the deal analysis in the Irish market. If you have more time I highly recommend reading The Book on Rental Property Investing by Brendan Turner, specifically chapter 5: Analyzing the rental property.