TBT: The REAL Returns of Real Estate Investing

Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.

I have an exciting episode for you today because it’s something that is actually very important. And it’s the real perspective of looking at the returns on real estate and realizing how powerful it can be. So this episode is really about the REAL Returns of Real Estate Investing. You know, there’s a famous real estate investing quote, and it goes something like this “Don’t wait to buy real estate, buy real estate and wait.”

Now for most people. That just makes sense. In fact, it’s probably common sense, you know, you buy and hold real estate and you increase your wealth over time, but really let’s dive in and look at why the suggestion in this quote is to buy real estate and wait, why do you wait?

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Throwback Thursday Episode (The episode originally took place in the year 2021)

This episode is part of our Throwback Series and may include references to older content such as web classes, events, promotions, or links that are no longer active or available. While the conversation and insights still hold value, please note that some information may be outdated.

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Well, I’m going to illustrate that, but it’s going to go way beyond that because what I’m going to show you in verbal format here is the power and the high returns that you can achieve investing in real estate, even in your first year. See, a lot of people don’t believe that they can achieve returns in the 20%, 30% or even higher return on investment. I’m talking total return on investment in year one, meaning after 12 months of owning a property, it is doable. Very doable happens all the time. Of course, you want to make sure that you’re investing prudently and wisely, not just going after highly speculative plays or being in very undesirable neighborhoods or investing in the war zone. You know, you just want to follow the suggestions, methods, and strategies that we talk about here all the time, not just on the show, but my investment counselors and what they talk about with you as our clients or prospective clients.

I mean, we all essentially drink the same Koolaid and follow the same investment philosophies and strategies here. So they are sound, tried, true, and proven, and they work virtually all the time. So if you stick to that, you have a formula for success. Now let’s talk about the real returns of real estate investing. Basically, there are three areas that generate returns for you as a real estate investor. And this is what makes real estate such a powerful investment. So the three dimensions of real estate as an investment are income, equity, and appreciation. And I know I’ve talked about this on and off over time, over the last five, six years, uh, in the acronym IDEAL and that is I.D.E.A.L. You can obviously see that three of those elements are in here, the income, the equity, and the appreciation. What I’m not talking about today is the depreciation, which is a beautiful, beautiful benefit that helps to lower or eliminate the tax impact on the income from the property. And I’m not going to talk about the leverage, but I’m going to make the assumption we’re using leverage. So I’ll get into that. And some examples here shortly.

So the three dimensions are income equity and appreciation. Now we can break these three down into two general kinds of returns. There are the realized gains or realized returns and the unrealized gains or unrealized returns. So realized gains are realized returns, refer to the cashflow. It’s the income, it’s the spendable cash that you get each and every month and each and every year, those are realized because it’s here, it’s in your hand, it’s liquid, it’s spendable, it’s real cash. The unrealized gains are what you gain each and every month and each and every year in terms of equity growth. And in terms of appreciation. So when you refinance a property or sell a property, or maybe put a line of credit, like a HELOC on a property, that’s when you can tap into those unrealized gains, because now you are essentially releasing that from the property and realizing those gains. So until then, the equity and appreciation is an unrealized gain. So income, equity, and appreciation can be broken down into realized and unrealized gains. But if you are gaining equity and appreciation in a property month after month or year after year, it’s still a return on your investment. It’s there. It’s just not necessarily liquid right away, but it’s there and it can be tapped into.

So let’s take a look at some examples, and I’m going to leave you with some takeaways today. Now I have to make some assumptions just to keep this conversation as simple as possible. And I like to keep things simple. So we’re going to use my typical $100,000 property. You can adjust this, however you like, you can model this any way you like. You can look at a $200,000 property, $150,000 property, the formulas, the math, and the principles are exactly the same, but it just makes it easy to understand if I talk about a $100,000 property with a 20% down payment. So that means your down payment is $20,000. We’re going to remember this number because we’re going to keep coming back to the $20,000 down payment in order to illustrate the returns because your return is based on the amount of investment capital that you put up and put into the property on day one.

And so in our case here for our examples, $20,000 is that number. I’m going to take a conservative estimate of cashflow on that a hundred thousand dollar property. I’m being overly conservative here and calling the net cash flow $200 a month. The reality is, is when you buy property, depending on the location, specifically the neighborhood, and certainly the state market that it’s in, all of that will have an impact on your cash flow, but I’ve seen cash flows from as low as a 100 and $150 a month, net-net, true net, meaning that you’ve deducted vacancy allowance, you’ve deducted maintenance and repairs, even though you don’t spend those necessarily right away or in the first month or necessarily the first year, you’re budgeting for it. Because over the long term, you’re going to have those expenses. You’re going to have repairs, maintenance, capital expenditures, and you will have vacancies.

They might be every year. They might be every five years, but let’s just say that cashflows typically range from 100 to about 300, 350 a month in the first year of an acquisition on a purchase like this, a property of a hundred, 120, $130,000 with 20% down. If you put more down, you, of course, your cash flow goes up because you’re servicing less debt. Your mortgage loan is smaller, but I’m assuming we’re going to do maximum leverage. So we’re going to buy a hundred thousand dollars rental property, put the maximum leverage on it, which is 80%. And that means the smallest down payment, which is 20%. And so that’s $20,000. We’re going to take a conservative cashflow example of a true net, $200 a month, which is 2,400 a year. That’s the immediate income, the spendable cash. Remember the realized gains we talked about, well, that’s the 2,400 a year.

I’m going to assume that our financing is a regular 30-year fixed-rate mortgage. So 360 months. And I’m going to, you assume that we are getting an interest rate of 4.9%. Now some of you are listening to this saying, well, Hey, I just got a loan for 3.8, seven, 5%, which is exactly what I’m closing on tomorrow. So rates are actually lower than that in fact, by more than 1%. But again, I’m taking a very conservative example here. I want it to call it 5%. The math works out better on 4.9%. So we have a 30-year loan at 4.9%. I’m also going to just kind of put a stake in the ground, the middle ground here on a, I can run this model or the scenario and these examples with 1%, 3%, 4%, 8%, whatever you want. I know that over the longterm, a lot of the markets, especially the markets we focus on appreciate anywhere from three to 8% per year, and it’s different every year, but they average out somewhere between four and six.

So for our scenario here, we’re just going to go with 4%. I think that’s a little bit conservative, but it’s certainly realistic because again, in the right markets, in the right neighborhoods, you should be averaging out 4% per year over the longterm. And last but not least again, this is the last percentage I’m going to throw at you here in terms of assumptions, I’m just going to take a 2% inflation rate. And that again is a conservative number. And I’m just going to use that, not in terms of appreciation, but just in terms of how much the rent is going to go up year after year over the longterm, 2% I think is actually very conservative. Those are the assumptions. So let’s just give you the raw numbers. Now, I’m going to tell you what those returns are, but this math is actually really simple.

You could do this yourself on a pad or a spreadsheet. So in year one, we buy a hundred thousand dollar property. If it’s cash flowing $200 a month, that means it’s $2,400 a year in positive cash flow. So what’s the math on that $20,000 down, we just made $2,400 in terms of cash flow. Well, the math is simple. You divide the 2,400 by 20,000 and you get 12%. So we just made a 12% return on our money. 12% return on cash in our first year. So that’s an immediate 12% return. Some people refer to this as the COC or cash on cash return. It’s all the same thing. Whether you talk about cash on cash or your immediate cash return, this is 12%. It’s an immediate return, but now we’ve got two other pillars. Remember we talked about this being multi-dimensional, we’ve got two more to go.

In your first year that $80,000 mortgage is slowly being paid away. Now keep in mind with a fully amortized loan. You’re going to pay the least amount down in the first year and the most in the last year, it just escalates or accelerates year after year. So every year it gets better than the last. So in the first year, you’re paying down the least amount. In fact, the equity gain in that first year, based on an interest rate of 4.9%, like we talked about is $1,202. So that means you’ve gained after one year or 12 months, $1,202 in equity growth in that first year. Well, again, let’s do the math. Let’s take that $1,202 and divide that into your $20,000 down payment. What kind of return on equity are you getting here? The number is 6%. So you’ve just made a 6% return in unrealized gains on your $20,000 down payment.

So that $20,000 investment has now made you 12% return on your cash in terms of cash flow. Plus another 6% return on equity because the loan has been amortized by over $1,200. And remember, this is being paid off as part of your principal and interest payment, which is coming out of the gross rent collected on the property. Remember, your tenant is paying your expenses and your debt service, but wait, there’s more, as they say in the famous infomercials on TV. So let’s look at the appreciation on this property. Let’s remember you bought this for a hundred thousand dollars. We are assuming a longterm annual average of 4% per year. Well, the math is simple, a hundred thousand dollars property, 4% appreciation. That’s $4,000. So your return on appreciation, if you want to call it that it’s basically your gain in equity from appreciation, but your return on appreciation is a whopping 20%.

Why? Because you just gained $4,000 in appreciation, an unrealized gain. And that 4,000 into the 20,000 down payment works out to be 0.2 or 20%. So let’s do the math here. Let’s add it up. If you add up your cash flow of 2,400, the equity gain of 1200, and the appreciation of 4,000, that’s an annual gain of $7,602. Again, let’s do the simple math divide, the 7,600 into the 20,000 down payment. And your first year with this one property, a hundred thousand dollar property has given you a total return on investment of 38%. It’s 20% on the appreciation, 12% on your cash on cash return, and 6% equity return. That’s 38%. And guess what? That’s your worst year? Because it only gets better from here. So I know you’re not looking at my spreadsheet, but I’ve got all 30 years laid out and you can do this yourself in a spreadsheet.

But essentially what we’re gaining is a little bit more than 12% as far as a cash on cash return in year. Number two. And the reason for that is because I decided to raise the rent 2% just to keep up with inflation. I didn’t have to do that, or I could have raised it more. I could have raised it by $25 a month, $50 a month. But yeah, just with a 2% inflation rate, it’s 12.2%. Let’s just call it the same 12%. Now we’re going to amortize our loan a little bit more in that second year. So this year, year number two, we are now paying down an additional $1,262. That’s a 6.3% return on equity because that $1,262 divided into the original 20,000 down payment, give us a 6.3% return. On the appreciation side we’re assuming we’re gaining another 4% this year. So 4% on the $104,000 property is $4,160 of appreciation.

So that’s a 20.8% return on appreciation. Add those three numbers up. Remember those three dimensions. And this year we get a 39.3% total return on investment. So we went from 38% total return in the first year to 39.3. And it goes up a little bit more each and every year. Now I want to point out one thing for those people who are listening to this and are really sharp. I want to make sure that you all understand, I am not adjusting these numbers each and every year for inflation. I am not adjusting that the us dollar is being eroded away by inflation each and every year. You could argue what that rate is. It could be 2%, which is what the federal reserve targets. It could be 4%, whatever it is, these are just nominal numbers. I’m not making adjustments for inflation other than the fact that I’m increasing the cash flows by the rate of inflation.

So I am in one way, actually adjusting for inflation here. But remember that real estate is a natural, powerful, inflation hedge. It is actually a natural inflation hedge as an investment, just like gold and silver is over the longterm. So by default, the inflation hedge is actually built into the investment. This investment class is powerful for that. So indirectly I am correcting or adjusting for inflation as time goes on because these will ultimately be inflation-adjusted dollars because it just adjusts naturally each and every year, but I’m not making those mathematical calculations in my conversation with you here. So let’s just fast forward. Five years, let’s go to year number five, in year number five, our monthly cash flow has gone up. So our annual cash flow is now $2,600. And those are small adjustments, by the way, that’s 2% per year. So now we’re getting a 13% cash on cash return on that $20,000 down payment in a year.

Number one, when we look at our equity, it’s a 7.3% equity return because now we’ve paid down another $1,461 from our principal. On the appreciation side, we are now gaining $4,679 in appreciation at the end of year five, which is a 23.4% gain or rate of return compared to the original $20,000 down payment. Now, I know this starts to get a little ridiculous-sounding because if you add those three numbers up, the three pillars here, you’ve got a 43.7% total return on investment. That is pretty incredible. It’s hard to imagine other investments that produce these types of returns for you. So that’s one property. Now, what if you purchased five properties this year, or let’s just say one per year for the next five years, or maybe you want to take it to 10 properties? Where are you going to be in five or 10 years from now across five or 10 properties that are producing returns like this?

Sure. It’s not the perfect investment, but is there really any perfect investment there’s going to be bumps in the road. You’re going to have some issues here and there. You know, something will happen. The sink is not working in the faucet. It needs to be replaced or whatever it may be. You let your property managers handle that stuff. Stay focused on the big picture, stay focused on the tremendous upside potential, and the big gains that compound and grow overtime over the years. So I wanted to illustrate what the real returns of real estate investing are. Not just the first year returns or the nominal returns, but what the potential is here. So again, just to recap, you have income equity and appreciation. Those are the three main pillars of returns. The depreciation just helps lower to minimize or eliminate the tax impact from that income.

Of course, you can eliminate the tax impact from the equity gains and the appreciation gains when you do a 1031 exchange or a cash-out refi. And so it’s a very powerful vehicle. So the bottom line here is this real estate is a multidimensional investment, meaning that you get returns, both realized and unrealized from different factors, different components of that real estate that grow year after year. Secondly, I want to make sure that you understand that you shouldn’t always focus heavily or exclusively on cashflow alone, especially in the beginning because the real magic, the real power of investing in real estate comes as you look at it year after year, as you start to compound returns, but also take advantage of equity growth, and redeploy that reinvest that into more property. And third focusing on the cash flow loan can actually be very shortsighted. I know that there are some investors that want to build a portfolio and they’re focused on property types and in locations that maximize cash flow.

And they’re really not concerned about equity growth, especially when it comes to appreciation and that’s all well and fine, you’re missing out on a big piece of the potential gains of real estate, but for them, their strategy is to just put their capital. They may be sitting on a lot of cash, a mountain of cash, but they just want it to put it to work. They want to park it into real estate, protect it with real estate and turn it into an income stream. They’re not after the appreciation thereafter, the cash flow, and that’s fine. That’s just a strategy for a particular type of investor. And in just closing, I just want to point out in my example, here with the a hundred thousand dollar property in that first year, I just want to point out the ratios of the returns with the cashflow that first-year return was 12%.

Compare that to the equity return on the amortization of the loan, which ended up being 6%. So roughly half of the cost cash return, but then look at the return again, unrealized return on the appreciation at 4% after that first year it’s 20%. So the appreciation gain is roughly about double the return on the cash. And it’s almost three times the return on the amortization, the return on equity. So as you start to look at those numbers after five years after years, and then even after 30 years, you will start to understand that the huge upside potential in real estate is creating wealth through equity growth, through appreciation, and then redeploying that equity growth into more real estate or maybe other investments. And turning that into your favor by increasing your income.

All right. Well, I hope that made sense. I know this was a little bit geeky. I do have my propeller head-on, but I love playing with spreadsheets anyway. I hope this was helpful. I think you just need to understand how powerful real estate investing can be and why, and you need to have patients. So again, it’s that old saying, don’t wait to buy real estate, buy real estate and wait, and you will see what happens, but by intelligently and by prudently. So with that, I want to just wrap it up here. If this is of interest to you and you haven’t really dug down deep into this, talk to one of my investment counselors here. If you’re already working with us, fantastic, if not, and you’re on the fence or you’re thinking about real estate or your next move with real estate, just contact us first free strategy session. We can go into this a little bit more with you.

I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. If you have a question about real estate investing or finance, simply go to passiverealestateinvesting.com and click the Ask Marco button. . I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So, I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco.  Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.

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