Friday, March 14, 2014

How much money will I make, buying a rental income property?

What does ROI (return on investment) mean for real estate income properties?
Return on investment for income producing properties is a measure used by investors to estimate the profitability of a real estate investment.  It measures the annual percentage income return on the initial amount invested in the property. When analyzing income properties or any other type of investment, smart investors look at past, current and anticipated future returns to determine if/ where they should invest their money. 
What financial data do we need to calculate return on investment?
All of the financial detail associated with the purchase, sale and operation of an income producing property should be included in the return on investment calculation.  The ROI calculation should incorporate anticipated purchase price, estimated future sales price, closing costs, operational expenses, mortgage fees, interest expense, rental and other income, depreciation, investor tax rate, and so on. 
When calculating current and potential future return on investment for real estate income property, we need to obtain the most recent annual financial data for that property.  To be sure that the annual income and expense data is viable it should be verified with a current owner’s tax return. The annual financial data can then be projected into the future on a year to year basis over a given period of time by applying an income growth rate, expense growth rate and appreciation growth rate.  I believe that it is sufficient to project financial data for up to the next 5 years. The farther you go out, the less reliable the projections.  As we have seen in recent years, economic conditions can change quickly.  Projecting the income and expense data forward over a five year period will enable us to estimate future annual cash flows and sales proceeds.  Our growth rate assumptions should be conservative and should be based on a good understanding of the local and national economic environment.  With a good real estate investment program, we can look at worst, average and best case scenarios to get a range of future wealth values and return on investment projections.
To calculate return on investment, we would use an initial investment amount, a projected after tax sales proceeds amount in 5 years and a series of anticipated annual after tax cash flows for each of the years.  It should be noted that current and future return on investment for real estate income properties should be calculated on an after tax basis since a properties income is taxed yearly. The ROI calculation for an investor is a subjective calculation, by that I mean that different investors are subject to different income and capital gains rates.  Investors with higher tax rates will have a lower ROI than investors with lower tax rates when analyzing the same property.    
What factors affect return on investment for real estate income producing properties?
The real estate investor should have a good understanding of income tax brackets, capital gains rates and recapture depreciation tax rates since they impact return on investment.  Investors should look at every aspect of their real estate investment with the objective of improving ROI. In favorable economic conditions, if you purchase an income property under market value and in the future sell it above market value, you can increase your return on investment.  The level of leverage utilized can greatly impact return on investment.  The use of accelerated depreciation can increase ROI.  Having a good understanding of the conditions that cause income properties to go up in value or down in value can help the real estate investor to increase ROI?   Property values are impacted by many factors such as location, over-/ under supply, mortgage rates, inflation/ deflation, property upkeep, general condition of an area, supply of potential renters, cost of construction materials, proximity to infrastructure, local and national economic conditions, etc.  These factors and many others impact real estate values and can increase or decrease future return on investment.   
Return on investment can be increased by reducing operational costs, minimizing vacancies and making sure that rental rates are at market value.  The investor should periodically check to see if rental rates reflect current market conditions.  To put it another way, smart hands on management can increase ROI. 
The lower an investor’s tax bracket, the greater their return on investment.   Mortgage interest rates and fees can impact ROI.  The real estate investor should seek the best mortgage rate with the least fees.   

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