Most people know these sources but they’re not necessarily all in one place at one time so that’s the purpose of today’s episode: to have all five types of return on investment from real estate in one place while you are contemplating future investments and use this list to analyze your current investments, to measure if you are gaining yield from all five sources with your existing portfolio.
Hello and welcome to John Wilhoit on Real Estate. My name is John Wilhoit. Today’s topic is return on investment in real estate, five sources.
Most people know these sources but they're not necessarily all in one place at one time so that's the purpose of today's episode: to have all five types of return on investment from real estate in one place while you are contemplating future investments and use this list to analyze your current investments, to measure if you are gaining yield from all five sources with your existing portfolio.
Your existing portfolio maybe a single-family house it may be a duplex, it may be an 80 for unit development in Times Square. Wherever it is, it's still going to have the opportunity in many instances to gain a yield from all five of the sources that we're talking about today.
In the show notes, please look for a spotlight page that will have these five on a single page that you can download and make as part of your working papers for investing or reviewing your existing portfolio.
Let's start with number one thing that everyone knows and loves and that is rental income. There's various sources of income that come an income property but rental income is by far and away the most importance because it almost always represents 90 percent or more of all the revenue derived from an investment property. We have to have income and that income allows us to operate the property, and hopefully on top of operating it, generate a profit, a yield beyond just expenses for running the property.
We have to have income to pay the bills including the mortgage interest, taxes and insurance. Also there should be revenue there or income to set aside for impound accounts for future capital expenditure needs. So all of those things are paid out of income and hopefully there is income remaining after all of those expenses and that income is referred to as a net operating income.
Out of net operating income is where we pay principal and interest.
I'm not trying to get into the weeds of looking at an income statement with respect to this particular episode but to focus on the five kinds of return on investment from real estate. The first one is income and always will be.
Second is one that is never promised but that we hope for and is sometimes very much over the top. Every place is different and that is appreciation. Appreciation is never even. It's always different depending on the market and depending on the property type. There is a lot of variables that go into appreciation, how it occurs and how fast it occurs.
It really is a springboard to our assets because although we don't capture it until the sale it does become very important as a factor in refinancing. If our property value is rising, appreciating, then we have opportunities to refinance the property to perhaps obtain fixed rate financing which is always a bonus, always something to shoot for when you can to obtain fixed-rate financing which always has benefits in the long run.
Third on our list is depreciation and depreciation although it affects yield it's not the be all end all. It does change of course because everyone's tax circumstances are different and the way that depreciation is treated could change depending on how the IRS feels from one year to the next. We can't necessarily depend on depreciation as affecting our life but it can have a positive effect. Talk to your accountant see what you should be doing with depreciation.
There is such a thing as over utilizing depreciation. Always have good counsel, good tax counsel with respect to your use of depreciation for long-term hold and recognize that it can come back and bite you. At sale, unless the proceeds are utilized to purchase another property of equal or greater value, then there is a taxable event based on that depreciation. All of those things should be discussed in advance of a sale with your tax counsel. That's the third, depreciation.
So far, we have income, appreciation and depreciation. The next one is the great and always wonderful forced savings plan that's called mortgage pay down. The best thing about mortgage pay down is that it works for us every month. Regardless of the size of the rental income, if there is a mortgage, a portion of that rental income goes to paying down the principal balance of the mortgage and that's why we call it a forced saving plan.
You don't have the option of whether or not to pay the mortgage if you're going to own the property. At the beginning of your loan very little of the principal payment of the mortgage payment goes to principal reduction but every month that amount increases just a little bit. Having that mortgage paid down, having that forced savings plan, is another method of increasing our return on investment over time. So it's very important. It works on our behalf. It's a good thing to do.
If you want to make extra mortgage payments the way I would suggest doing that is, particularly on smaller properties, is setting it up for a biweekly mortgage payment. And that way you are in essence making one additional mortgage payment per year and all of that goes towards principal. I should say the majority of it. This doesn't work for commercial properties per se but it does for units that are 1 to 4 meaning less than 5 units. That's something to consider, to get that mortgage pay down bump going and activating for you a little bit further than just making the 12 mortgage payments a year. Add one payment by making biweekly payments. That certainly works for single family homes too and it works very well in terms of reducing the term or the length of time that you have to pay the mortgage. It really does knock it down by several years by just making that one extra payment per year.
Before I get to the fifth one I want to share a story and one that reflects on yield. It's a story that I've told many times over the years but I think this is a great place to insert this.
Imagine looking at a property on a relevantly busy street. Let's presume that it's a retail property or at least it was but presently it's a closed retail property. There are office buildings all around, active businesses, a lot of traffic on the street. This property is shut down; the windows are dirty, the doors are locked and it's not being utilized for anything. There is no income being derived from this property.
Buyers come by to look at the deal. The first buyer drives up and looks at the property from the curb, shakes his head and moves on. A second potential buyer comes by and gets out of the car. He goes up to the building and cleans a spot, looks inside and doesn't do much else. He notices that there's too many people wandering around that do not seem to belong and gets back in his car and drives off.
A third potential buyer comes by the property. She gets out of her car. She brings a flashlight, looks at the front of the building and takes the flashlight and looks inside the building and then walks all the way around the building. Thus far, she is obviously very interested and is looking at the deal a little bit more closely, at least at the physical structure, before making a decision on whether or not to proceed further.
What is it that she sees that the other two buyers didn't see that make this property have some potential? In this example, I'm asking you to look at the property in the daytime and also at night. In the daytime, it looks to be a rundown retail building but at night if you were to walk around the building to the back you would see a great panoramic view of the city- just lights everywhere.
There is busy traffic humming from the city and lots of stuff going on. From the front of the building it looks like a rundown retail center that's closed, but from the back of the building, if it were converted into something for nighttime use it would be an active spot because of all the existing traffic that's already on that street. Also, because of the view that the building has at night from the rear of the building. That gets us to our fifth item about ROI.
The fifth item is active management or active ownership.
If this young lady were to purchase the property it wouldn't be on the results of what you see at the front of the building; it would be on the premise that the property can be changed into something that takes advantage of that night view, of that panoramic City View from the rear of the building. Things that the other buyers didn't take the time to contemplate. One potential buyer didn't even get out of the car. And the other potential buyer didn't do anything more than look through the front glass to see that there wasn't much going on there.
But the third buyer saw the potential of the property just by spending a little bit more time on site and thinking about the possibilities. And that's what that fifth ROI item is: it's thinking about the possibilities. It's what I call active management. That's the one thing that an active real estate buyer can bring to a transaction than an inactive real estate buyer never will.
An inactive or passive real estate investor, many of them will never see the asset that they've purchased. This is particularly true at the institutional level but it is also is true with much smaller transactions. The actual money people don't see the asset. They see the reports, the photographs and they see the asset management reports. They may even see the balance sheet and the income statement but they'll never go and see the property.
For smaller properties, particularly if you're the one buying the deal you need to not only look at the front of the property but go all the way around it of course and this is an example that reflects what else can be seen by an active manager or an active owner. With respect to a particular piece of property we want to look at it from an aerial view.
We also want to see what is around the property from a demographics perspective. We want to know population counts, traffic counts. We also want to know what can be done with the property that perhaps no one else has thought to do. How can we add value? How can we increase our ROI by utilizing active management or by being an active owner? That's the fifth source for increasing your ROI from real estate.
To recap we have income appreciation depreciation mortgage pay down.
In all of your transactions I hope you are an active manager or an active owner and I hope in all of your transactions your return on investment from real estate is utilizing all five sources that we've mentioned here today.
Think about what you can do to assure that all five of these sources of return on investment are deployed on every asset that you own or are engaged in. It doesn't mean you have to own it to be an active participant in a deal. You may be an asset manager or property manager or an interested party. What I mean by interested party is a service provider or a vendor for the property owner that could benefit from your insight.
When you're thinking about your real estate and real estate that you own or are engaged in think about making sure that all five of these components are being deployed to assist in increasing the real estate value based on increasing the return on investment. In this episode, we're not talking about formulas or financial measures of real estate. We're just doing the overview of the five different types of areas that impact ROI.
If you want to get more granular then please consider buying Frank Gallinelli’s book. You can find it on Amazon. It's entitled What Every Real Estate Investor Needs to Know About Cash Flow. It’s one of the best-selling books in real estate. Frank is a good friend and I'm more than pleased to recommend his book for learning more about how to review real estate from a financial measures perspective. Think about deploying all five methods at the same time on every asset that is under your umbrella. For specifics on rent roll analysis, check out my best-selling book How To Read A Rent Roll.
I hope this helps and I hope you come back for our next episode. Thanks for listening. This is John Wilhoit on John will on real estate.
John Wilhoit is the Author of five books, including: "How to Read a Rent Roll: A Guide to Understanding Rental Income". Join the conversation at JohnWilhoit.com for updates, blogs, books and podcast.