Figuring Rates Of Return
Brian has some rental property that he needs some help with; Dave helps him figure out the 3 types of rate of return.
QUESTION: Brian wants to know how to figure rates of returns on his rental properties so he can come up with income projections. Dave knows exactly how it’s done.
ANSWER: It’s kind of complicated to do it right. There are several types of rates of return. There’s cash on cash, which is your rent minus expenses. Whatever is left is divided by what you’ve got invested into the house. If the rent is $1,200 a month and you net $800 after expenses, and the house is $100,000, you net about $10,000 a year, which is a 10% return. If you paid cash for the house, the rate of return would be cash on cash.
There are 2 other ways that you are making money on this house. You are able to depreciate the property, and that saves you on taxes. In this case you would save about $2,000 as an estimate, so your rate of return would be 12%. The third way you make money is that the house goes up in value. If you projected that the house will go up in value by 6% a year and you’ll sell it in 10 years at almost $200,000, then you put all 3 of those numbers into a formula that calculates your full rate of return. All that wrapped together is called an internal rate of return.
If I owned a residential rental, I wouldn’t mess with all that. But if you do cash on cash I in a decent neighborhood where things are appreciating normally, and the rate of return is about 10%, then it will probably be about a 17% or 18% internal rate of return on your money.