Investment Rate of Return, Equity, and Depreciation

Rate of return, equity, and depreciation are concerns only if you’re purchasing real estate to rent. Most investors don’t buy properties and leave them unoccupied in hopes of the value increasing sometime soon. If you’re flipping houses left and right, rate of return might be of interest. House flippers should not expect to make the same rate of return on every property unless it’s truly a seller’s market.

Equity is perhaps the easiest financial term to understand. Equity is the difference between what a property is worth and what’s owed on it. If your house is worth $650,000 and you owe $300,000 on the mortgage, your equity is $350,000. Building equity by simply making the monthly mortgage payments is a very slow process. Every month only a few dollars of your payment goes toward reducing the principal. Most goes toward the interest charges. Equity is important if you intend to take out a second mortgage. If you have $50,000 equity in the house, lenders might give you a loan for 80 or even 90% of the $50,000 equity. If you have little or no equity in your home, you probably won’t be eligible for a second mortgage but you might qualify for refinancing, also called a refi.

Investment rate of return normally applies to rental units, leases, or commercial properties. Since the recent stock market recession, many people have been investing their retirement funds in rental properties. Why risk losing half your cash in a 401K when you can buy an apartment building that puts cash in your pocket each month? That’s the reasoning most people follow when they buy rental units. We’ve covered Rental Properties in a separate real estate course.

As an example of simple rate of return, let’s say your purchase a 3-unit apartment building for $180,000. The monthly rent from the three units is $900, $850, and $750. Apartments on the second and third floors almost always rent for less than the bottom floor. Monthly rent for all three units is $1,500. The annual rental income would be $18,000. To determine your annual net profit you must subtract operating costs such as property taxes, repairs, insurance, landscaping, etc. If the total costs were $9,000 per year, your net profit would be $9,000. To determine the rate of return, divide the net profit by the investment cost. In this case, $9,000 divided by $180,000 would be 5%.

When is 5% not worth 5%? When it’s earned from rental property! Depreciation allows you to deduct a certain percentage of the cost of rental property from your taxable income. Currently, residential rental properties can be depreciated over a 27.5-year period. Excluding the first year, which is called a mid-month exception that’s beyond the scope of this course, for every year you own the rental property (up to 27.5 years) you’re allowed to deduct 3.636% of the cost. Depreciation applies to the building only and not the land. For our example, the land is worth $80,000 and the building is worth $100,000. For up to 27.5 years you’re allowed to deduct 3.636% of $100,000 as a business expense. The depreciation expense would be $3,636 per year. Your $9,000 net rental income would be reduced by $3,636. Your taxable income would then be $5,364.

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