It is finally here!
We've already had the ability to chart the four areas of return when investing in real estate: appreciation, depreciation (tax benefits), cash flow and debt paydown on the same chart in the Real Estate Financial Planner™ software.
On the chart in the Real Estate Financial Planner™ software you can choose to toggle each of the four areas of return on/off so you drill down and look at one or compare one to the other returns of your choosing. This will allow you to compare the relative size of each of the returns.
Or, choose to stack the returns and see the total return as a sum shown below.
You could see this chart for a specific Property or for all your rental Properties combined on one chart for the entire Scenario.
Return on Investment Quadrant™ Now on The World's Greatest Real Estate Deal Analysis Spreadsheet™
But, on the older version of The World's Greatest Real Estate Deal Analysis Spreadsheet™ (aka Brian's Spreadsheet) we never had an easy way to quickly see a summary of what the four areas of return where for the first year… until now.
With the release of the newest version of The World's Greatest Real Estate Deal Analysis Spreadsheet™ (version 4.01), Brian has added in my Return On Investment Quadrant™ for year 1 to his spreadsheet as shown below.
Return on Investment Quadrant™ Summarized
Why does this even matter?
The Return on Investment Quadrant™ quickly shows you each of the four areas of return and sums them up to show you the overall return you're getting on an investment property.
For the spreadsheet version, it gives you a quick visual of how your investment property is performing in year 1.
In real estate markets like mine in Fort Collins, Colorado—where finding cash flowing properties with 20% down payment (or less) is nearly impossible to do—we need to take a more holistic view on return and consider more than just Cash on Cash Return on Investment.
Even if you are in a real estate market where you can get decent cash on cash returns, the Return on Investment Quadrant™ gives you a clearer picture of what your overall return on investment looks like when you include all 4 areas of return: appreciation, cash flow, debt paydown and cash flow from the tax benefits of depreciation.
Cash on cash is still probably the most important area of return, but if you're looking only at Cash on Cash Return on Investment, you're ignoring 3 other major primary areas of return.
Most deal analysis spreadsheets—including older versions of The World's Greatest Real Estate Deal Analysis Spreadsheet™—do not quickly and easily summarize all four areas of return like the Return on Investment Quadrant™ does.
The Return on Investment Quadrant™ allows us to easily see a holistic view of the true overall return.
The appreciation quadrant on the spreadsheet takes the dollar amount of appreciation that is calculated from your assumptions and divides by your Total Investment and displays it as a percentage return.
The appreciation quadrant tells you what return you're expecting to see from appreciation if you make this investment.
When investing with 20% down payments and assuming a modest 3% appreciation, we typically expect this return to be in the ballpark of 15%. It can vary a little depending on your actual closing costs and if you're buying the property at a discount (or paying a premium above current fair market value).
If you're buying a Nomad™ Property and using a 5% down payment loan program but getting the same 3% appreciation rate, we typically see returns in the 60% range. Again, this will vary based on your other closing costs and if you buy the property at a discount or paying a premium.
Appreciation is largely speculative in nature and dependent on the market going up but it tends to be one of the larger areas of return.
The quadrant for cash flow is the same as your Cash on Cash Return on Investment. We take net cash flow after all expenses you've entered on the spreadsheet including vacancy, taxes, insurance, property management, maintenance, HOA dues and mortgage payment and divide by your Total Investment.
Cash on Cash Return on Investment (this quadrant) has typically been our primary focus for analyzing rentals for cash flow. It answers the question: what kind of cash flow return will the property provide to us based on our initial investment to acquire the property?
Rents can go up and down over time based on market conditions. Rent is a primary driver of what we can expect in cash flow. Therefore, cash flow and specifically the return from cash flow (Cash on Cash Return on Investment) is largely speculative.
The top half of the Return on Investment Quadrant™ is made up of the two speculative returns… the returns that are largely dependent on the market performing in your favor. If the real estate market remains strong, you might expect strong returns in these two areas (appreciation and cash flow). If the market softens or becomes depressed, we might expect lower depressed returns in these two top quadrants in the Return on Investment Quadrant™.
For this reason, I am reluctantly hopeful for these returns, but I mentally rely more heavily on the returns from the less market-dependent, less variable, less volatile bottom half of the Return on Investment Quadrant™ which includes debt paydown and depreciation.
If you take the amount of principal that was paid down on your loan for the year and divide by your initial Total Investment it gives you the return your earned from debt paydown this year. That's what appears in this quadrant of the Return on Investment Quadrant™.
This typically varies each year since the amount you pay off on a typical amortizing loan increases each month over the life of the loan. In other words, you end up paying more principal with each payment you make on the loan. The first payment you make on your mortgage typically pays less of the loan than your last payment and similarly your first payment is paying more in interest than your last payment.
On a related note, if you want to see the annualized return on investment for the full term of the loan, here's an image I made for a presentation that shows a number of loan programs. I might write another, more detailed blog post on just this image in the future. Leave a comment below if you're interested in that.
Debt paydown is not market dependent… it does not matter if the property value goes up or down (that's already taken into account in the appreciation quadrant)… nor does it matter if the rents go up or down and if the property cash flows (that's already taken into account in the cash flow quadrant). It also doesn't matter what the stock market or bond market is doing if you get a fixed rate interest rate that remains the same for the term of the loan (15 year, 30 year, etc). Debt paydown is the return you get from the loan being paid down.
Because the return from debt paydown is really just dependent on the “contract” you have with the lender for the term of your loan, it is as close to a “guaranteed return” as you can get without it being guaranteed. If you make your regular monthly payments and pay off the loan over the agreed upon term of the loan you get this return. Period.
The two quadrants on the left side of the Return on Investment Quadrant™ are the “cash later” quadrants. Any equity you gain from the property value increasing and the loan balance being paid off is not typically money you can spend today unless you sell the property or do a cash out refinance. So, appreciation and debt paydown (the left side of the Return on Investment Quadrant™) is money you're “banking” to be able to spend later. I refer to them as “cash later” quadrants.
Cash Flow from Depreciation™
The current tax code allows you to depreciate the value of the buildings on your residential rental real estate investments. This explicitly excludes the value of the land (which is why the spreadsheet and the Real Estate Financial Planner™ software both ask you to estimate the percentage of the purchase that is the value of the land beneath your property).
For residential properties, you can depreciate the value of the property (excluding the land) over 27.5 years. That means you can take the value of the building, divide by 27.5 and take that amount in the first year. I call that your Gross Depreciation in the Real Estate Financial Planner™ software. Brian calls it Depreciation Amount on his spreadsheet.
A layman's version of how depreciation works with your taxes follows. Realize, for a more detailed and 100% accurate explanation, you should speak to your accountant or CPA. You can subtract this Gross Depreciation from your income so you're paying taxes on a lower income. This depreciation benefit allows you to pay less in taxes which results in more cash in your pocket.
For an over-simplified example, if you earn $60,000 per year in income and you have $9,000 in Gross Depreciation you end up paying taxes on $51,000 instead of $60,000. A more detailed discussion of this topic should also include a discussion of depreciation recapture should you sell the property and not do a 1031 exchange. The Real Estate Financial Planner™ software does allow you to do a full depreciation recapture calculation when modeling your investing strategy. Depreciation recapture discussions will be saved for another blog post.
For now, it is important for you to realize that the spreadsheet (and Real Estate Financial Planner™ software) takes your gross depreciation of the building and multiplies it by your Effective Income Tax Rate to give you an estimate of how much less in tax you will need to pay based on owning this rental property. Technically, it is your highest tax bracket rate and not your Effective Income Tax Rate that you should be multiplied. The Effective Income Tax Rate will be lower and so the calculation is more conservative (lower) than your actual return will likely be.
When we multiply the Gross Depreciation by your Effective Income Tax Rate you get the amount of money you will save on your taxes. I call this your Cash Flow from Depreciation™ since you can opt to change your number of exemptions (with the help of your accountant or CPA) and receive this money as less tax paid with each paycheck. It really is extra cash in your pocket by owning this property.
In fact, your True Cash Flow™ on your property really should be your cash flow (after all expenses) plus the Cash Flow from Depreciation™ since both are “cash now” benefits of owning investment properties. The “cash now” quadrants are the two quadrants of the Return on Investment Quadrant™ on the right side.
If you remember from our discussion above the top two quadrants (appreciation and cash flow) are largely speculative and dependent on the real estate market performing in terms of home price appreciation and rents/rent appreciation. The bottom two quadrants though are not speculative nor dependent on the real estate market. You get debt paydown as long as you pay your mortgage and you get cash flow from depreciation as long as the tax law remains unchanged. This is true regardless of what happens to the real estate market including home prices and rents. So, we call the bottom two quadrants less speculative and more certain.
Total Return On Investment
Finally, the white box located at the center of all four quadrants of the Return on Investment Quadrant™ is the sum of all four other areas: appreciation, cash flow, debt paydown and depreciation. For the spreadsheet, this tells you the overall total return you're seeing in year 1 of your investment quickly and easily.
Get Newest Version of Spreadsheet
If you'd like to get a copy of the newest version of The World's Greatest Real Estate Deal Analysis Spreadsheet™ which includes the Return on Investment Quadrant™ and several other new exciting improvements, it is included with all of the paid Real Estate Financial Planner™ software plans.
The Real Estate Financial Planner™ software was built on the foundation of The World's Greatest Real Estate Deal Analysis Spreadsheet™ but allows you to model your entire investment strategy and not just analyze a specific property.
The Real Estate Financial Planner™ software answers questions like:
- How many properties do I need to buy to achieve financial independence?
- Is it better to pay off my properties early with cash flow or invest that extra money in something else instead?
- How much will buying this next property speed up or slow down my time to retire? Will it mean more money or less money in retirement?
- How likely am I to run out of money in retirement if we see market corrections?
- And many, many more…
Get access to the newest spreadsheet to analyze individual real estate deals with the new Return on Investment Quadrant™ and the ability to model your own investing strategies by clicking on the spreadsheet below.