Return Quadrants™

If you think about the 4 areas of return you get from owning a rental property they are:

  • Appreciation – The tendency for property values to increase over time.
  • Cash Flow – The net proceeds you get from collecting rent on a property after all expenses.
  • Debt Paydown – The amount of the loan that is paid down each year (presumably—albeit indirectly—by your tenants) when you make your mortgage payments.
  • Depreciation – The tax benefits you receive by statute from owning rental properties.

As I was teaching real estate investing classes, I would methodically go through each of these 4 areas of return using the old pneumonic of real estate being the IDEAL investment.

At some point I began to represent the 4 areas of return visually in a quadrant with an additional space at the center of the four areas representing the sum of the 4 quadrants.

These were… and continue to be… ESTIMATES of the benefit from each area especially if we are projecting what the values might be in the future.

3 Different Variations of Return Quadrants™

I would display this simple diagram in 3 different variations.

  • Return in Dollars Quadrant™ – Which showed the raw dollar amount of the benefit you received from owning the rental property.
  • Return on Investment Quadrant™ – Which showed the raw dollar amount of the benefit you received from owning the rental property divided by the initial investment used to acquire the investment.
  • Return on Equity Quadrant™ – Which showed the raw dollar amount of the benefit you received from owning the rental property divided by the current equity in the property.

Return in Dollars Quadrant™

The Return in Dollars Quadrant™ was helpful at any point of owning the property since it showed the raw dollar amount that the property had earned for that time period.

Here’s an example of the Return in Dollars Quadrant™. It is displayed in dollars.

Return on Investment Quadrant™

However, the Return on Investment Quadrant™ is really only appropriate at the very beginning of making the investment. This is because we are using your initial investment as the denominator to determine what the return would be. In almost all cases, uses your initial investment to talk about the returns you’re receiving at some point in the future is not a meaningful measure.

Here’s an example of the Return on Investment Quadrant™. It is displayed as percent of your initial investment to acquire the property.

Return on Equity Quadrant™

For any other period of time (besides when you first purchase the property), you may want to use the Return on Equity Quadrant™. This takes the raw return earned for the period and divides it by the equity in the property. It gives you an idea of how much you’re earning on the investment compared to the equity you have tied up in the property.

The thought is that you could… in theory at least… sell the property and deploy the equity by investing in something else (another property, stocks, bonds, et cetera). So, you want to know what return you’re earning (from the 4 areas) in relation to the equity you have. This gives you a starting point to compare the return you’re receiving to another possible investment.

Here’s an example of the Return on Equity Quadrant™. It is displayed as percent of your initial investment to acquire the property.

Appreciation

Appreciation is the tendency for property values to increase over time. Property values can also go down. This number would be negative if property values declined.

Appreciation can be forced through improvements made to the property although we most often think of it in terms of market appreciation (think inflation here).

This is measured in pre-tax dollars since the property increasing in value is not a directly taxed event. However, as your property value increases you’re likely to see an increase in your yearly property taxes.

The return from Appreciation is unbounded (infinite) since property values have no hard upper limit on them. This is similar to Cash Flow but different than Debt Paydown and Tax Benefits.

Cash Flow

Cash flow is the net difference between the income you collect on the property (usually from rent although it can include others things like laundry from a multi-family property as just one example) and all the expenses on the property.

You can improve cash flow on your properties and impact the cash flow return on your rental properties.

As income on the property increases, cash flow also tends to increase.

This can be negative if your income on your property is less than the expenses on the property.

This is measured in pre-tax dollars.

The return from Cash Flow, like Appreciation, is unbounded (infinite) since rents have no hard upper limit on them. This is different than Debt Paydown and Tax Benefits.

Debt Paydown

Debt paydown is the amount of the loan that was paid down during the period covered. It is the principal paid off on that property.

If you have an interest only loan, this would be zero.

If you do not have a loan on the property, this would also be zero.

For normally amortizing loans (15 year loans, 30 year loads, et cetera), the amount you pay off each year in principal tends to increase over time. So, you’d expect larger numbers in the Return in Dollars Quadrant™ the longer you own the investment.

Of course, if you pay off the loan (in part or in full) or refinance the property this quadrant will change.

If you got an additional mortgage (second mortgage, Home Equity Line of Credit also known as a HELOC, et cetera) this quadrant should also reflect that number as well.

This is measured in pre-tax dollars.

The return from Debt Paydown is strictly limited to the amount of debt on the property. If you borrow $400,000 to purchase a property your total return… over the lifetime of the investment (unless you refinance) cannot exceed the loan amount of $400,000. The $400,000 return from Debt Paydown is spread out (unevenly, according to an amortization schedule) across the term of the loan.

Tax Benefits

Tax benefits is the amount of tax benefits you’ve earned by owning this as a rental property.

If you are owner-occupying the property, you do not get the tax benefits of depreciation until it becomes a rental. If are renting part of the property (house hacking with roommates and/or it is a duplex, triplex, fourplex where you are living in part of the property) you are likely to be able to get a partial depreciation benefit.

If you’ve owned the property beyond the depreciation period, this could also be zero. So, if you owned it for more than 27.5 years as a residential property or 39 years as a commercial property this would be zero as well.

You’ll see this number presented as both a pre-tax number (which I refer to as Gross Depreciation) and post-tax number (which I refer to as Cash Flow from Depreciation™). I am often tempted to present it as pre-tax since the other quadrants are all pre-tax. However, it is easier for many investors to think about it in post-tax terms since it estimates how much extra cash flow you’re likely to see when we show you Cash Flow from Depreciation™.

For Gross Depreciation it is calculated by taking the value of the property (excluding the land) and dividing that by 27.5 years for residential property or 39 years for commercial properties. This is the amount the owner can reduce their income by on their tax returns (assuming they qualify to take depreciation).\

For Cash Flow from Depreciation™ it is calculated by taking the Gross Depreciation (calculated above) and then multiplying that by the tax rate of the property owner. This shows how much the owner will save on their taxes. Depending on how they’re doing their taxes it could be a larger tax refund and/or paying less taxes from their paychecks (weekly, monthly, etc).

As long as the tax code does not change, your Gross Depreciation benefit will likely remain the same for the depreciation period (27.5 years or 39 years depending on the investment type). Cash Flow from Depreciation™ will change based on your income tax rate.

The return from Tax Benefits is strictly limited to the depreciable value of the property at the time of purchase. If the depreciable value of the property is $320,000 then your total return… over the lifetime of the investment (unless you complete additional depreciable improvements) cannot exceed the depreciable value of the property of $320,000. The $320,000 return from Debt Paydown is spread out (evenly, in equal yearly installments) across the depreciation period of 27.5 years or 39 years (depending on the property type).

Speculative Returns

Not every quadrant has equal certainty. Some are more speculative in nature and rely—to varying degrees—on the market.

For example, property values can go up and down in any given year. So, appreciation is considered relatively speculative. It won’t always be constant and won’t always be positive.

Probably to a slightly lesser degree, but still speculative, cash flow can vary. Rents don’t always go up. Maybe you got top of the market rent one year, but the tenant moved out over the Thanksgiving/Christmas season and now you’re forced to rent in a lower rental season. Your cash flow return could be lower… even negative if you were close to zero to begin with from one year to the next.

Plus, rents don’t always rise. Sometimes markets see a decline in popularity and demand and rents could be lower in the future than they are now.

For these reasons, appreciation and cash flow (the top half of the quadrants) are said to be more speculative.

The top half also consists of both unbounded (infinite) returns since there is not a hard upper limit on either property values or rents.

Less-Speculative, More-Certain Returns

On the other hand, the bottom half of the quadrant consist of returns that are less prone to market fluctuations and are considered to be less-speculative and more-certain by their very nature.

For example, Debt Paydown is a contract between you and the mortgage company. If you make your mortgage payments as agreed you get this return. It doesn’t matter if the market goes up or down. It doesn’t matter if rents go up or down or vacancy goes up or down. These market factors are reflected in the other areas of return (Appreciation and Cash Flow respectively) and do not impact the Debt Paydown part of your return.

Another example of a less-speculative and more-certain return, is Tax Benefits. Unless the tax law changes, you likely receive Gross Depreciation and Cash Flow from Depreciation™. Of course, if you earn too much money this benefit may be delayed until either your income is such that you qualify again or until you sell the property. But, similarly to Debt Paydown, the return from Tax Benefits is not impacted by market conditions.

It is extremely rare to see the returns from Debt Paydown and Tax Benefits to ever be negative. It is possible (for example a negatively amortizing loan) but extremely uncommon.

When we think above the returns on the bottom half of the quadrant, we can think of those returns as the more likely, more steady returns that will—at a minimum—buoy the overall return of the investment even if Appreciation and Cash Flow may be low or even negative. For large negative returns from Appreciation and Cash Flow, the returns from Debt Paydown and Tax Benefits will almost always make the overall return less negative.

The bottom half also consists of both limited returns (in both amount and duration) since the return you can get from Debt Paydown and Tax Benefits are both fixed at the time of purchase.

Cash Now

The two returns on the right of the quadrant are returns that tend to generate immediate cash… what I call Cash Now. Cash Flow and Cash Flow from Depreciation™ tend to put money in your pocket right away (monthly especially if you set up your income taxes to to decrease your tax liability from your paycheck to reflect the depreciation benefit by adjusting your exemptions with your employer).

Of course, Cash Flow can be negative so your Cash Now half of the quadrant could be negative if Cash Flow from Depreciation™ wasn’t large enough to offset negative Cash Flow.

The Cash Now side is taxed now.

Cash Later

On the other side of the quadrant, we have Cash Later. This is the part of the return that you’re getting but it is harder to access. It shows up as equity in your property from the property going up in value (Appreciation) and the amount you owe on the loan going down (Debt Paydown).

When you sell or refinance the property you can access any increase in property value and take advantage of owing less on the property.

The Cash Later side of the quadrant consists of some money that is taxed now (Debt Paydown of principal is made with after-tax dollars) and some that is taxed later (capital gains on any Appreciation when you sell).

However, you can often times access the increased equity by borrowing money (an untaxed event) against the property. This is usually accomplished by doing a cash out refinancing of the property or adding a second loan to the property (like a HELOC).

Reserves

In 2020 and 2021 I created some more realistic, more advanced versions of the Return Quadrants™.

You should NOT invest in rental properties without appropriate cash reserves.

However, few folks were calculating returns that included the drag of these reserves on your return and no one was including the return you were earning on the reserves as part of the overall return.

I introduced these are additional variations of the three existing versions of the quadrants.

The Return in Dollars Quadrant™ became the Return in Dollars + Reserves Quadrant™ (abbreviated as RIDQ+R™). And, this came in two flavors: 6 month of reserves and 12 months of reserves.

Here’s the 6 month reserves:

The Return on Investment Quadrant™ became the Return on Investment + Reserves Quadrant™ (abbreviated as ROIQ+R™) again in both 6 and 12 months.

Here’s the 6 month reserves:

And, here’s the 12 month reserves:

Anytime you enter a  Property in the Real Estate Financial Planner™ software you will be able to see these quadrants with the correct calculations at the bottom of the edit page.

Finally, Return on Equity Quadrant™ became a 6 month and 12 month version called Return on Equity + Reserves Quadrant™ (abbreviated as ROEQ+R™).

To learn more about these, check out the Everything You Learned About Deal Analysis is Wrong – ROIQ+R™

Return Quadrant™ Reports

Prior to 2021, you could easily see the Return Quadrant™ for any given  Property you entered in the Real Estate Financial Planner™ software.

However, in 2021 I added a new series of reports for each  Scenario you have in the Real Estate Financial Planner™ software that can show you the Return Quadrants™ for all  Properties in that  Scenario.

For example, here’s an image of a sample report.

Sample RIDQ+R Report
Sample RIDQ+R Report

Plus, there are some new interactive charts like this one.

Sample RIDQ+R Chart
Sample RIDQ+R Chart

These new charts are available for return in dollars, return on investment and return on equity versions with 6 months or 12 months for each.

Plus, for return on equity, I introduced a new concept called True Net Equity™ which you can optionally use to calculate the return on equity but using your equity minus all expenses of selling the property.

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