Real estate investing is a numbers game. Unless you take time to crunch hard numbers, you are really just guessing and hoping when you try to figure out if a given property is a good investment. Professional real estate investors are not so much interested in the physical property itself as they are in its income stream. There are four important calculations you should do in order to read a property's vital signs to judge how healthy it is as an investment.
The formula for cash flow is simple enough: Cash in, minus cash out, equals cash flow. The key to cash flow is that it must be positive. Negative cash flow -- such as collecting $2,000 a month in rent yet owing $2,500 in monthly expenses -- is a bad situation for a real estate investor to be in. If your cash flow calculations do not add up to you being able to collect enough in rent to cover your debt payments, taxes and operating expenses, at some point it is likely that you will have to ante up your own personal money to cover the shortfall on an investment property that should be paying you an income.
While positive cash flow is the monthly income an investor receives from real estate investments, you don't enjoy the benefits of appreciation until you sell, and the rewards of appreciation can potentially be much greater. The formula for appreciations is: Future resale price, less the original sale price, equals price appreciation. But cash flow and appreciation work hand-in-hand. The more income the property generates in monthly rent payments, the more another investor would be willing to pay for the property. You can increase the rents by making improvements to the property. Sometimes surrounding development in an area can make your rental property a more fashionable community to live in.
When you use a mortgage loan to buy real estate investments, your renters will, in effect, end up paying off the debt. Each payment you make includes interest and principal. The lion's share of your mortgage payments -- at least in the early years of the mortgage -- will go to the bank as interest, rather than building your equity. Calculating the loan amortization will show you exactly how much equity your mortgage payments are actually building for you. The amortization formula is: Total mortgage payment, minus the interest paid, equals amortization. Hypothetically, if your monthly mortgage payment is $1,800 you are paying $21,600 a year to the bank, minus approximately $18,000 in interest. That would result in amortization of about $3,600 for the year. This means the rent payments you received from your tenants reduced your mortgage debt by that amount.
Real estate investments can shelter some income from taxes so that you end up being taxed on less than you actually earn. If your depreciation deduction on a real estate investment is large enough, it can even exceed the amount needed to shelter the property's own income, and provide shelter for other investment income as well. Depreciation is a deduction you receive that assumes the value of a building is wearing out -- although the value of property tends to go up. For example, assume your property generates income of $50,000 after expenses. If you deduct mortgage interest of $38,000, and take a depreciation deduction of $9,000, your taxable income is only $3,000. Even though you have positive cash flow of $12,000, you pay taxes on only $3,000 because of the tax shelter.
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- Does Taking a Large Deduction Hurt My Ability to Get Financing?
- Does Having a Mortgage in Your Name Count Against You When Renting an Apartment?
- What Can You Deduct on Your Taxes as a Homeowner With Rental Income?