The Biblical King Solomon understood the relationship between what you invest and what returns you receive from that investment, as many of the wisdom sayings attributed to him attest. In real estate terms this means that what you get out of an investment should yield more than what you put in. According to Jason Hartman, determining the return on investment (ROI) of income property is a key to financial success.
Solomon’s adages about investing remind us that putting in hard work yields a profit (Proverbs 14:23) – investing yields results. So too in the modern world of income property investing, where an initial investment also yields results, the return on that kind of investment being driven, according to Jason Hartman’s investing plan, by four pillars: appreciation, cash flow, principal reduction and tax benefits.
A basic formula for calculating ROI for real estate investments begins with determining the annual gain from the investment. A different calculation than profit, investment gain establishes how much is returned from the property annually. The next step is to subtract all investment related expenses from this number. This cost of investment is then divided by the total cost of the investment.
But rental income property is a multidimensional asset whose ROI is best calculated by factoring in less obvious elements as well. The first and most obvious of these elements is appreciation: the “buy low and sell high” principle. And appreciation can be increased with leverage – borrowing money to increase profits. Fixed-rate mortgages that set the cost of borrowing for terms of 30 years can amplify the appreciation of the investment.
The second pillar in this ROI framework is cash flow. A positive cash flow from the property clearly demonstrates a return on the investment. But even a negative cash flow, which can occur in the early years of owning a property or in periods of vacancy, may not be a drawback if taken in the context of other aspects of the framework such as tax benefits, which can offset that negative income.
Principal reduction also drives the ROI. If an income property is purchased on a fixed-rate mortgage, that loan can be paid down over time by rents from the property’s tenants. Finally, the many tax benefits pertaining to income property play a major role in determining that property’s return on investment. With deductions for virtually every aspect of repairing and maintaining the property as well as any activity or travel associated with it, current tax laws favor property investors. These tax breaks, which include depreciation, ongoing maintenance and capital improvements, can offset temporary periods of a negative cash flow.
No two properties are equal, and the best way to build a viable income property is by diversifying into as many markets as possible. The ROI for each property is driven by its unique performance relative to each of the four pillars in Jason Hartman’s framework for determining just how, in Solomon’s terms, what you receive can yield more than what you invested. (Top image: Flickr/geezaweezer)
The Solomon Success Team