Friday, February 25, 2011

Why should I invest in real estate? CADA!

Why real estate?  CADA of course!  CADA is a little acronym I made up standing for cash flow, appreciation, depreciation and amortization.  The 4 main reasons allow an investor to measure their return by a numerical value!  Let's take a look at the last home I bought and consider all 4 fields...

  1. Cashflow- my most recent purchase was a $57,000.  I put $5,700 down and got a mortgage for $51,300 at 4.5% for 30 years.  The payment with taxes and insurance is $367.  A military family that I rented the home to pays me $795 a month.  So $795 - $367 = $428 in monthly positive cashflow.  That's a total of $5,136 in annual cashflow before maintenance and vacancy.  This is the greatest of all returns; therefore, it's listed first!
  2. Appreciation- I conservatively estimate that a 3 Br. 1.5 Ba in Columbia County will appreciate on average 4% per year.  With the home being bought for $57,000, it would go up in value over time by 4% per year, or $2,280.  Now an aggressive appreciation estimation would be 6-8%, considering how much money the Federal Reserve just printed we might should go with 20%, and since the home is really worth $90,00 we should multiply $90K by 4% to begin with.  However, I'm being conservative...
  3. Depreciation- We'll depreciate the value of the structure after subtracting out the land ($57K - $5,700 = $51,300) and divide by 27.5 years (view my last post if you have any questions).  This equals out to annual wear and tear on my house of $1,865.  If I am in a 25% tax bracket, this $1,865 write off would be worth $466 in tax savings per year.
  4. Amortization- When I make my $367 payment, $67 of my payment actually goes towards repayment of the principal loan amount of $51,300.  So after 1 year of payments, I'll owe $67 * 12 months = $804 less on my house!  The best part: it's my tenant paying off the loan!  So after year one, I'll only owe $50,500.  Surely this return on my investment must be accounted for because after 30 years I'll own the home with no mortgage whatsoever!  So that's an annual principal pay down of my loan in the amount of $804.
So we've now made $5,136 + $2,280 + $466 + $804 = $8,686.  Supposedly, according to the news, real estate is a terrible investment.  Yet somehow I was able to buy the above foreclosed home in today's real estate market?  With $5,700 down, $3,000 in closing costs, and a $4,000 rehab, I've achieved a 68% Cash on Cash return?  So remember CADA as you evaluate your next investment...  

Sunday, February 20, 2011

A Straight-Line Depreciation Schedule

Since it's tax time, I wanted to give you a simple explanation for what may seem like a complicated topic.  Depreciation is the IRS's definition for real estate incurring wear and tear as time goes on; in fact, for tax purposes, the IRS allows you to assume that your real estate will be totally worn down and useless after 27.5 years for residential investment property.  Here's how you calculate depreciation:

If you buy a home for $100,000, subtract out the value for the land since even the IRS knows that dirt doesn't wear out.  A liberal valuation for land would be 10% of the purchase price.  So $100,000 - $10,000 = $90,000.  So we're depreciating $90,000 over 27.5 years, this would be as follows: $90,000 / 27.5 years = $3,272 / year.  This amount you can write off as a deduction against the cashflow of your home, essentially allowing that income to be tax-free.  So if you have a home and you earn $200 / month positive cashflow, or $2,400 per year, you can not pay tax because you have $2,400 in income, with a loss of $3,272 in wear and tear.  So $2,400 - $3,272 = -$872.  Guess what?  You can now take the remainder of this "loss" against your personal earned income from you JOB!  So now you just sheltered $2400 in rental income, plus $872 in earned income, and you didn't even have to spend the $3,272 to get the write-off because depreciation is a NON-CASH EXPENSE!!!

Now imagine if you had 5 homes depreciating at $3,000 per year...imagine if you had 20?  Would you pay any income tax on your earned income?  Would the government actually have to write YOU a check in your depreciation exceeded your earned income!?

Any questions?