Austin is one of the hottest real estate markets in the nation, and property investment remains an attractive opportunity for many people who are looking to grow financially along with the local economy. Some investors want cash flow. Others, long-term value appreciation.
Sure, the real estate market here in Austin is poised for another record breaking year. But even in a high-demand area like Austin and its neighboring communities, potential investors must still think carefully and crunch the numbers to make smart choices and avoid costly mistakes with their hard-earned money.
For new investors, knowing how to measure the three sources of Return on Investment (“ROI”) from a real estate investments is an essential core competency
Value Appreciation and the Magic of Leverage
If you’ve been monitoring Austin’s property values, you’ve probably seen the price of homes steadily climb upwards for years. That means those who own property can usually sell their home at a significantly higher price than they paid. It’s a pretty elementary concept. But it has some more sophisticated elements.
Let’s start with one of the most exciting concepts in real estate investment – leverage. For example, if you put 20 percent down on a $300,000 home, you have $60,000 invested and a mortgage of $240,000. As the value of your property rises, your initial investment has more value.
If that property grows 5 percent a year, which is well within reason based on Austin’s recent history, you would have a property worth $315,000 after the first year. That means your down payment of $60,000 leveraged a $15,000 increase in net worth. That’s a 25 percent return on your initial investment.
Of course, that increase in net worth is not immediately available to you as disposable income. But if you decide to sell, the leverage will pay off in the end. (Learn more about leverage from our previous blog.)
Plus, making money on value appreciation isn’t limited to only investors. For many homeowners, leveraging the down payment on their home is their single greatest source of financial gain over a lifetime.
Rent Rates and Income Elasticity
Like property values, rental rates in Austin have also been increasing for years. Income from renting your property is one of the primary forms of “ROI” or return on investment. But there are many moving parts.
To start, you have expenses. Traditionally, these include principal payments on the mortgage, interest, taxes and insurance that go along with owning a home. Additional costs may vary, but they typically include maintenance and upkeep, as well as managing the property. Those expenses vary widely depending on the condition of the property and its utilities, as well as whether you manage the property yourself or hire a professional.
After you run the numbers, you’ll hopefully have rental income that will cover expenses and generate a profit in the form of positive cash flow.
Savvy investors are always on the lookout for an opportunity to make improvements to the property and raise rents as a result. This is known as income Elasticity. Depending on the cost of the improvement and the resulting rent increase, the property improvement may, or may not, yield additional ROI.
Uncover Tax Shelter Opportunity
Tax sheltering is perhaps the least understood form of return on investment. In essence, a tax shelter is something that protects some of your income from federal income taxes.
The most common form of sheltering is through tax deductions. With residential investment property (non-owner occupied), expenses like mortgage interest, insurance and property taxes can be deducted from your taxes. This works for interest on home equity loans placed on rental property, as well.
Investment property owners can also deduct on a depreciation schedule, a method provided by the IRS in acknowledgement that the real estate on the property won’t last forever.
Residential real estate, for example, is depreciated over 27.5 years. That means the house (not the land) on the property, for tax purposes, depreciates “on paper” about 3.6 percent each year.
Let’s say you have a rental home valued at $300,000, and that the land is worth $80,000 and the home itself contributes $220,000 to the overall property value. In this case, 3.6 percent depreciation would yield an annual tax shelter of apx. $8,000 and for investors in a 50% tax bracket, the net savings during tax season would be apx. $4,000.
It gets even better. Don’t forget to pencil in the additional tax shelter from deducting the mortgage interest, insurance and real estate taxes. In the example above (assuming a 30% down payment for a $300,0000 non-owner occupied property), the tax shelter from these ongoing expenses will typically exceed the shelter from depreciation, which in this case could bring the total tax shelter savings to around $10,000 a year.
Although it’s critical for you as the investor to understand how to calculate the projected return from a real estate investment, it’s wise to seek council from a tax professional and trusted real estate expert who can help guide your market research, ROI analysis and overall real estate investment strategy.