Real estate investors like to use the “meal” analogy when describing how they assess a property’s investment returns.
Let’s see how that work
Appetizer = Cash Flow
Take the monthly gross rent of the property and subtract all the expenses (mortgage payment, property taxes, utilities, property management, repairs, vacancies etc…). You are then left with the monthly “cash flow” that the property spits out to you.
You preferably want a property that is positive cash flow.
However, a negative or neutral cash flow property could still be desirable for some sophisticated real estate investors, depending on whether the other parts of the meal are enticing enough.
Entree = Mortgage Paydown
The entree is usually the part of the meal that you can count on each time to satisfy your hunger.
Each month, part of the rent that the tenant pays goes towards paying the mortgage payment on the rental property.
A portion of the mortgage payment goes towards paying the interest of the mortgage (money you basically give away to the bank), while the other portion of the mortgage payment goes towards paying down the principle of the mortgage.
This principle mortgage paydown is money to you in the form of equity in the property that you can tap into later on either by:
1) selling the property
2) refinancing your mortgage with the bank
Dessert = Appreciation Rate
The icing on the cake for real estate investment is the appreciation rate. You can’t always count on it, but sometimes the dessert can be the best part of the meal.
Sophisticated real estate investors will strategically invest in areas/neighbourhoods that their research tells them will appreciate now and in the future.
Although the appreciation rate of a certain area can be very high, when investors calculate their return on investment (ROI) of a property, he/she will usually use a conservative estimate of around 3-5%.
We will see an example of real estate property’s ROI using this meal analogy in a future post.
Any active or passive real estate investors willing to share the breakdown of their Rental Property’s ROI?