The goal of real estate investing is to create wealth, and wealth is generated in four primary ways:

• Cash flow
• Loan Amortization
• Appreciation
• Tax Shelter

An understanding of the relationship between these four wealth creating elements and their underlying numbers is the only way to consistently make money in real estate investing. Here’s a brief description of each:

Cash Flow – This is the income after deducting for operating expenses and loan payments from the gross operating income. Operating expenses are costs incurred during the operation and maintenance of a property. They include real estate taxes (but not personal taxes), insurance, management fees, repairs and maintenance, etc. Subtracting the operating expenses from the operating income yields the net operating income (NOI). Loans aren’t needed to operate a property, but they may be needed to buy it, increasing the overall expense. If the property is financed, then loan payments must be paid, decreasing the available cash flow. Here’s the math:

Loan Amortization – Consider a $300,000 property. Assuming you had $300,000 you could just write a check for this amount, but you could also write a check for $60,000 and get a loan for $240,000 and have enough money to buy four more properties. Unlike your residence, investment property generates an income and a tenant is essentially paying most if not all of your loan payment. All loan payments include both principal and interest, and amortization is the liquidation of the debt by the application of payments over time. You make, for example, $17,000 in payments for the year and your bank reports you have paid $14,000 in interest. Your amortization for the year is $3,000.

Appreciation – Real estate has appreciated about five percent on average over the past 100 years and more than seven percent in the past 30 years. Over a short term real estate values may fall, but most real estate purchased for income is held for several years and historical measures are usually a more reliable indicator. For example, a property that appreciates 5% per year will increase in value by over 27% in five years. That means a $300,000 property could be worth $382,880, providing a $82,880 gain.

Tax shelter – The last element is tax shelter. The government encourages real estate investing to provide affordable housing, and an investment property can shelter most of its own income and occasionally shelter other passive investment income. The first deduction is mortgage interest. This is an expense of acquiring a property rather than operating it, and your tenants are effectively paying it. Nevertheless, the IRS lets you deduct it. Depreciation of the property is the second major deduction. While the property is actually appreciating, it’s assumed the building (but not the land) is wearing out and becoming less valuable. Just be aware that what the IRS givith, it can take away. The depreciation deduction reduces the cost basis of the property, and this is used to determine the taxes paid when it is sold.

Three Key Financial Measures Every Real Estate Investor Should Know

Real estate investors don’t buy real estate for the sake of owning property. They buy income streams and use various financial measures to evaluate different properties and their expected returns. Three measures are most widely used. Each has their strengths, but only one measure can account for all four ways of making money with real estate.

Capitalization rate – This measure, commonly called the cap rate, is a quick way to evaluate the value of a property. It’s the ratio of the net operating income and the property’s value. A property with an NOI of $30,000 that’s worth $300,000 has a cap rate of 10%. If this property is listed for sale for $400,000, then its cap rate is only 7.5%. If you're looking for a 9% return, then the value of this property is about $333,333. Using simple algebra, you can compare different properties to decide if one is worth pursuing. While the cap rate is in important measure for comparing different properties, it doesn’t provide a way to measure the efficiency of creating wealth because it doesn’t account for amortization, appreciation or tax benefits.

Cash on cash return – This measure takes financing into account by looking at the current year’s cash flow in relation to the initial investment. An initial investment of $30,000 that produces a first year cash flow of $3,000 has a 10% return. The cash flow includes the loan payment as an expense, and different financing terms are easily compared. It’s a popular measure, because it provides a quick read on a property’s return on investment, but it ignores amortization and appreciation.  

Year Cash Flow Year 0  ($1,000) Year 1  $50 Year 2  $50 Year 3  $50 Year 4  $50 Year 5  $1,050 IRR  5% Return on simple income stream

Internal rate of return – This is perhaps the most powerful capital budgeting measure used by firms to decide whether they should make investments, and it can account for all of the wealth creating elements. The IRR formula is too complex to calculate manually, but it’s easily evaluated using a financial calculator. The IRR takes into account the time value of money and provides a measure to compare alternative investments. The time value of money is based on the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal, because money received today can be reinvested to create more value. For example, assume $1,000 is invested and pays 5% interest for five years and then withdrawn. Here’s the cash flow and IRR over five years:

The time value of money for a real estate investment is based on a series of cash payments and it includes the initial investment, the expected cash flow in future years, and the equity gained through amortization and appreciation. The IRR allows an investor to compare two properties that may have totally different values, cap rates, cash on cash returns, and financing terms. Essentially, it allows you to find the interest rate this is equivalent to the dollar return you expect. For example one property may require a larger down payment, have a smaller cash flow, and yet have greater appreciation potential than another property. Consider two properties that have the following income streams and sold after five years. The IRR shows that both properties are equally efficient in producing wealth.

Property #1 Property #2  Property Value  $100,000 $200,000 Investment $24,000 $48,000 Annual Cash Flow for Five Years $2,000 $700 Sale Proceeds in Five Years $43,000 $109,000 IRR 19% 19% The IRR provides a measure to compare alternative investments

The power of each of these financial measures is illustrated in the figure as they are able to account for the different wealth creating elements.

Cap Rate  Cash on Cash  Internal Rate of Return (IRR)  Property Value  x      Cash Flow    x  x  Loan Amortization      x  Appreciation      x  Tax Shelter      x  The IRR measures all wealth creating elements

Why don’t more real estate investors use the IRR measure? First, it’s a mysterious concept for many, and while it’s thrown around a lot, most people really don’t understand it. Secondly, most investors focus on a narrow range of property types and financing programs. Within this narrow range investors develop guidelines for expected cap rate and cash on cash return, and they only buy properties that meet their criteria. The power and importance of the IRR measure is profound when radically different property types or financing programs are considered.

There's an adage that money is made in real estate when you buy it. But more money can be made if all the elements of wealth creation are understood and the right financing is used. Serious investors understand the key elements of creating wealth and how they interact. Each type of financing has its advantages, and success comes to the real estate investors who work the numbers to find and structure the best deals. All three measure should be part of every investor’s tool kit.