Financing affects returns on real estate investments

Dale Beede
Dale Beede

How do you develop a clear picture of expected returns on real estate held for investment? What should you consider if you’re planning to finance that investment? Is it possible to realistically calculate expected returns? Let’s look at the numbers.

Assume you own a 10,000-square-foot industrial building in the third year of a five-year lease, The building nets you $45,000 a year because the lease is a true triple-net. Your tenant pays for repairs and maintenance, annual property taxes, replacement insurance and utilities.

If you bought the property three years ago for $560,000 cash, your cash on cash investment yields an 8 percent return before depreciation and taxes. Because you paid cash for the property, the annual net operating income yields a simple 8 percent return on investment before depreciation and taxes.

Suppose you paid 30 percent down, or $168,000 cash, for the $560,000 building. What has happened to the return on investment? Your property still provides you $45,000 a year before debt service and taxes. Your loan payments on the $392,000 borrowed are $2,587.03 a month — $31.044.32 a year — because you were able to lock in a five-year loan amortized over 20 years at 5 percent interest. Your net income before depreciation and taxes of $13,955.68 — or 8.31 percent on your initial $168,000 investment — is just part of the story.

Beginning with year three of your loan, your balance is now $367,980.27. In just two years, your tenant has paid off $24,019.73 of the principal. At the end of the five years, your loan payoff is $327,142.81.

We can calculate the effect of that debt reduction by using an internal rate of return analysis — the amount each dollar invested has earned over the holding period of the investment. To do this, we must anticipate a sale of the investment at some future date.

Let’s assume you decide to sell the investment at the end of five years when the loan matures. Your tenant has signed a new five-year lease with a 10 percent increase in annual payments over the last lease, meaning your annual income before depreciation and taxes is now $49,500.

A local investor is willing to pay $660,000 for the property with its new income stream. You net the $660,000 less the loan payoff of $327,143 and closing costs of $45,000 — or $287,857 before depreciation and taxes on the initial investment of $168,000.  In addition, you’ve enjoyed more than $13,900 of annual income on that investment after debt payments. A simple internal rate of return calculation indicates a total return on each dollar invested over a holding period of five years of 218.47 percent.

One lesson here is that investment returns could be increased if appropriate debt is employed. The downside of using any debt in a purchase of investment real estate, as exemplified by the past seven years, is we can’t always predict the future. Downturns as well as inflationary times occur. Properly managing your property’s leases and procuring quality tenants could be the difference between a winning and losing investment.