Understanding what kind of returns real estate investments can provide and what works best for you
In the modern day, as an investor who’s new to the real estate asset class, the first step is to educate yourself before plunging capital into an investment. Depending on your familiarity with technology, you may seek out tutorial videos on YouTube or peruse the website of a crowdfunding company whose advertisement you saw a few times while watching television. After getting a grasp of the basics of WHY you should invests in real estate, for example:
· how you can use a mortgage to help fund your purchase,
· how total returns from real estate investments can outperform the stock market,
· how over the long-term real estate value tends to go up, so on and so forth,
you get a bit more excited about the prospects of this asset class. At this point, thanks to the prevalence of educational material available online & in books (reach out to me at firstname.lastname@example.org if you’d like some material I highly recommend), the motivated investor spends time learning HOW to invest in real estate. At this stage they’re learning the key metrics used to evaluate a project, the jargon needed to communicate effectively with industry professionals as well as the steps they need to take to successfully close on a deal. If you reach this point you’ve achieved more than most people ever will, you’ve equipped yourself with the tools to execute deals successfully and get your money to start working for you. However, the elite investors ask themselves one more question before moving forward and this question helps solidify their investment goals with every new investment made:
HOW do I want to make money from my investment?
The first step to answering this question is to understand the different ways investing in real estate makes you money:
The Components of Returns
There are four key components to the return profile of a real estate investment:
· Cash Flow — the periodic cash flow received from distributions of the investment.
· Appreciation — the increase in value of the asset invested in over the term of the investment.
· Depreciation — the recorded reduction of the monetary value of the asset that’s used to offset the income for tax purposes.
· Tax Mitigation — the recorded costs incurred during the operations of the asset that are used to offset the income for tax purposes.
Returns for real estate investments (as well as all other asset classes) are represented as a percentage, usually derived from the amount of money produced by the investment divided into the amount of initial capital that investor deployed, adjusted for the time horizon of the investment (commonly referred to as “IRR”, Internal Rate of Return). Picture the four above components as four unequal pieces that make up a whole pie with that pie representing the total return from an investment.
Furthermore, these four components of real estate returns can be segmented into two separate subgroups. Cash Flow & Appreciation are INFLOW returns because these components increase the inflow cash from an investment, in other words, these returns put money in your pocket. Depreciation & Tax Mitigation are OUTFLOW returns because these components reduce the outflow of cash, in other words, these returns help you keep money in your pocket. Aside from a few sophisticated tax strategies employed by savvy investors that are beyond the scope of this conceptual discussion, the outflow returns are relatively consistent across investment projects. The inflow returns however, vary greatly and are the returns that a newer investor should focus on when determining their returns goal.
Those investors who ask themselves the very important question outlined above, develop an understanding of whether they’re more interested in investments that will pay them outsized, predictable cashflow periodically or appreciate meaningfully overtime and be sold at a profit. An example of each would be:
Example A: Cash Flow Investor
An individual has saved a large sum of money and would like to put that capital to work. They have an income that pays them enough to cover monthly expense and also continue to save but they would like an additional, passive stream of income to boost that savings and even have extra funds to travel or donate to charity periodically. They aren’t necessarily interested in taking large risk and they would prefer an investment that is relatively predictable.
Example B: Appreciation Investor
An individual has saved a large sum of money and would like to put that capital to work. The have an income that pays them double or even triple the amount needed to cover monthly expenses and also continue to save but they would like to deploy some of that savings in an investment that gives them an opportunity to grow it significantly & passively. If they can do this, they may be able to retire sooner than expected or simply scale back time spent working. They have a higher risk tolerance because of successes in their career and don’t necessarily require predictable, near-term returns.
These investor profiles are on far, opposite ends of what I call the Investor Spectrum and most investors fall somewhere between the two. Once you’ve determined where you fall on this spectrum, you can seek out investment opportunities or investment operators that align with your goals. If you want help determining where you lie on the Investment Spectrum, reach out to me (email@example.com) and we can chat.
Thanks for reading!!