In economic terms, the prospect of inflation sets off alarms and fears of out of control spending. But viewed as part of the return of investment, or ROI, on real estate income property, inflation can actually help boost a property’s return by reducing the value of the debt associated with it. Since each property has a unique profile, there’s no single formula that allows for infallible predictions about a property’s future returns. Jason Hartman offers a framework for calculating the ROI of a particular property that’s based on four pillars: appreciation, cash flow, principal reduction and tax benefits.
A basic formula for calculating ROI for real estate investments begins with determining the annual gain from the investment. A different calculation than profit, investment gain establishes how much is returned from the property annually. The next step is to subtract all investment related expenses from this number. This cost of investment is then divided by the total cost of the investment.
But rental income property is a multidimensional asset whose ROI is best calculated by factoring in less obvious elements as well. The first and most obvious of these elements is appreciation: the “buy low and sell high” principle. And appreciation can be increased with leverage – borrowing money to increase profits. Fixed-rate mortgages that fix the cost of borrowing for terms of 30 years can amplify the appreciation of the investment.
The second pillar in this ROI framework is cash flow. A positive cash flow from the property clearly demonstrates a return on the investment. Btu even a negative cash flow, which can occur in the early years of owning a property or in periods of vacancy, may not be a drawback if taken in the context of other aspects of the framework such as tax benefits, which can offset that negative income.
Principal reduction also drives the ROI if an income property is purchased on a fixed-rate mortgage. That loan can be paid down over time by rents from the property’s tenants. Finally, the many tax benefits pertaining to income property play a major role in determining that property’s return on investment. With deductions for virtually every aspect of repairing and maintaining the property as well as any activity or travel associated with it, current tax laws favor property investors. These tax breaks, which include depreciation, ongoing maintenance and capital improvements, can offset temporary periods of a negative cash flow.
One additional factor that contributes to the reduction of loan principal is inflation in the general economy – during periods of inflation, a given amount of money is worth less. Because this is true, not only are tenants paying down mortgage debt, the debt itself becomes devalued, costing less in actual dollar terms than when the mortgage was taken out. For this reason, although inflation sends up red flags in general economic terms, it can actually help raise the return on an investment by simply allowing the debt to cost less.
No two properties are equal, and the best way to build a viable income property is by diversifying into as many markets as possible. The ROI for each property is driven by its unique performance relative to each of the four pillars in Jason Hartman’s framework for establishing not just the return on investment, but also the return on inflation. (Top image: | Flickr/squirrelradio)
The American Monetary Association Team
