The return potential for real estate is at least 30% return on investment. The fact that real estate is so profitable is the reason why 90% of the world’s millionaires invest in real estate!
I’ll show in this article that my average 30 year return for a long term rental is about 27%.
If you’d like to compare real estate to other types of investments, check out these other articles I’ve written:
- Return potential for bonds
- Return potential for mutual funds and index funds
- Return potential for precious metals
- Return potential for collectibles
- Return potential for business investments
The Four Types Of Return
Real estate offers four different ways to give a return on your initial investment:
- Appreciation of the property value
- Cash flow
- Equity added from the mortgage payment
- Tax breaks
And we can calculate the total return potential for real estate by adding together the returns for each of these four.
Appreciation Of The Property Value (15% ROI)
The return you get on your property’s appreciation is dependent on your home’s average appreciation and your down payment.
The smaller your down payment, the bigger your return on investment from home appreciation.
Take this example. There’s a $100,000 home that appreciates in value 3% every year.
So year 1 the value of the home will go up by $3,000. It doesn’t matter what my down payment was, the home will still appreciate $3,000.
If I put $50,000 down, then that would be a 6% return ($3,000 / $50,000), but if I put $20,000 down it’s a 15% return ($3,000 / $20,000).
This is why investors always want to put less money down on a property. It increases their returns!
Generally, you’ll be putting 20-25% down on an investment property, and the national average appreciation for a home is 3-4%.
This would put your returns from home appreciation at 12-20%. I’ll call it a 15% average return on investment from home appreciation.
Cash Flow (7% ROI)
Cash flow return is both the most important and hardest to predict of all the types of real estate return. It is dependent on many factors.
- Purchase price of the property
- Size of down payment (usually 20-25%)
- Rent or revenue collected
- Expenses related to repair and upkeep
- Property taxes
- HOA fees
- Property insurance
This list is far from comprehensive, so cash flow can be very difficult to predict, even with real world numbers.
My own experience with long term rentals has suggested that a first year pretax return from cash flow averages about 15-20%.
This means if I put $20,000 to purchase a property and get it up and running, I could expect to make $3,000-4,000 in cash from rent minus all expenses.
That 15-20% is only for the first year though. We’re interested in our return over long periods of time.
The following years will see expenses increase and rents increase. I generally see a 2-3% increase in cash flow each year.
This causes the long term return from cash flow to be much, much lower than the first year return.
Using my numbers, a rough estimate for a 30 year return on investment from cash flow is about 7%.
Equity Added From The Mortgage Payment (5% ROI)
Your mortgage is an expense when you’re measuring cash flow returns, but a portion of your mortgage increases the amount of equity you have in your property.
Your return in this category is dependent only on the size of your down payment. It turns out that the interest rate and length of the loan term don’t matter here, although they definitely matter for cash flow.
A pretty standard loan for an investment property is a 30 year mortgage with 20% down.
So that means over 30 years you will have gained the other 80% equity in your home.
This down payment would give you a 4.7% return on investment over those 30 years from equity gained.
Tax Breaks (Income Taxed At 0%)
Income is taxed anywhere from 10-40%. The income from a rental property is the cash flow.
If we assume the 40% rate of tax then that 7% return on cash flow turns into a 4% return, but real estate investment offers some unique tax benefits in the form of hefty tax deductions.
Rental property depreciation is the biggest of those, and currently allows a tax break of 3.6% of the value of the property.
Since yearly cash flow is usually between 3-4% of the total value of the property, there’s a very good chance that all your income from cash flow is tax deductible.
And since the value of the property continues to grow, so does your tax deduction from depreciation.
While taxes on your regular income results in a negative return, sometimes as high as -40 percent, taxes on rental income is usually 0 percent!
Taxes on sale of property
When you sell a property you can also be taxed on the gains realized from that sale. Or you can use more tax benefits offered to real estate investors to defer the taxes paid!
If you were to sell a property and put the money into your bank account, you would be subject to a capital gains tax on all the value you gained on the home since purchasing it. So if you bought it at $100,000 and sold it at $160,000, you would be taxed on the $60,000 you gained in value.
This of course eats into your return potential.
There is a way to avoid paying those taxes though. If you use the money gained to purchase another investment property following the rules of the 1031 exchange, then you can avoid all capital gains taxes that would have been paid on the sale of the property.
No taxes on anything?
It’s possible to pay income taxes on the cash flow you earn, but based on the tax breaks allowed, there’s a very good chance you won’t. And the taxes paid on gains from increased property value can be eliminated using the 1031 exchange.
That allows your wealth to grow basically tax free. Very few investments have that kind of tax outlook.
Real estate can be like a 401k or IRA in that it allows your wealth to grow tax free, but it also creates cash flow for you right now.
Long term rental real estate is without a doubt one of the best investments out there. Between property appreciation (12-20% ROI), cash flow (6-8% ROI), equity added from mortgage payments (5% ROI) and the tax breaks (income from cash flow and gains mostly untaxed), the return potential for real estate is 25-30% over 30 years.
And there’s potential for even better returns. Our short term rentals have cash flow that maps out to 11-12% return over 30 years. This would take your return potential closer to 35%!