I stated in my first blog post that one of the three reasons I chose to start investing in real estate was to beat the yearly returns of the S&P 500. Over the course of the last 100 years, the S&P 500 has returned an average of around 10% per year. My primary goal with real estate investing is to beat this return.

So what does that mean? Let’s try an example.

Say you have $100,000 invested in the stock market and the stock market returns 10%. At the end of year 1, you will have $110,000. If the market continues to average 10% returns, by the end of year 10, you will have $259,000. This is a simple compound interest calculation. See the table below.

What is the point of this calculation? Here is how I think about it. There is a high likelihood that the stock market will have positive returns over the next ten years. Whether the average return is 10% or 7% or 5% or 3%, you are earning money just by having your money invested in the market. The beauty of investing in the stock market is that this is truly passive income. The stock market has never called you at 7AM and told you you need to replace the toilet. There is absolutely nothing wrong with keeping all of your money invested in the stock market and just sitting back and watching it grow. It’s the easiest, least time-consuming path to wealth, and I applaud all of those who choose this route.

Choosing to invest in a rental property is choosing not to invest in the stock market. For this reason, an investment property needs to, at a minimum, provide similar returns to the S&P 500. And while we don’t know exactly what the S&P 500 will return in the coming years, I think 10% is a good target. It is aggressive which causes us to be aggressive in selecting the property we want to buy.

In fact, even a 10% return on a real estate investment property is too low for me to consider investing in it. If I can return 10% just by letting my money sit in a brokerage, I need to earn substantially more than that to become a landlord and take care of a physical asset. Only you can decide what premium is acceptable for real estate investing to be worth it. For me, I targeted a minimum of 14% annual returns on a property. And just for fun, let’s look at the difference between 10% and 14% returns over time:

Quite a difference! This is the wonderful thing about compound interest. Over long periods of time, that extra rate of return really starts to stack up.

Once you have an idea of what you would like your financial rate of return to be, you can start running calculations. There are essentially two ways to achieve a positive rate of return in real estate investing: cash flow and appreciation.

Cash flow is the amount of money you earn in rental income minus all of your expenses. For example, if you earn $30k a year in rental income, but you have $25k a year in expenses, you have cash flowed $5k.

Appreciation is the delta between the purchase price of the property and how much you can sell it for today. For example, if you purchase a home for $250k and can sell it today for $300k, you have experienced $50k in appreciation. The downside to appreciation is that it is a paper gain; that is, you only realize that gain when you sell the house.

Property appreciation and cash flow are often at odds with each other. Properties that appreciate often do not have positive cash flow. Properties that have positive cash flow often do not appreciate in value. It is interesting to think about the reasons why, but I will save that for another blog post.

It is up to you whether you prefer earning money via cash flow or appreciation. When researching properties, I was more interested in cash flow. Having tenants pay off my mortgage and expenses and achieving positive cash flow is a tantalizing prospect. I also find it to be more conservative; I’m not hoping and praying that the value of my property increases. By finding a property that is cash flow positive on day 1, I am instantly achieving positive financial returns.

Running the Calculation

So let’s get back to a rental property’s annual returns. The easiest way to compare a property’s return is to use an online calculator. There are many you can use (and you should in fact create your own calculator in Excel), but this is my favorite:

https://www.propertycalculator.co

Let’s review the following fictional property:

The property is a duplex selling for $500,000. Say that we want to put 20% down, with closing costs of $15,000, renovation costs of $10,000 and a mortgage rate of 6.5% over 30 years. This equates to a monthly payment of $2,528.

Now, let’s review operating expenses. Operating expenses includes things such as property taxes, homeowner’s insurance, repairs, vacancies, HOA fees, utilities, and maintenance. For our fictional property, I have the property taxes at $7,500, insurance, at $2,500, a vacancy rate of 8.3% (one month of vacancy a year), capital expenditures (repairs) at $5,000, utilities at $100/month, and maintenance (such as landscaping or snow removal) at $2000. This brings our total monthly expenses, including the mortgage, to $4,465.

For cash flow, let’s assume this duplex rents for $2,500 per unit, for a total of $5,000 per month in rent.

Lastly, let’s set rent growth at 2%, appreciation at 2%, and other costs at 2%

That’s it!, Now click on the “Cash Flow” tab. In year 1, the property cash flows $6,461. Pretty good!

Now click the “Value Over Time Tab. In year 1, the property has a return on investment of 17%, or $21,132. By year 10, the property has a return on investment of 218%, or $272,140. That 218% over 10 years averages out to around an 11.5% annual return. (This 11.5% return is based on the initial investment into the property which is $125,000, a $100,000 down payment, $15,000 in closing costs, and $10,000 in renovation costs).

So what do we take away from our fictional property? Based on our forecasts, this property has an annual return of 11.5% per year over the next ten years. It is also cash flow positive from day 1, meaning that rental income is covering all of the mortgage payments and operating expenses. This is a solid property. It beats the 10% annual returns that we forecasted for the S&P 500 by 1.5% per year without ever having to invest additional funds. While it does not meet my target goal of 14% annual returns, I would certainly take a hard look at this property. There are things we could do to boost these returns, especially if we have been conservative with our inputs and assumptions. But depending on your rate of return goals, this fictional property could be a winner.

This is an example of how I reviewed properties. For every property that I was interested in, I would run this calculation and look at both the year 1 and year 10 annual returns and cash flow. This calculator is a great tool to help narrow down a huge list of properties. Ultimately, however, this calculator is just a tool. And this tool is only as good as our assumptions. I will go through these assumptions and how I chose them in the next blog post. But for now, I recommend playing around and becoming comfortable with this calculator. This is the first start in locating a property that meets your financial goals.