David Larock in Mortgages and Finance
In today’s interest-rate environment, using a rental property’s Free Cash Flow to determine its value will significantly understate its potential return as an investment. For those who don’t know, Free Cash Flow is basically the money you are left with once mortgage payments, property taxes and
One of the golden rules of successful real-estate investing is that the rent cheques must go straight to the bank to pay off the mortgage. Every time this happens, the mortgage shrinks and equity increases. The hidden value in today’s low interest-rate environment is found in the percentage of each mortgage payment that goes to principal. To illustrate, let’s compare two scenarios. In scenario #1 we’ll use an i
So in today’s interest-rate environment, not only are the payments lower, but even more importantly, the proportion of each payment that goes toward principal is more than three times greater. In scenario #2 you’re not just paying less interest, you’re paying off your mortgage twice as fast. This hidden benefit is well understood by seasoned investors but is often overlooked by less experienced buyers who focus solely on Free Cash Flow when evaluating investment opportunities. Here is a summary of what the two scenarios would look like over a five-year period, using the details from a rental property currently listed for sale by one of my realtor partners at $669,000. (I have assumed a 2% annual increase in rents and expenses because this is the lower end of the central bank’s inflationary target band.)
Note that in the examples above, we are assuming no appreciation in property value. The returns shown are based solely on the Free Cash Flow generated, combined with the amount of equity built up as the mortgage principal is reduced. If we assume annual house-price appreciation of 3%, the cumulative five-year return on investment at a 3.7% interest rate jumps from 47.6% to 119%.
There are other hidden advantages when owning a rental property. Most people know that you can write off the cost of your mortgage interest ag
If you’ve been evaluating rental property investments using the Free Cash Flow method, take a second look including mortgage principal payments in the calculation of your returns. You’ll be surprised at the difference it makes.
David Larock is an independent mortgage planner and industry
insider specializing in helping clients purchase, refinance or renew
their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog (integratedmortgageplanners.com/blog). Email Dave
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