Article #2: "Four Elements of Return" for the Real Estate Investor

Topic: Second "Element of Return" for RE Investors--Equity Growth from Loan Reduction

Last month we began our monthly Real Estate informational pieces by first discussing the "Elements of Return" for Real Estate Investors. In October, I stated the the FIRST Element of Return is Cash Flow. This month I will discuss the SECOND Element of Return which is Equity Growth from Loan Reduction.

When you first purchase your property your initial equity is the down payment. From that point forward as you make your monthly mortgage payments, a portion of your payment will be interest expense and the remainder will go toward reducing your loan balance..thereby building equity. In the early years the majority of your mortgage payment is interest, however over time the portions will shift and your payments will begin reducing your loan significantly.

Let's look at our example:

If you recall on our Boardwalk street property we put $30,000 down and financed the balance of the purchase. Our loan on the property was for $190,000, payable at $1,450 per month. Again, that payment includes principal reduction and interest at 9 percent per year. The total payments on the loan for the year are $17,400 (12 X $1,450 = $17,400). Roughly speaking, the interest paid to the bank would be 9 percent of $190,000, or $17,100 (.09 X $190,000 = $17,100). As you can see the difference between the loan payments $17,400 and the interest expense $17,100 is $300This $300 is the principal reduction in the first year. If we now divide that amount by our down payment of $30,000 we can calculate a return of 1% on our capital invested.

Don't let this modest 1 percent return the first year scare you. As mentioned previously, principal begins to pay off at a much faster clip in future years of ownership, and your percentage return dramatically increases.

Also, remember one more important thing...it's your RENTERS money that is paying your mortgage!!

To recap: So far our property is providing a 4% return from Cash Flow and now we see that we are making a 1% return on Equity Growth from Loan Reduction, for a total return of 5%. But, we are NOT done yet. Next month we will discuss the THIRD Element of Return--Equity Growth from Appreciation.

See you then!

BILL