I keep saying how much I really like real estate, and here’s a hidden example of why that’s the case.
It’s based around one simple little fact – the tenant pays your mortgage.
Back in an earlier post I talked about Cap Rates and Cash on Cash Return (I know it sounds boring, but turns out it’s pretty exciting!). To keep things consistent, I’m going to use Example C from that post. It went something like this:
You find a house with a value of $100k, and are able to buy it for $80k. Using your HELOC, you buy the house cash. Wanting to keep a little of your own equity in the house (never a bad idea), you put a $70k mortgage on it. So you “put down” $10k of your own money, and get a $70k mortgage.
The pre-mortgage expenses are $350 a month, and the rent is $1k. A 15 year mortgage costs $536 a month, leaving you a Net Operating Income of $114.
Based on putting that $10k into it, your Cash on Cash Return is:
($114 * 12) / $10,000 = 13.68%
Here’s where it gets good. In 15 years that mortgage will be paid off.
Your Net Operating Income goes from a mere $114 to a whopping $650!
You yourself still only put in $10k, right? So your Cash on Cash Return after your mortgage is paid off suddenly turns into:
($650 * 12) / $10,000 = 78%!!!!
It’s all because the tenant has been paying your mortgage off for you!
But let’s think of it a different way for a second.
A mortgage payment is made up of 2 parts – Interest and Principal.
Interest is the cost of borrowing money. It’s the “rent”, if you will, of borrowing money from the bank.
Principal? Principal is basically forced savings. Along with your “rent”, they’re making you pay off the loan. In other words, forcing you to add equity to your house.
Again, the nice part is that your tenant is paying all of that – interest and principal.
Here’s the deal. You’ll never see the interest money again. Bye! Principal though, you will see again in terms of equity in your house. Principal is essentially an extra payment to yourself.
But yet, we usually don’t consider the principal part of our mortgage payment as part of our income. Partly because it changes every month (every month you pay a touch less interest and a touch more principal), but still… what would happen if you actually added the principal into your Net Income? What would that look like?
Using the example above, the mortgage payment is $536. At the beginning, your interest payment is $263 and the principal is $273. At the end, your interest payment is.. well… basically zero, and your last payment is basically $536. So rather than calculate the exact return for every month, humor me, and let’s take an average. I’m averaging all the interest payments and all the principal payments.
That comes out to:
Average interest payment: $147
Average principal payment: $389
Yay, they still add up to $536. Got worried for a second…
So what I’m saying is your “expense” for having that mortgage is only $147. The rest of your payment is forced savings which builds your equity up!
So rolling back to the beginning, your monthly costs started as $350. Now instead of adding the whole $536 mortgage payment, only add the “cost” of the mortgage, or $147 of interest.
So your monthly expenses now are only $497, giving you a $503 “net income”!
Put that into our Cash on Cash return, and you get:
($503 * 12) / $10,000 = 60.4%!!
To quote myself from above – “WHOA!!!”
So when you look at rentals, the returns on them are truly huge. You may not even recognize it up front, but those numbers don’t lie. When the tenant is really paying your mortgage for you, the savings and returns are enormous.
Real estate truly is a golden egg.