Intro to "Calculate the Net Profitability of your Rental Income Property"
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Buy to rent; evaluating your real estate investment
Buying a real estate property with the goal of renting it is an investment that insures a constant cash flow income. However, even if it is a popular investment, when looking at the numbers, it is an opportunity comparable to any other investment like the stock market, government titles or other business projects.
This simulator will help you calculate the potential financial outcome, net of taxes, of your investment property, which could then be compared to other investment opportunities. However, this calculator cannot measure more qualitative aspects like the relevant expertise required to run the business, which can favor this form if investment over others.
Income and expenses of a rental property
Managing financially a rental property is comparable to all other businesses; you have a start-up cost which will later on generate income and expenses, and then create a profit (or a loss). You will also add a capital gain or loss when you resell the real estate property, hoping that, like any other stock market purchase or businesses; you bought it at a good price in order to resell it at a higher price.
Such a real estate project requires initial investments: the cash negotiated to buy the business (based on the evaluation of the future cash flow), the cash down on the mortgage balance, the acquisition costs and, if it's the case, the disbursements needed for renovations. For the investor, this initial cost is considered the purchase price of the project that will generate income from rent and other services, but also current and capital expenses.
Current expenses are the costs related to normal operations such as cost of utilities, insurances, property taxes, repairs and maintenance. All these expenses are tax deductable. It is important to differentiate the two types of work on a real asset. The costs of repairs are current expenses made to maintain the building in good condition in the short term (painting the walls for example). The capital expenses, on the other hand, are disbursements made for additions or improvements to the property (installing new windows for example).
The capital expenses aim to increase the value of the property. They are considered an investment with the objective of creating higher revenue in longer term, while the current expenses are made to maintain the revenue. The capital expenses are not tax deductable, but instead amortised, which will reduce the tax load when included in the depreciation expenses.
If the rental property is resold, there will be a capital gain or loss, depending on the level of appreciation or depreciation of the real estate asset. Some expenses are directly related to the sale, such as the realtor fees and the closing mortgage cost; these are all tax deductable on capital gain. Finally, two different taxes are applied when resold; one on the depreciation recapture and the other one on the capital gain.
All these revenue and expenses enumerated are quantifiable and can be included in an analysis. It is important to measure the performance of a rental property investment and convert it in a universal language, such as the rate of return on investment or net present value, so it can be compared with the performance of other potential investment.
Taxes and depreciation
There are strong similarities between countries when it comes to tax application, only the tax rate and type of depreciation on rental real estate differs. This calculator takes into account your country's regulation, by giving you the choice to insert a tax rate bracket and the type of depreciation (see reference on type of depreciation for countries). Our financial simulator executes the calculation automatically, but to better understand the taxes' law and depreciation mechanism, here is an explanation:
In a financial report, we include an annual depreciation expense, tax deductable, related to the purchase, addition and improvement of the real estate property. It is not a real cash disbursement, but it is added as an expense to reduce the tax load. In other words, it offers a tax break to encourage capital investments. The annual depreciation amount is calculated by spreading the purchase cost of the property and other capital expenses over many years.
There are two main types of depreciation used for buildings: straight line and declining balance, but only one per country is adopted. The calculator provides the option to select one of the two, but note that only the building and its related costs are taken into account for the depreciation calculation. The land and its related costs are never considered as a depreciable asset.
In the case of declining balance, the annual depreciation expense is calculated by applying a rate on the purchase cost. The following year, the same rate is applied on the new depreciated balance. Let's take Canada's rate of 4% as an example:
|Purchase cost: 100,000$||Depreciation rate: 4%|
|Calculation of the annual depreciation charge:|
|1st year:||100,000 X 4% = 4,000$|
|2nd year:||(100,000 – 4,000) X 4% = 3,840$|
|3rd year||(96,000 – 3,840) X 4% = 3,686$|
Note that for the declining balance, it is not possible to create or increase a loss with the annual depreciation. The accepted amount is the minimum between the official rate and the rate that would bring the profit before tax to zero. As for the straight-line type, the amount of depreciation stays unchanged every year, even though it could create or increase a loss.
The straight-line depreciation is calculated by dividing the purchase cost with the amount of years it can be depreciated. The annual depreciation is equal every year, and stops being declared when it surpasses the limited period it can be depreciated. Let's take the United States at 27.5 years and France at 20 years as an example.
|Purchase cost: 100 000$||USA||France|
|Annual depreciation:||100 000 / 27.5||100 000 / 20|
|1st year:||3 636||5 000|
|2nd year:||3 636||5 000|
|(...):||3 636||5 000|
|20th year:||3 636||5 000|
|21st year:||3 636||-|
|28th year:||1 818||-|
|Total depreciation:||100 000$||100 000$|
However, this tax break will come back to you when reselling the building. Governments will demand to be paid back on where you saved with the depreciation. It is called depreciation recapture and the tax rate is similar to the one applied earlier on the gross profit.
There is a different rate applicable on the capital gain and most governments only ask for half of the normal rate. This calculator gives you the possibility to specify the rate on capital gain.
Things go differently if the building loses value over time. There will be no tax on the capital loss. Moreover, the depreciation recapture is not the same. The rate is applied on the difference between the selling price (as opposed to purchase price), which is smaller, and the new depreciated balance, which helps reduce the tax load.
In this analysis, we take into consideration that the purchase of the property is done on the day 0 of the fiscal year, which allows us to declare a complete first year in depreciation. Finally, the tax rate is applied on losses during deficit years, which helps decrease the tax load for the next year.
Return on investment
We can calculate the return on investment by comparing the cumulated profit with the initial investment. This will basically indicate all the profit generated by the original investment. It is very useful in the eye of the investor, because it shows the performance of its initial investment and evaluates its opportunity cost.
For example, if an initial investment of 100,000$ generates a cumulated profit of 121,000$ after two years, the return on investment is 10%, which we can see in that example:
|Initial investment:||100 000$|
|Profit on the 1st year:||-11 000||24 000||75 000|
|Profit on the 2nd year:||130 000||97 000||46 000|
|Cumulated profit:||121 000||121 000||121 000|
|Return on investment:||10%||10%||10%|
|Calculation:||100,000 X (1+10%)2 = 121,000$|
However, as we can see in the chart, this calculation doesn't take into consideration the cash flow in time. The return on investment is 10%, no matter what profits are recorded on the first and second year, as long as their addition totals 121,000$. To integrate the notion of money in time, we have to work with the net present value.
Net present value (NPV) and internal rate of return (IRR)
When dealing with a rental property, we have different cash flow every year. It is appropriate in that case to discount each annual profit respectively to its cashing year. To get a present value of all future cash flow, we discount the annual profit based on their cashing year using one specific required rate of return.
By subtracting the initial investment from the total discounted cash flow, you obtain the net present value. If the result is positive, you record a higher rate of return than you expected. If it's negative, the rate of return is lower than the one you required. See under an example with an initial investment of 100,000$:
|Required rate of return:||10%||7,32%||5%|
|Year||Cash flow||NPV negative||NPV nil||NPV positive||Calculation|
|0||(100 000)||(100 000)||(100 000)||(100 000)|
|1||1 000||909||932||952||Cash flow/ (1+rate)1|
|2||15 000||12 397||13 024||13 605||Cash flow / (1+rate)2|
|3||30 000||22 539||24 273||25 915||Cash flow / (1+rate)3|
|4||40 000||27 321||30 157||32 908||Cash flow / (1+rate)4|
|5||45 000||27 941||31 614||35 259||Cash flow / (1+rate)5|
|NPV||31 000||(8 893)||0||8 640|
When you invest an amount and hope to cash a higher amount in several years, you integrate the notion of rate of return. When you discount and summarize all the amounts you plan to cash within the years to come, based on one single interest rate, you obtain the amount you need to invest today in order to later receive all these amounts. In other words, you measure how long it will take to reimburse your initial investment based on a required rate of return.
When your net present value is zero, you found the project's internal rate of return (IRR). In our example, the IRR is 7.32%. This means that you will be able to totally reimburse your initial investment at a rate of return of 7.32% over 5 years. The NPV and IRR will give us a measuring tool to compare with other investment or business projects that have a variable annual cash flow.
Using the calculator
Even though investing in rental properties is popular, a low rate can mean that it would have been better to invest on the stock market, government titles or other business projects, and sometimes for a lot less effort.
This calculator will help you make a good financial projection of your next rental property purchase and measure the potential of its net profitability for a specific period of years. You could also evaluate when you will totally reimburse your initial investment. It is free, very accurate and easy to use. However, it won't take into consideration the more qualitative aspect that involves managing rental real estate property, like being able to do reparations & renovations by yourself instead of hiring contractors. This calculator is the first step to evaluate before going along with buying a rental property.
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