Bob Brinker MoneyTalk Commentary 1/5/08-1/6/08

Bob spoke a lot about real estate this weekend. I think one interesting discussion point worth mentioning here is how to evaluate investing in rental properties vs. investing in mutual funds (or any other investment).

Bob said he likes to use cash on cash to calculate return. He didn't quite go into all the details and seemed to assume the property was payed off. Your total return is calculated by first estimating the starting value and final value of the equity in the property. Second, determine the yearly cash flow of the property, income - all expenses (mortgage, maintenance, insurance, taxes, etc.).

The return on equity for the year would simply be (final equity - starting equity)/(starting equity)=x
Note that the final equity would be a factor of appreciation and repayment of principle

The return on income would be (income - expenses)/(starting equity)=y

Total return = x + y

You can now compare the return to an investment in a mutual fund. This may seem pretty obvious, but the trap people often fall into when evaluating, is that they'll use their initial down payment on the property as a reference point. Since the purchase was highly leveraged, they'll look at the return on that down payment. In actuality, they should assume they would be swapping the cash value of the house (equity) for a mutual fund and comparing the return on that. Quite often one will find that the equity appreciation has outpaced the rental income and you can actually do much better cashing out and reinvesting in something else, especially if you factor in the management time involved with being a landlord.