Cash Flow Is One of Four: The Full Return Stack on a Rental

Ask most investors how a rental is doing and they quote monthly cash flow. On the example property in this post, cash flow is $960 in the first year, which is about 7% of the total return. The other 93% comes from three sources that never show up in the bank account: the loan balance falling, the property value rising, and the tax bill shrinking.

So how do rental properties make money? Four ways, and they differ in size, in reliability and in whether you can spend them. Judging a deal on cash flow alone undercounts it. Judging it on total return alone hides how much of that return is a forecast. This post follows one property through all four, adds them up, and then deals with the awkward case: a deal that loses a little money every month.

The four returns: cash flow, principal paydown, appreciation, tax benefits

Cash flow is rent collected minus operating expenses minus the mortgage payment. It is the only return that arrives as spendable cash during ownership. Divided by the cash you invested, it becomes cash-on-cash return.

Principal paydown is the part of each mortgage payment that reduces the loan balance. The tenant's rent funds the payment, the balance drops, and your equity rises by the same amount. You collect it when you sell or refinance.

Appreciation is the change in the property's market value. With a mortgage, the gain on the whole property accrues to your smaller cash investment, which is why it dominates the math. It is also a forecast until the day you sell.

Tax benefits come mostly from depreciation, a deduction for the wear of the building that costs you no cash. It can shelter the rental's income and, within limits, other income.

The four differ on two questions that matter more than their size: how sure is it, and when can you touch it?

Worked example: a $300,000 rental's first-year return stack

This is an example with stated assumptions. The interest rate is an example rate, and the appreciation rate is an assumption that your market may or may not deliver.

Purchase. Price $300,000. Down payment of 25%, or $75,000. Closing costs of $9,000. Total cash invested: $84,000. Loan: $225,000 for 30 years at an example rate of 7%. The monthly principal and interest payment is $1,497, or $17,964 per year.

Operations. Rent is $2,600 per month, or $31,200 per year.

Operating costs total $12,276, which leaves net operating income of $18,924. After $17,964 of mortgage payments, cash flow is $960 per year, or $80 per month.

Principal paydown. Of the $17,964 paid in year one, $15,678 is interest and $2,286 is principal. The loan balance ends the year at $222,714.

Appreciation. Assume 3% growth. That is an assumption for illustration and not a prediction. On $300,000 it adds $9,000 of value.

Tax benefit. Assume 80% of the price, or $240,000, is building and the rest is land. Residential buildings depreciate over 27.5 years, so a full year's deduction is $8,727. For an owner in an example 24% federal bracket who can use the full deduction, that is worth $2,094. The first calendar year is prorated based on the month the property goes into service, so the full-year figure is used here to keep the example clean.

The stack.

The total is $14,340 on $84,000 invested, a 17.1% first-year return. Cash-on-cash return alone is 1.1%. Same property, same year, and the two figures differ by a factor of 15. Which one is right depends on the question. If you are asking whether the property supports itself, 1.1% is the answer. If you are asking how fast your net worth is growing, 17.1% is the answer, with the warning that 63% of it rests on one assumption.

Principal paydown: the return investors forget to count

Paydown gets ignored because it is small at the start and invisible throughout. In year one of this loan it is $2,286, a 2.7% return on the $84,000 invested. That is more than double the cash flow.

It also grows every year without any action from you. An amortizing loan has a fixed payment, and as the balance falls, less of each payment goes to interest and more to principal. On the example loan:

After ten years the balance has dropped by $31,922 in total. All of it depends on the payment being made and none of it on the market, which is why it rates as the most certain of the four.

Two cautions. First, paydown is only a return paid by the tenant when cash flow is zero or better. If the property runs $888 negative for the year, then $888 of that year's paydown came from your paycheck. You moved money from your checking account into home equity, which is saving and not earning. Second, paydown is locked up. Getting it out means selling, with transaction costs, or refinancing, with a new loan at whatever rate exists then.

Appreciation: the biggest number and the least reliable

Appreciation is large because of financing. A 3% rise on a $300,000 property is $9,000, and measured against the $84,000 you put in, that is 10.7%. Borrowed money magnifies the asset's growth rate by about 3.6 times in this example, which is the ratio of $300,000 to $84,000.

The magnification works in both directions. A 3% fall in value is a $9,000 loss. The other three returns add up to $5,340, so a 3% decline leaves the year at a net loss of $3,660.

Three habits keep appreciation honest in your analysis:

• State the rate and test others. Run the deal at 0%, at your base case, and at a modest negative. At 0% the example returns $5,340, or 6.4% on cash invested.
• Separate forced from market appreciation. Value you create through renovation or raising below-market rents is within your control. Market appreciation is not.
• Remember it is gross. Selling costs come out of it, and the gain is taxed at sale. A rule of thumb is to allow 6% to 8% of the sale price for selling costs, which on this property is $18,000 to $24,000, or two years and more of the assumed growth.

Appreciation belongs in the return stack, clearly labeled as the forecast component. A deal that only works when the forecast is generous is a bet on the market with a tenant attached.

Tax benefits: depreciation in plain terms

The tax code lets you deduct the cost of the building, not the land, over 27.5 years for residential rentals. No cash leaves your account for this expense, yet it reduces taxable income.

In the example, taxable rental income before depreciation is net operating income of $18,924 minus $15,678 of mortgage interest, or $3,246. Principal payments are not deductible. Subtract $8,727 of depreciation and the property shows a tax loss of $5,481 while producing $960 of positive cash flow.

What that loss is worth depends on you:

• The first $3,246 of depreciation shelters the rental's own income. Nearly every owner gets that benefit.
• The remaining $5,481 is a passive loss. Owners who actively participate can generally deduct up to $25,000 of such losses against other income, and that allowance phases out as modified adjusted gross income rises from $100,000 to $150,000. Above that range, unused losses carry forward to future years or to the sale.
• At sale, depreciation is recaptured and taxed at a rate of up to 25%. So part of the benefit is a deferral. A deduction taken today at 24% and repaid years later still has value, because of the time between the two.

The $2,094 in the stack assumes the full deduction is usable this year at 24%. Your figure may be lower in the current year and higher later. To get the number for a specific property, including the first-year proration, use the free depreciation calculator. The other calculators for rental owners are collected under investor tax tools. Confirm your own position with a tax professional, since passive loss treatment turns on facts a blog post cannot see.

Total return math and what it means for negative cash flow deals

Here is the hard case. Take the same property and drop the rent to $2,400 per month, or $28,800 per year. Vacancy at 5% is $1,440, taxes $3,600, insurance $1,500, maintenance and reserves $2,880, management $2,304. Operating costs total $11,724, net operating income is $17,076, and after $17,964 of mortgage payments cash flow is -$888 per year, or -$74 per month.

The negative deal still shows a 14.9% total return on $84,000. Without appreciation it shows 4.2%. Both statements are true, and the second one is the one to underwrite.

A small negative cash flow can be acceptable when all of these hold:

1. The return excluding appreciation is still positive. Here paydown plus tax benefit is $4,380 against an $888 shortfall. The deal builds wealth even in a flat market, just slowly.
2. The shortfall is measured after real reserves. The -$888 already includes vacancy, maintenance and management. A deal that is negative before those lines is far worse than it looks.
3. You can fund it from income through a bad year. One vacant month and a $4,000 repair cost $6,400 against the $4,320 budgeted for vacancy and maintenance, which turns -$888 into -$2,968. If that would force a sale, the deal does not fit you, whatever the spreadsheet says.
4. There is a specific reason the gap closes. Rents documented below market, a fixed payment against rising rents, or a planned improvement. "Rents always go up" is not a reason.

It is cope when the case rests on an appreciation rate above what you would defend to a skeptic, when the shortfall is large relative to paydown so you are simply buying equity with your salary, or when the plan to fix it is a refinance at a lower rate that nobody can promise. At -$400 a month on this property, the shortfall of $4,800 exceeds paydown and tax benefit combined, and the entire return is the forecast.

Practical next steps:

1. For any deal, write the four returns on four separate lines. Never quote only the total.
2. Compute the total with appreciation at 0%. That is your floor.
3. Size the cash reserve to cover the negative case for a year with a vacancy in it.
4. Project past year one. Paydown accelerates, rents and values move, and depreciation stays flat, so the mix changes every year. The single-family calculator runs the first-year numbers free, and the Pro 30-year projection shows the four returns compounding together as a year-by-year wealth line, which is the view that tells you whether a thin month-one cash flow grows into something or stays thin.