Have you ever been at a neighborhood gathering and your neighbor regales you with tales of his passive investment property making $2,000 per month?
Sure you have. We all have. But, really now, what does “making” really mean anyway? Have you asked your boastful neighbor that question? To an accountant, it seems simple. However, as I often say, four out of three people can’t do fractions and I’m here to correct that.
Let’s take the above $2000 profit per month example. Definitionally, this is calculated as follows:
Rent less (Interest, Insurance, Repairs, Taxes, Management fees and other expenses) equals PROFIT.
Notice that nowhere in the above do you see the phrase mortgage payment or principal payment. There is a good reason for that. Those are not expense items but rather balance sheet items. Principal is important but it is an element of cash flow, not of profitability and is a function of the debt level, note length, and interest rate. All are important but that is a financing transaction. Notice also that nowhere above do you see return. Not all $2,000 per month profits are created equal.
In determining whether to be impressed with a rental or passive income stream, there are several key factors to look at.
Is profit being calculated correctly?
What are the equity and debt levels?
What is the cost basis of the property or investment?
Now, let’s look at this further. Let’s say your friend calculated this correctly (they almost never do - typically the banknote is treated as an expense). What does this mean? $2000 in profit means nothing without context. If I have a $1mm building, no debt and I netted $2000 that qualifies as a pretty poor performance. If I have a $100,000 building with $80,000 in debt and I netted $2000, that qualifies as an outstanding performance.
The key here is the level of equity and debt. To determine whether $2000 is good, you need to know the level of equity (essentially the cash invested) in the project. This allows you to calculate the return on equity. After all, the returns are what you’re after, right? To calculate this, you divide the annualized profit ($2000 * 12) / Equity. The answer is stated in terms of a percent.
In the above example, $2000 in monthly profits on a property with $1mm of equity yields a return of 2.4%. In the other, $2000 in monthly profits on $20,000 in equity yields a return of 120%.
This isn’t golf. Highest score wins.
So, the next time the neighbor talks, ask how he calculates profit and what his equity level is and then decide if the neighbor is a wizard or just a guy wearing a funny hat.