Investment real estate: the real net return

How it works

Each year. Rent grows by the rent increase, less vacancy and credit loss. Operating expenses (fixed dollar items growing with expense growth, plus management, repairs and reserves as a share of collected rent) are subtracted to get net operating income (NOI). Loan payments are on a fixed-rate, monthly amortizing loan; the principal part builds equity.

Taxes. Taxable rental income is NOI minus mortgage interest minus depreciation (27.5 years for residential, 39 years for commercial, on the building only, not the land). Losses are carried forward and released at sale, or used against other income if the client qualifies. At sale, depreciation taken is recaptured at up to 25% federal, the rest of the gain is taxed at capital gains rates, plus state tax and the 3.8% tax if it applies.

Real net return. The after-tax internal rate of return on the client's own equity: what went in, every year's after-tax cash flow, and the after-tax proceeds at the end. For a property the client already owns, the equity is what they would walk away with if they sold today, after costs and taxes: that is the money a sale would free up to invest elsewhere.

Keep or invest elsewhere. The property's real net return is compared with the after-tax return the same equity could earn somewhere else. The wealth comparison reinvests each year's cash flow at that alternative rate.

Not included. The 20% qualified business income deduction, cost segregation or bonus depreciation, 1031 exchanges, refinancing, loan fees, balloon payments, capital improvements beyond reserves, and changes in interest rates. Returns and values are assumed to grow evenly.