In today’s post, we’ll discuss total return investing. This post is a follow up to a previous post, where we talked about the investment return of your rental property. Simply, you want to know how much money your investment is generating. This knowledge can help you determine if the investment makes sense for you. That is, should you give it the boot, or hold it forever?
To figure out the return of any investment, you need to make sure that you’re looking at both ways an investment generates money. That is called the total return. Your investment can generate a return via:
• Cash flow: This is the money an investment throws off – the cash that you collect. This cash can come from:
o interest payments, from a savings account
o dividends, from a share of stock
o income, from a piece of rental property
• Capital appreciation: This is how much an investment grows in value. Examples of investments that rise in value include:
o a famed oil-on-canvass
o the share of a stock
o an ounce of gold
While there are other components that affect your investment return (such as the tax treatment of investments, and the tax write-offs available for depreciation on certain types of investments), this article will focus on the two components of investment return just described: capital appreciation and cash flow.
Some investments (like a savings account) only generate an investment return from cash flow. Other investments (like an ounce of gold, or a Star Wars action figure) only offer price appreciation. Certain investments (like stocks and real estate) can offer both cash flow and capital appreciation. When it comes to the last category of investments (those that offer both cash flow and capital appreciation), consider both parts in calculating the investment return. This is called total return. For an example of total return, consider the following investment in rental property.
Caesar invades Britannia, with the seventh and tenth legions in tow. The large landing party requires a place to spend the night, driving up property values on the barbarian isle. Caesar – not just a brilliant military tactician but also a savvy business man – snaps up all the rental property he can find.
Eventually, the legions tire of living without running water and the without the weekly chariots races offered in Rome. The legions head home, to return to the higher quality of life they are accustomed to enjoying in central Italy. As a consequence of the mass exodus, the value of Caesar’s recently-acquired rental properties plummet.
This begs the question: For his Britannian real estate investment, is Caesar in the red? Maybe. We cannot answer the question until we know how much in rent Caesar was able to score from the legionnaires relative to just how much the property value declined. In fact, given how much money Caesar was able to collect in rent, he could actually be looking at a nice total return; i.e. if a lot in rent money was collected.
The story above shows us that there are two ways that an investment can generate a return. Investors should not lose sight of the big picture: fixating solely on the price offered for an investment, while ignoring the income generated by the investment – or vice versa. Consider both components – cash flow and capital appreciation – to determine your total return.