The Four Ways You Can Make Money Through Investment Properties
Our favorite real estate investment strategy and the one that we are using as our primary vehicle on the road to financial freedom is buy-and-hold investing in single family homes. We feel that this is the simplest form of real estate investing and if purchased correctly, single family homes are historically proven to provide solid returns and have many advantages over traditional stock and bond investments.
There are four potential ways in which investing in single family homes provide the opportunity to make money. This makes real estate a multi-faceted investment. Even if one of these facets doesn’t perform as well as you hope, you have the others to fall back on.
The following are the four ways you can make money investing in real estate.
Cash Flow
Our favorite aspect of real estate investing is the monthly cash flow that it provides. Our ultimate goal is financial freedom. Financial freedom to us does not necessarily mean being a “millionaire”. It means that we have enough stable monthly income to cover our expenses (and hopefully some additional income to keep investing and growing our net worth). Cash flow from rental properties can be a fantastic source of income. With enough rental properties, maybe the cash flow can even be enough to cover all of your monthly expenses.
The basic concept of cash flow is that each month, your Income minus your Expenses equal your Net Operating Income or Cash Flow. With the right kind of single family home, your rental income can be high enough to cover all expenses and still have a little bit left over.
For an example of a typical month of a cash flowing property in our portfolio (Link coming soon).
Depreciation
This is one of the biggest advantages of owning rental properties over stock or mutual fund investments. When you own an investment property, you are allowed to deduct the depreciation from your income as an expense. Here’s how depreciation works.
Your investment property will have a land value and a value for any structures that are on that land. Land values cannot be depreciated, but since the structure on the land does not last forever, and will eventually need to be replaced, you are allowed to depreciate the value of the structure over 27.5 years.
For example, if the rental property you purchased was $100,000 and $20,000 is the value of the land, that means that the structure is worth $80,000. Divide $80,000 by 27.5 years and you get $2909. For the first 27.5 years that you own the property, you can deduct $2,909 as a loss to offset your rental income, making much of the income you earn from your property tax free!
The full explanation of depreciation is worthy of an entire post, but for now suffice it to say that depreciation is a very powerful tax saving tool. Money saved is money made, so by not paying taxes on this income, you are essentially making money.
Of course, good old Uncle Sam does not give anything away for free. When you sell an investment property you have to pay depreciation recapture. The concept is that you have been deducting the yearly depreciation as a loss each year, so that means that your adjusted cost basis on the house has been going down each year. When you sell the property, you subtract the adjusted cost basis from the price that you sell the house for and must pay ordinary income taxes on the difference. Using our previous example, if you bought the house for $100,000 and took $2,909 in depreciation each year for 10 years, the new adjusted cost basis is $100,000 - $29,090, or $70,910. If you then sell the property for $120,000, you would pay ordinary income taxes on the difference between $120,000 and $70,910.
There are some specific strategies (yes, they are legal) to sell an investment property and avoid paying income tax on gains. One of those strategies is called the 1031 exchange. The details of the 1031 exchange will have to be saved for another post.
One important thing to note is that there are limits on how much depreciation you can deduct from your income ($25,000 per year). The deduction also phases out for high income earners.
Debt Pay-Down
Another great advantage of investing in single family homes, in particular of you buy them with a loan is leverage. With a relatively small amount of money (typically around 20% with a good credit score), you can own 100% of an asset. Think of the bank as your partner in purchasing the real estate, but you don’t need to share any of your profits with them!
Once you own the property, you will rent it out to a tenant that will pay your mortgage (plus all of your other expenses) off for you.
Let’s say that you make no money each month, but you do manage to break even, meaning that your income and expenses are exactly the same. If you just break even for 30 years, you will have a completely paid off house. At this point, you can continue to rent it, and your monthly cash flow will increase, or you can sell it and purchase another property (or several) with the cash.
Let’s say you purchase a $100,000 property but only had to put $20,000 down on the property. After 30 years, assuming no appreciation, the house is paid off and worth $100,000. Your initial investment of $20,000 grew to $100,000 in 30 years, or an average rate of return of around 5.5% per year. And if your property has appreciated, this number is even higher! This rate of return is a great supplement to the cash flow and depreciation that you are already getting each year.
One thing to note is that in the first few years of the loan, most of the mortgage payments are going towards paying off interest. As the mortgage principal gradually decreases, the interest paid each month also decreases and more of the payment is applied to the principle. The 5.5% calculated above is the average return over 30 years. The return in the first few years will be less, due to less of the monthly payment going towards the principal.
Appreciation
In some cities, appreciation can provide a substantial return on investment in a short time. We also feel that it is the least predictable way to make money on real estate of the four discussed here which is why we don’t count on it or factor it in to any of our investment analysis. We look at appreciation as the cherry on top and it is a great bonus if it happens.
Depending on the state/city and the source of the information, historical real estate appreciation values range anywhere from a couple percent per year to 6 or 7 percent per year on average. In cyclical markets such as Miami, Los Angeles, San Francisco or New York, appreciation can bring huge gains in a very short period of time. The flip side is that real estate in these areas also lose a lot during a down-turn.
More stable markets, such as many areas of the Midwest see modest appreciation, but don’t see the wild downturns that cyclical markets see.
While the housing appreciation market is un-predictable during the short term, historical long term gains can be a great additional supplement to increase the value of an investment portfolio.
Disclaimer: This article is intended to be a general resource only and is not intended to be nor does it constitute legal or professional advice. Any recommendations are based on personal, not professional, opinion only.