Four Ways to Make Money in Real Estate
As I mentioned in my last post on how to make money following the real estate bubble, there are 4 primary ways of making money in real estate. Knowing and considering each one before purchasing a piece of property is an important part of the analysis of any real estate investing opportunity.
1. Cash Flow
The first way to make money in real estate is through positive cash flow. This requires either getting an incredible deal on the purchase price so that the rental proceeds exceed the cost of debt service, maintenance, and expected vacancies or that the amount of leverage used to purchase the property is low enough so the debt service is easily manageable.
I like to look at a property’s potential by looking at the capitalization rate if I had all cash to purchase a property. Here in central Indiana, it is fairly easy to find a single family home that can be rented out for $900-$1000 per month for $90,000-$100,000. This is actually the market that I have targeted. If I figure about 5% for vacancy and 5% for annual maintenance, that means I would be able to expect an annual net income of $12,000 minus $1200 or $11,800 on a $100,000 giving a cap rate of 11.8%. Think of that as the yield on a stock or bond. Not bad when compared to a savings account.
If you can find a property that has a decent cap rate, you are almost guaranteed to make money provided you don’t overleverage.
2. Appreciation
The second way to make a profit in real estate is through appreciation. Many investors in the real estate bubble counted on this as their main source of profits. It works pretty well until the music stops and there are no chairs left. Of course, the one ending up holding the bag is out of luck. That is why it is so important to analyze cash flow on a property and not overpay.
There are two types of appreciation. The first is that which is mentioned above which is the natural appreciation of a piece of real estate that occurs because demand is high and supply is low or the appreciation that comes as a result of natural inflation over time.
The other type of appreciation is forced appreciation. This is where an investor purchases real estate and deliberately increases the value of the property to either sell at a profit or to improve the cash flow. Think about buying a foreclosure that is in need of lots of repair and making those repairs for the purpose of flipping. That is forced appreciation. Another example might be buying a piece of raw land and building a storage facility or apartment building on it that will be rented out.
3. Leverage Pay Off
Not everyone can invest in real estate without using some borrowed money. The mortgage principal that is paid down each month is another way to profit from real estate especially if the mortgage payments are being paid by a third party. This is one of my main goals for investing in real estate. I don’t make a ton of cash flow each and every month and what I do make usually ends up being spent on vacancies or repairs. However, my goal is to come close to breaking even on a cash basis so that in 30 years, I will own a piece of property free and clear which will provide an on-going source of monthly income during retirement.
4. Depreciation and Tax Benefits
Depreciation as it relates to accounting and taxes is a method of decreasing the value of an asset over its usable life. The amount of depreciation can be used to offset income when figuring taxes. The purpose is to be able to set aside tax free money that can be used to ultimately replace that particular asset. However, when the asset is sold, that depreciation must be recaptured and tax eventually paid.
In real estate, it is possible to roll the proceeds from a sale of property into another property and defer taxes much like investing in a tax deferred retirement account. There are also tax benefits that individuals can use when selling a primary residence at a profit. It is important to consult an accountant or real estate tax attorney for all the details regarding the tax benefits of property ownership but these benefits can add up to substantial sums of money. Once these have been determined, be sure to get the best tax software available to ensure the accuracy of your returns.
In summary, there are several different ways that an investor can profit from owning real estate. Cash flow, appreciation, debt reduction, and tax benefits can all be used as potential sources of profit. It pays to know about each method and to maximize them all if possible.
I’ve heard of these methods before, but thanks for spelling it out so clearly. Are you currently in the market? Did real estate hit bottom yet?
You are welcome. I am in the market with some rental homes and a partial interest in a commercial property. I think there are some areas where real estate doesn’t have too far to fall but others that could lose quite a bit more. There is a lot of supply sitting with the banks and awaiting foreclosure. It will take a few years to work through the supply.
Sounds like you are well diversified in different asset classes (real estate, stocks & options)! Nice job!
I have deliberately tried to diversify knowing that it is impossible to accurately predict the future. My biggest problem right now is debt. I want to pay off some before adding to any of my investments. The nice thing is that I am content with the lifestyle and don’t need any more things although I may have to replace items now and then. Six kids mean that appliances wear out much more quickly.
That was the best explanation of cap rate I have seen. I’m going to reference your explanation when I teach this concept to my MBA students. You did miss one point, tenants and rentals have the potential for late night phone calls, non payment of rent, and other various stressors!
There are some stressors that occur from time to time but no different than watching your 401(k) drop on a daily basis. I have never been called in the middle of the night since I warn each tenant that I can’t do anything for emergencies anyway. Simply call the plumber or furnace repair yourself and send me the bill. It has worked for the last ten years. I evict when necessary. Just a part of doing business and is a relatively mild problem considering all the problems that could occur.
Being a huge cash flow investor, real estates and REITs are near and dear to my heart.!
Thanks for stopping by and commenting, Robert. I enjoy your blog very much. It is hard to get into financial trouble if you have enough cash flow. I want to get more myself.
I’m the more passive kind! I invest through REITs!
REITs are a great way to invest in real estate. Knowing how they plan on making their money is important to evaluating the strength of the management.
Seeing as how I am getting rid of my tenant from hell and I am a little over 2 years from break even on my property, I’m bookmarking this. I want my property to be a cash flow asset for years to come.
Can I reprint this on mytenantfromhell.com?
Sandy,
I would be honored for you to reprint this. I have been reading about your tenant and wish you luck as you search for a new one.
I’m primarily a fan of renting, as I am without a family or long-term attachments and I do enjoy my freedom. Once I make enough passive income to retire I’d like to travel cheaply and lightly, if possible.
However…real estate in my neck of the woods is becoming almost too good to pass up. I see 2 br condos popping up for $50-60k that are in great shape. I could see renting out the second bedroom to a roommate and having my “rent” add up to less than $300 after all is said than done. We’ll see.
At any rate, great article and I enjoyed the explanations on cash flow.
Renting is fine provided it fits with your lifestyle. My wife and I rented for quite a while during school until we got to the point where we felt like we would stay in the same location. Owning a place and renting out part is a good way to decrease the costs of ownership. Duplexes or four-plexes work well for this.
I love the real estate sector but I just can’t bring myself to deal with all the hassle. There is just too big a P.I.T.A. factor when it comes with dealing with tenants. I’ve sworn off real estate (except for REITs) forever.
But maybe you are just more patient then I am
I can be patient at times. I have 6 kids. Dealing with tenants is much the same as dealing with them.
It’s a tough market right now for both commercial and residential real estate. Obviously the best strategy is to “buy low” and “sell high”; the hard part now is the “selling high” part. I think the points you make here are essential for buyers or investors to know when it comes to real estate investing.
Right now, I think a good strategy is to stand pat and make sure that any new purchases are at least cash flow positive so you can get paid while you wait.