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.
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.