rental property investing

How Do You Make Money In Real Estate?

As an investor, your first concern is what is your return going to be? With so many options of places to invest your money (stocks, bonds, mutual funds, real estate, etc.) it can be overwhelming at times trying to find the best investments.

With real estate, you can earn a high return but more importantly it gives you the opportunity to make money.

Someone who owns rental property gets paid every month and if you set up your business model right, you can live off this monthly income during retirement and never worry about whether or not social security is going to dry up and fail.

For those who flip houses, they can make money quickly in short periods of time and build a stash of cash fairly fast.

In my opinion, what matters most is what income are you going to live off of in retirement when you stop working your corporate 9 to 5 job.

Real estate provides you with income and saves you from having to withdraw from your savings if you set up a smart financial plan.

Let’s get into the major reasons why I love real estate and how it makes you money!

Method #1: Cash Flow

You’ve heard of rental properties before. You might even be renting currently. Owning rental property is a great way to build wealth because of the monthly cash flow. The source of this cash flow is the rent collected from the person leasing your property, known as the tenant.

As the property owner (investor) you will pay operating expenses with the income collected which may include and not be limited to: utilities, maintenance, property management, property taxes, and property insurance. If you bought the property with financing (such as a bank loan) you will also have to pay a monthly mortgage payment.

Lastly, the cash flow that remains will be taxable income and you will likely have to pay income taxes but in a future email we will get into the tax benefits of real estate investing the IRS provides.

The after tax cash flow is the cash flow that remains from the collected rents after all expenses have been subtracted. This is your spending money to live off of or reinvest and grow your business.

If an investment produces a negative cash flow, where expenses are more than the income, then it’s not a deal you want to own. The goal is to create positive cash flow, or cash that remains from the rental income after all expenses have been paid.

Example of Cash Flow:

  • Rental Income = $10,000
  • Property Taxes = $1,200
  • Property Insurance = $1,000
  • Lawn Care = $500
  • Snow Removal = $750
  • Repairs to Unit = $600
  • Total Expenses = $4,050

Your rental income is $10,000 and your operating expenses total $4,050 leaving you a net income of $5,950 to cover any debt if you used leverage.

If not then it’s cash flow in your pocket until tax season.

Fortunately, the IRS will let you deduct interest payments on loans, property taxes, and depreciation to reduce your taxable income.

Method #2: Appreciation

Another motivation for investing in income producing real estate is the possibility of appreciation.

Properties do not always increase in value, but investors will target investment properties that are projected to increase in value with or above the rate of inflation.

U.S. Housing Price Index Since 1900

Historically, residential real estate has risen 3% on average in the U.S. keeping in line with inflation.

Therefore, in times of expected inflation, people will flee financial assets such as savings accounts and put their money into real assets such as real estate that appreciate with inflation and have depreciation benefits to them as well.

Example of Appreciation:

Let’s say you buy a home in 2017 for $200,000. You did your research and see that home prices have historically risen in this neighborhood 4% on average.

Over the next 15 years you expect the property to increase 4% annually on average which would result in a total compounded increase of 80%. You expect this $200,000 house to now be worth $360,000.

As a result, you’d earn $160,000 in appreciation over this time period which hopefully helped you stay in line with or above inflation rate.

Remember, some areas appreciate much more rapidly than others. Here is an extreme example.

I read an article story of a man who bought ocean front property in Miami for $25 million in 2006. He held onto the property for several years and decided in 2013 the time was right to sell. T

hat ocean front property in Miami sold for $125 million, appreciating $100 million over those 7 years.

How do home values actually appreciate?

Supply and demand. When there is limited supply or a high demand of buyers, prices rise as buyers compete to purchase the houses available on the market.

In the Miami example, undeveloped ocean front property is rare.

Since supply is low, buyers (demand) were willing to pay a fortune to acquire such rare land as they know in the future this land will keep appreciating and be worth more since supply can’t impact it due to it’s rare and unique location along the ocean.

For the average home owner, your property value increases as the market increases around you over time due to population growth and income wage growth.

The comparable sales method is typically used in residential real estate to value a property.

For example, if a house down the road that is very similar to yours sold for X dollars per square foot, then you have a comparable price per square foot to multiply your property by to get your home value.

Or if the square footage of your house and theirs is identical, you can assume your house would fetch a similar price in the market if you were to sell.

There are other factors we will get into later in the valuation section of this course but you get the general concept of the comparable sales method of valuation.

Method #3: Equity Build Up

When you purchase a house, you can either pay all cash or pay a down payment on the property.

If you make a down payment you will need to finance the remainder with a loan which typically is a mortgage. Each time you make the monthly payment on your mortgage you are building equity in your home.

Those who elect to rent out their properties receive income from tenants that is then used to pay for the mortgage. So essentially your tenants are paying your loan off for you and building your equity.

Another way to earn equity is to find houses under market value.

Usually these are distressed homes that need fixed up. Other times it may be foreclosed homes that the bank wants to sell to get off their books and they’ll accept less than market value.

Upon purchasing an under-valued home you build instant equity if you were to re-list it on the market at market value.

Rehabbers will often improve the home instead of just re-listing it and their improvements allow them to sell the house for even more money depending on the upgrades and the comparable sales in their local area.

Upon the sale of the investment, the investor pays off any debt and income taxes and what is left is the after tax equity that grows the investors net worth.

Method #4: Tax Benefits

real estate taxes

Real Estate offers a great tax saving strategy called the 1031 deferral/exchange.

In simple terms, when an investor sells a property they can roll that money into a new property of equal or greater value tax free.

This is a legal tax method for avoiding capital gains taxes that the IRS set up in 1979 allowing investors’ money to compound greater thanks to the tax shield.

Considering some wealthy investors own millions in real estate, this is huge for them especially and why so many elect to store their money in real estate.

For the average investor, you can work your way up to owning millions using the 1031 exchange.

For example, if you start out buying a small apartment building for $200,000 and after a few years of increasing it’s income you are able to sell it for $400,000 earning a capital gain of $200,000.

Plus any equity you had in the property and any equity gained from loan pay down during ownership of the building.

Then you take this money and instead of paying taxes, which could set you back $100,000 potentially, you get to roll this money tax free into your next large investment.

Remember the power of leverage?

This $100,000 you didn’t pay in taxes will allow you to potentially purchase an extra $300,000 more of real estate than you could have otherwise.

Math Example:

  • Tax Free Capital Gain: $300,000 allows you to acquire $1 million apartment complex if bank requires 30% down payment.
  • After Tax Capital Gain: $200,000 = only can purchase a $667,000 apartment building if bank requires 30% down payment.

So to build wealth starting with little capital, you would buy a smaller property first, increase it’s value, and sell out for a capital gain.

You would roll these capital gains into the next investment and do the same process, until you’ve done several deals and worked your way up to the bigger million dollar apartment deals that produce 6 figure cash flow.

Additional Tax Benefits:

Other tax benefits relate to the calculation of taxable cash flow.

In real estate, land appreciates so you cannot deduct this as depreciation but the building on top of this land does depreciate.

Therefore, the IRS will let you divide the cost of the structure by 27.5 years to get an annual depreciation expense you can subtract from your income to reduce your taxable income.

This will keep more money in your pocket.

If you took out a loan, you’ll be able to deduct points, mortgage interest, and other costs of the loan from your taxable income, saving you money.

Which method from above do you enjoy building your wealth from the most as an investor? Or if you’re new, then which of these methods sounds the most exciting to you? Leave me a comment below!

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