Photo Credit; Biggerpockets.com
There are multiple ways you make money with a residential rental property. This is perhaps the most exciting aspect of purchasing residential real estate. Let’s examine each way a rental property strengthens your bottom line.
Cash Flow
Perhaps the best known aspect of residential real estate investing is the monthly rental income generated. Assuming your property rents for more than the monthly amount you spent on the mortgage, property tax, insurance, maintenance, and other expenses, you’ll have extra income left over each month.
This is your cash flow. The objective of every property you purchase is to enjoy cash flow.
Since you’re allowed to depreciate the value of your property each year (more on that later), you can save on your taxes. This could help make your cash flow tax free.
What if you reinvested your cash flow, in buying more rental properties? For example, let’s say you earned $4,000 in yearly rental income from a property.
You could put this $4,000 in a checking account, which is dedicated to the purchase of additional rental properties. This $4,000 probably won’t cover the full cost of purchasing your next rental property.
However, it can help. What’s more, you get into the habit of reinvesting your profits. After you acquire a second rental property (let’s say the new property also generates $4,000 in rental income), you’ve now got $8,000 per year in cash flow.
You can see where we’re going with this. As your cash flow increases, you have more money available to purchase more rental properties, which generate more cash flow. Your rental income compounds.
This puts you in a position to retire early, donate more money to charity, or live a more affluent lifestyle. In short, cash flow can replace existing sources of income, and allow you to achieve financial freedom. \
Paying Down The Mortgage Principal & Building Equity
Let’s say you purchase a single family rental home for $200,000. Suppose your down payment was 25% of the purchase price, or $50,000. You borrow the rest of the purchase funds from a bank.
This means you have a mortgage of $150,000. More specifically, the principal amount you owe is $150,000. You will, of course, be paying interest on this loan.
You lease the home to a tenant. Let’s assume that you generate sufficient cash flow to cover the mortgage and other expenses, and put some extra cash in your pocket every month.
Let’s also say that the property does not appreciate in value at all. While this is rare, it helps demonstrate the power of paying down a mortgage. Lastly, let’s pretend that you maintain the same loan for the lifetime of the property, i.e. you never refinance into a new mortgage.
When you purchase the home, your share of ownership in the property (known as equity) is $50,000. Over the years, the monthly rental income pays off the mortgage.
Let’s say that after 5 years of owning the property, you have paid off 12%, or $18,000, of the $150,000 you borrowed. Your equity in the property is now $68,000 ($50,000 + $18,000).
As you pay down the mortgage further, your equity increases more. This means your wealth is increasing. This is without assuming any appreciation in the value of the property.
As you acquire more rental properties, you’ll have more mortgages being paid off through rental income. This means your equity in each property continues to increase. Simply put, you’re becoming richer.
Let’s return to our earlier discussion, about reinvesting the cash flow to purchase more rentals. As you implement that strategy, you’re not just generating more cash flow.
You’re also building wealth. After all, the rental income is being used to acquire another income property, which will be paid down by the rental income generated.
Paying down the new property thus builds equity, and increases your wealth. Keep repeating the process and grow.
Appreciation
We’re writing this article in late 2021, in the midst of a historic increase in the prices of residential properties. As of August 2021, the median sale price of homes had increased by more than 20% from 2020, hitting levels never seen before. If you own a home, times are good.
We also lived through the housing bubble that burst in 2008, with median home values nationally fell by around 33% in the aftermath. In some cases, that wiped out a few decades or more worth of appreciation.
When it comes to real estate investing, appreciation is one of those things which is very nice to have, but is not promised. While property values tend to increase over the long run, they can also drop, in response to market conditions.
If your rental property is located in a coastal market with a high degree of appreciation (like southern California), then your property is especially likely to outperform. If you hold properties for years (or decades) you’re likely to build meaningful wealth.
On the other hand, if you purchase in areas with consistent population outflow, and a lack of economic opportunities, appreciation may be weak to nonexistent. This has been true of many American cities which were once industrial powerhouses.
Appreciation is primarily realized when you sell a property. By “realized” we mean that upon the sale, the wealth stored in the property becomes money in your bank account.
However, there is another tool to tap into appreciation: The cash out refinance. Let’s say that your property was purchased for $200,000, with a 25% down payment of $50,000. This means your mortgage was $150.000.\
5 years have passed. Based on a strong local market, the property is now worth $300,000. Let’s also assume that the property now rents for $1700 per month.
You can go to a bank, and ask to take cash out of the property – that is, tap into your existing equity. Let’s say the bank agrees to lend at 2/3, or just over 66% of the home value. Let’s assume that the interest rate on this new loan is 4.3%.
That means the new mortgage is $200.000. $150,000 of that amount is used to pay off the old mortgage. $50,000 comes back to you as a check. That’s tax free cash, placed in your hands.
As noted earlier, your down payment was $50,000. Through this cash out refinance, you still own the property, but you’ve gotten back your entire down payment.
You can now apply those funds towards purchasing another rental property, and continuing to grow your wealth. Remember, compounding is key.
Recall that the property generates $1700 in rental income per month. With a 30-year fixed mortgage, your new mortgage payment is $990. With taxes, insurance, vacancy and maintenance expenses, let’s assume that your average total monthly expenses for the property are $1500.
This means you’ll continue to collect $200 each month in cash flow. Think about that for a second.
You’ve taken your entire down payment out of this investment, but are still earning monthly rental income. The cash out refinance, when implemented properly, is a powerful strategy.
Natural Appreciation vs. Forced Appreciation
When a property increases in value due to market conditions (without any effort on your part) that is natural appreciation. In the right market, you can enjoy quite a bit of natural appreciation. However, it’s never guaranteed.
With forced appreciation, you’re upgrading the property, and thus increasing it’s value. Let’s say you purchase a home for $200,000. However, similar homes in the area, fully upgraded, usually sell for $300,000.
This home needs a good amount of work. You must spend $30,000 on renovations and repairs for the property. At the end of this process, you own an asset which is worth $300,000.
By spending money on improving the property, you’ve increased it’s value. The increase in value was considerably more than what was spent on improving the property. After all, you spent just $30,000 to add $100,000 in market value.
You’re not relying on market conditions to create appreciation. Even if prices don’t organically increase by a penny, you’ll own a more valuable asset.
Implementing forced appreciation is also known as a value-add strategy. Value-add is one of the most powerful strategies in real estate.
Reducing Taxes
You can make money by saving money. One important method of implementing this strategy is through reducing your tax bill. As we’ve discussed in more detail elsewhere, investing in real estate offers major tax benefits.\
Thanks to depreciation, part or all of your annual rental income can be tax free. It’s pretty rare to earn income and avoid taxes on it.
If you choose to accelerate depreciation through a cost segregation study, you might realize even more tax benefits. Cost segregation allows you to compress depreciation into a short amount of time. This means you realize large tax benefits in just a few years.
Here’s the thing: These tax benefits normally only apply to passive income, such as real estate rental income. This means you typically cannot offset your personal income (say from your job) with depreciation or cost segregation deductions.
There is an exception to this rule. If you (or your spouse) qualifies as a real estate professional, you might be able to offset your personal income with these passive losses.
If you want to sell a property, you can do so while deferring (postponing) your capital gains taxes. This is done through the 1031 exchange. In a 1031 exchange, you sell your property, and use the profits to acquire another property of equal or greater value. You are then able to avoid paying capital gains taxes on the sale of the original property.
Money which you didn’t spend in taxes on is money that can be allocated elsewhere (including towards future real estate or other investments). There are few other investments which offer as strong tax benefits as real estate.
The Final Word
Rental properties offer multiple means of building and preserving income and wealth. It is worth noting that properties with very high levels of cash flow (relative to price) often have much less natural appreciation. By the same token, properties in markets with heavy appreciation tend to offer less cash flow.
Tax benefits like depreciation and cost segregation help you grow your real estate portfolio more quickly. After all, if your cash flow is partially or entirely tax free, that money can be invested in acquiring more rental properties.
There are not many other investments which offer such a range of ways you can build and preserve income and wealth. This is one of the many reasons why real estate is such a compelling investment.