A Guide To The Four Ways Investors Profit On Real Estate
“Buy land, they aren't making it anymore."
― Mark Twain
“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world."
― Franklin D. Roosevelt
Have you thought about how a person can make money investing in real estate? How do the pieces come together, really? And what numbers should you consider? There are four ways real estate investing puts money in investors’ pockets: Cash flow, amortization, tax advantage, and appreciation. Today we'll dive into each.
Whether you are contemplating buying a home, or buying a vacation house in Tahoe, or maybe renting out a starter home while you move into something bigger with your kids, I hope the following discussion will create a framework for your thinking as you walk through this process yourself.
Success in real estate investment is most of all about the numbers, not the emotions. As with so many things financial, neither ambition nor fear are guarantees for capitalizing on opportunity. Let's dive in and explore the four ways real estate investors really profit. From there, we will briefly discuss the differences between owning a home and purchasing investment property and why it's important not to confuse the two.
1. Cash Flow
Money flows in and money flows out. If you've ever balanced a budget or tracked a bank account you know that the more that remains in the account over the course of the long-term the better. In real estate, this is known as net spendable cash. There are many valid reasons for a negative cash flow (construction, renovation, tenant turnover, etc.) but a savvy investor plans for periods of negative cash flow and coordinates expenditures to produce profit. When considering a property, get as much information as you can about its current cash flow before making a purchase. The quality of your questions matters. What are tenants paying, and what could you expect to receive from future tenants? What rehab needs to be done? What ongoing maintenance issues or one-time costs are on the horizon? What will insurance, taxes, and utilities cost? Thoroughness and honesty with yourself here will save you miles of headache. Measure twice, cut once.
Real estate investors generally use a tool known as an APOD (Annual Property Operating Data) to measure cash flow and profitability. The commercial real estate professional organization CCIM has made a basic example of an APOD available here. Your qualified financial planner should be familiar with this tool and have a system or software to guide you through this process as well.
Imagine if you could find a volunteer to pay your debt for you. Let's say I bought a $3,000 TV, put down $500, and let you borrow it for a year while you paid off the remaining $2,500 then returned it to me. I'd have a pretty nice deal. Now what if I could find five more friends who would give me the same deal? I'd end up at the end of the year with six one-year-old $3,000 TVs instead of just one. While the complexities of property ownership, cashflow, and upkeep cause the TV analogy to break down quickly, the idea is simple: others pay to build your equity. You amortize your costs and build your wealth with their money. This is the power of amortization in the context of investment property.
Of course, if you have a mortgage on a property much of the mortgage payment is likely at first to be allocated to interest. If my annual mortgage payments total $50,000, and $45,000 goes to mortgage interest and other fees, my amortization for the year is $5,000. That's $5,000 in equity I built on that property financed by my tenant. The point is that your tenants are paying down your mortgage for you.
3. Tax Advantage
One of the significant appeals of real estate investing is tax shelter. On the first level, an investor receives taxable rental income and deducts tax-deductible operating expenses like repairs, utilities, mortgage interest, and insurance (reportable on IRS Schedule E). This leaves the investor with their Net Operating Income (hopefully positive cash flow).
But unlike a personal residence, investment property has a second level of tax benefit. Under our tax code, investment property is depreciable. Even though the property itself might be appreciating and growing in value, it's almost as if the tax code assumes that the property is losing its value at a specific rate over what the IRS has determined is its 'useful life' (often either 27.5 or 39 years, depending on the type of building). The IRS thus allows property owners to recover their cost. Buildings are given a useful life which begins when you buy or build a property (regardless if the building has already been around for decades). This allows you to offset a portion of the purchase price from your income each year. Buildings may be deducted using straight-line or accelerated recovery (which allows you higher deductions in the earlier years and much less at the tail end).
Real estate investor and author Frank Gallinelli writes, "The exhilarating part about depreciation, if any part of the tax code can be so described, is that it is a noncash deduction. In other words, you get a deduction without writing a check. It does not affect your cash flow and it is not an operating expense. It is a deduction that can shield some or all of your property's year-to year income from taxation. If the depreciation deduction is large enough, it can even exceed the amount needed to shelter the property's own income and provide shelter for other investment income as well. In that case, the deduction creates what is effectively a cash yield of its own by reducing your other tax liabilities."
Note that capital improvements to the building cannot be deducted in the year they are made. Rather, they must be added to the property's cost basis. Land itself on which a property is built is also not depreciable, since it is assumed that the land's useful life is infinite.
Let me illustrate all this with a quick example. You buy an apartment building for $1,000,000, of which $200,000 is assumed to be the value of the land. Thus $800,000 would be depreciable. Under straight-line depreciation you would divide the $800,000 by the building's 27.5 years of useful life. Your first year of ownership would offer you a tax advantage of $800,000/27.5 = $29,091. To expand this example to provide a true picture of what cost recovery actually looks like in practice, we would need to delve more deeply into the technical aspects of the tax code, which is outside the scope of this post. Consult a tax professional or financial planner who has this expertise to guide you through that process.
Everyone who has even casually observed real estate in Northern California for the last 20 years can viscerally understand the power of appreciation. Both internal forces (such as a remodel), and external forces (such as an influx of industry or a highly paid workforce) can affect a property's growth in value. One of the tricky things about appreciation is that the future isn't predictable. If it was, property values would be priced accordingly and reflect their future worth. Appreciation is the hardest and riskiest of the four methods of real estate profit to plan for. Bear in mind that during the real estate crisis a few years ago, thousands of people all over the USA who had been counting to make a quick buck through the appreciation of their real estate investments lost their shirts.
One of the key elements in understanding appreciation is “marginal thinking” – comparing the rate of return of one option with other ways the money could be invested instead. This concept of Time Value of Money (i.e. what a dollar now can buy vs. what a dollar 20 years from now can buy) must shape an investor’s view of a property investment.
Consider the hypothetical grandparents down the street: forty years ago they purchased a rental apartment for $150,000. Today they sell for $1,000,000 and use the money to fund their retirement. At first sight, that sounds like a savvy decision. But the rate of return on their investment for those 40 years would be just under 5%. And that’s not yet considering the expenses of taxes, repairs, insurance, and mortgage interest. Once all these costs are factored in, their return on investment may not even beat inflation.
Had they instead invested in the stock market and received 8% return, the same money would have grown to almost $3.3 million. Still, the real estate investment they made may have come out quite well. If during the time of their ownership they took in thousands of dollars of rental income and invested this, they may have both the property and their investment returns. This example demonstrates that we can't analyze a property only based on tax advantages, appreciation, amortization, or cash flow. Coordinating the four aspects of real estate investing is what allows wealth building.
So How is A Personal Home Different?
A personal home is a personal use asset, not an investment. It provides us a place to live, make memories, decorate, host friends, and enjoy our neighborhood. We'll shop at the local stores, make new friends, and send our kids to local schools. A home becomes a deep part of our lifestyle and of what shapes our family identity. In exchange, we give up liquidity and tie a significant portion of our present and future wealth to a property.
Let's go through the four financial ways we make profit on investment property and compare them to a personal home.
Cash Flow: From down payments to new roofs to kitchen remodels, the cash flow on a personal residence is negative. Negative isn't necessarily a "bad" thing. We don't mind paying for these things, but they are not building wealth since we derive no positive cash flow during our stay in the home.
Amortization: The portion of our mortgage payment that goes to home principal (as opposed to interest and expenses) is our amortization amount. The large difference here is that with property from which we derive no income we are utilizing our own means rather than a tenant’s rent to pay down the mortgage.
Tax Advantage: The tax advantage of owning a home includes the ability to deduct interest, mortgage points (pre-paid mortgage interest), real estate taxes, and mortgage insurance premiums. All else being equal (and it never is) this allows homeowners to afford a higher mortgage than they could otherwise afford to pay in rent. Upon resale the IRS also allows homeowners to exclude from taxation the first $500,000 of gain on their home ($250,000 for singles) if they lived in the home for at least 24 months in the last 5 years.
However, the "second level" of tax advantage is only available through the depreciation of investment property and provides an important delineation between our consideration of buying a home and buying an investment.
Appreciation: Albeit the least predictable, appreciation is one way that home ownership and investment property ownership functions similarly. If the value of your property goes up, you will reap the benefits. If it goes down, you lose.
I hope this discussion has provided you a framework for considering a property purchase. If you love podcasts, check out "Bigger Pockets", which will drop you straight into the mind of two guys who spend the bulk of their waking hours analyzing real estate investments and interviewing successful property investors.
If you have an analytical mind and would like to dive into more reading I highly recommend, "What Every Real Estate Investor Needs To Know About Cashflow... And 36 Other Financial Measures," by the previously quoted Frank Gallinelli. As he writes:
"Don't make a decision to buy, hold, or sell based on emotional factors. In particular, don't buy a building because you have fallen in love with it; and don't hold because of a sentimental attachment when you really ought to sell. If you need that warm and fuzzy feeling, get a puppy."