There are many benefits to owning investment property. Pride of ownership, portfolio diversification and direct management control are just a few. However, let’s face it, if investment property didn’t contribute to our personal bottom line, few would find it attractive.
So what do successful investors know that others don’t? The secret is to understand the four ways investment real estate increases your net worth. Let’s get started:
1. Cash Flow
The most basic and understandable method to make money owning real property is cash flow. Cash flow is simply defined as the net change in dollars in your checking account during a period of time (such as a month) that occurs as a result of owning and operating real estate. Put another way, cash flow is equal to the money that is left over after you collect rents and pay all the bills, including the bank note. Having a positive cash flow is crucial to the ability to hold an investment in the long term.
2. Price Appreciation – with Leverage!
The appreciation, or increase, in the market value of property is many times responsible for the lion’s share of the profit from investment property. This is especially true for short holding times. The old adage, “buy low, sell high”, expresses this basic principle.
What makes appreciation so powerful in real estate is the ability to borrow a portion of the purchase price. Consider an example whereby an individual has $10,000 to invest either in stocks or commercial property. Furthermore, let us assume that both investment choices will appreciate the same amount in a year, say 5{cf291cfc7269490771c2e5c8f8cab8cac79ddb0009ca0d6c13a6d788af335a8c}. At the end of the year, the stock account will be worth $10,500, or an increase in $500.
However, the real estate investor understands leverage; the ability to borrow a portion of the purchase price of an investment. Most investors can borrow 80{cf291cfc7269490771c2e5c8f8cab8cac79ddb0009ca0d6c13a6d788af335a8c} of the value of a property. So the $10,000 cash available can, with this leverage, purchase $50,000 worth of real estate. Growing the $50,000 by the same 5{cf291cfc7269490771c2e5c8f8cab8cac79ddb0009ca0d6c13a6d788af335a8c} results in $52,500, or an increase of $2,500. Who likes $2,500 better than $500? Answer: real estate investors.
3. Debt Pay Down
This method flows from the leverage principle introduced above. When investors borrow money from the bank to purchase real estate, they pay it back with monthly payments exactly like a home mortgage. A portion of those payments goes to interest and a portion goes to principle. To the extent that collected rent is used to fund the principle portion of the monthly debt service, this rent money builds the equity of the investor by paying down the debt. Lowering debt increases net worth.
4. Tax Depreciation
This method of wealth creation is entirely due to the vagaries of our current tax code. However, it does create real dollars in your bank account, so we should understand it. Here we go: The government acknowledges that buildings age and in doing so, lose value. They allow us to recognize this loss of value annually by treating it as an operational expense, just like a utility bill. This operational expense can be used to offset the profit from operations, thus lowering the tax due on those annual profits. The government does recover a portion of this tax loss upon the sale of the property via capital gains, however, for most investors capital gains tax is less than operational profit tax so a net gain is realized over time.
Now you know what real estate investors know. What you do with that knowledge is up to you!