You know you can make millions in real estate—the question is how. With determination and some key information up your sleeve, you could be your market's next mogul.
You know rental properties can be profitable. But if someone asked you exactly how rental properties make money, you might have trouble answering.
Just how are rental properties profitable? Why are they worth investing in?
Having the answers to these questions will not only help you understand the benefit of investing in properties, but also act as your guide to receiving the best investment return as you shop around for real estate.
The 5 Profit Centers of a Rental Property
Rental properties offer investment returns in five different ways. Not all properties offer all five, so you’re going to want to understand each one.
Appreciation is the first thing you should look for when you make any investment. Appreciation is an increase in value over time. Predictable appreciation is one of the biggest perks of real estate investing. Now, there is never an absolute guarantee that a property’s value will appreciate. But there are three factors that will help you determine the level of appreciation that you will see:
- The city/market you are buying in. Different markets report different levels of appreciation trends. For example, Los Angeles and San Francisco report fairly consistent appreciation booms, whereas appreciation in Midwestern cities is typically less dramatic. If you are looking to invest outside of your country, make sure you acquaint yourself with the laws and taxation practices of that country.
- Where in the real estate cycle you are buying/how much you pay. If you’re buying in the middle of a recession, you’re more likely to see a lot of appreciation because real estate prices are lower than usual. They have nowhere to go but up. If the real estate market is doing well, you’ll get less appreciation because prices are high and you’re paying the property’s actual value— sometimes more. This doesn’t mean you can’t get lucky and score a great deal during a real estate boom or overpay for a property in a recession. The bottom line? Know your property’s value so that you can pay less and make more.
- The actual property. Is the property you’re buying a fixer upper or squeaky clean and brand new? Are you buying a single-family home in a primarily owner-occupied neighborhood or a triplex in a renter-heavy neighborhood? Different property types in different neighborhoods will earn you different levels of appreciation.
Keep each of these factors in mind when you’re investing and you should see a higher level of appreciation on your property.
2. Cash Flow
The term “cash flow” is thrown around a lot. What does it actually mean? When speaking about rental properties, the cash flow is the money you make each month after all expenses are paid. If a property is “cash flow positive”, it means that you’re pocketing income each month. If a property is “cash flow negative”, your expenses are greater than your income and you are losing money.
Know that you’ll need to scout out cash flow positive properties if cash flow is what you are looking for. Many markets won’t offer cash flow on properties (Los Angeles, San Francisco, New York City). Even within the markets that do have cash flow options, there are only certain areas and certain property types that will provide cash flow.
Regardless of your actual interest in cash flow, you’ll need to be able to calculate it for any property you’re checking out.
Follow this equation and you should walk away with a solid idea of what your cash flow will look like.
3. Tax Benefits
This is one of the biggest perks of real estate investments. Residential rental properties are arguably the most profit-friendly real estate investments in terms of taxes.
With current tax laws, rental properties both “appreciate” and “depreciate” at the same time. However immaculate your property may be, the IRS assumes wear and tear will eat at your property’s value over time. To combat this, the IRS will give you a write-off for what they perceive your “loss” is each year.
Most residential rental properties use the General Depreciation System (GDS). Under GDS, your property has a recovery period of 27.5 years— what the IRS considers the “useful life” of a property. Under this system, the depreciation deduction is 3.636% per year on each building or home on your land.
Combine this with all of the write-offs for general expenses on the property and you have so much in write-offs that you either end up with tax-free income or even a return!
4. Equity Build Through Mortgage Payoff
Did you notice that “mortgage payment” is on the list of expenses above? There’s a very important reason for this. If you have purchased a rental property, the mortgage should be covered by your tenants’ monthly rent. Now your mortgage is being reduced via their payments.
That’s right. You’ll be paying off a mortgage without ever opening your checkbook.
Let’s say you buy a $100K property and put $20K into it, so you have mortgage loan for $80K. By the time the property is paid off, that entire $80K has been paid off… by your tenants!
5. Hedge Against Inflation
While inflation screws the pooch in most areas of our lives, it can actually be a huge help with rental properties.
Assuming you get a fixed-rate loan, you won’t have to spend a dime more than what you agreed to. Isn’t that great? No matter how high the value of your property climbs, you will continue to pay only what you bought it for— regardless of what the present inflation rate is. Imagine you bought a property for $20K in 1965. Now it’s 2018. Inflation over the last 53 years has increased the value of that property 700 percent. It is now worth $160K, but you still only pay $20K for it.
Inflation is also a huge help when it comes to paying off an original mortgage or loan. Through inflation, more money is introduced to the market and the value of the dollar decreases. Let’s say you still owe $60K on your loan. The value of each dollar has gone down, so the value of that $60K now is less than what it was originally.
Are you sold on rental properties as an investment strategy yet?
What to Look for as You Shop for Rental Properties
Knowing the five profit centers is key when you shop for a rental property. You should know ahead of time which profit centers you are focusing on.
To make sure you’re maximizing your return, ask yourself these three questions before you invest in a property:
- Am I buying at the right time and in the right place to get the highest appreciation rate possible?
- Can I expect positive monthly cash flow from this investment?
- Will the rental income cover the mortgage?
The more you maximize your potential in each of the five centers, the higher your chances of ending up with a successful and profitable rental property. If you can’t maximize, or even access, all of them— that’s okay! The advantage to having five profit centers is that if one of them doesn’t pan out for some reason, the others may be able to make up for it.
At the end of the day, real estate investments can be an excellent way to generate passive income. Done right, they can even help you retire early. Deciding which property to put your money into is the hardest part, but keep the five profit centers in mind and you’ll have a head start on picking a valuable property!
Formerly an Aerospace Engineer, Ali Boone is a lifestyle entrepreneur, business consultant and real estate investor.