…this post will be a bit heavier on the numbers, so buckle up. But whether you are a seasoned real estate investor or a budding beginner, numbers shouldn’t scare you. So let’s get started.
There are four ways to earn money from investing in real estate. In no particular order, first, there’s the potential for the property to increase in value (appreciation). Second, by using leverage, you or your tenant will be paying down the mortgage and building equity in the property. Third, my personal favorite, you should be able to collect a favorable monthly cash flow, above and beyond your mortgage payment and operating expenses. Last, and the most often overlooked, is the tax savings available to real estate investors.
So let’s go in-depth and analyze the impact of each revenue stream and layer them, one on top of the other. To simplify the process, we will examine each profit layer, individually, and express the impact in the form of a rate of return (ROR).
For our analysis, we will analyze the purchase of a single family residence (SFR), at a purchase price of $100,000. The object of this purchase will be to buy and hold the property for 30 years. Regardless of your chosen strategy to real estate investing, these four pillars should be present in varying degrees. Rather than use a complicated deal, I have chosen a simple example so we can stay focused on impact of each pillar and not get lost in the weeds of the deal itself.
PILLAR 1: APPRECIATION
Appreciation, or the increase in the market value of a property over time, is often the main focus of new real estate investors. This follows the “buy low, sell high” mentality we are taught that makes successful investors.
Appreciation can be achieved two main ways. First, we can let time slowly increase the value of our property over time. The rate of increase will depend on our holding period and overall economic performance, but it is not unrealistic that the increase in value will approximate general inflation. This type of appreciation is passive in nature, meaning it does not require much input on the part of the investor to be realized.
Second, we can force equity through any number of strategies including fix and flip, market timing or repurposing. These strategies bring with them significantly more risk typically and therefore require specialized knowledge and expertise to be successful. Success also often requires impeccable timing by the investor but can allow for significant and quick profits. This type of appreciation is active in nature, requiring significant time investment by the investor or his team.
Since our purchase here is a buy and hold strategy, we will assume that our property will appreciate slow and steady, in line with inflation. Appreciation of 3% per year will result in the property will be worth $242,726 at the end of our 30 year time horizon. Appreciation, all by itself, will only result in a yield of its appreciation rate as proven in Figure 1.
PILLAR 2: LEVERAGE
If the purchase price is $100,000, and you are not offering an “all cash” transaction, you will be securing a mortgage. Assuming a 20% down payment, you will only be required to provide $20,000, out of pocket, to “close” on the property. Adding “leverage” to the equation, we begin to see how our real estate investment provides several ways to make money.
By adding a mortgage, we have effectively leveraged the 3% inflation (from the above example) into an 8.68% rate of return. That’s almost triple the earnings per dollar invested! In other words, in order for your initial investment of $20,000 to grow to be worth $242,726, after 30 years, you would have to earn a compounding 8.68% return every year.
PILLAR 3: CASH FLOW
Here is where things begin to really get exciting. You’ll soon see why cash flow is my favorite way for real estate to earn me money. The metric we will use to analyze our cash flow is an assumed cash on cash return.
Using conservative figures, we will assume that our net annual, before-tax, cash flow is $2,000 per year or roughly $167 per month (profit after paying mortgage and monthly expenses). This would result in a “cash on cash” return of 10%. If we add that $2,000 on top of the appreciation and leverage, we will see the following result.
Our cash flow has increased our ROR from 8.86% to 13.47% or more than a 50% increase in earning power! Just to be clear, if you were to invest $20,000 (present value) in an investment that pays you $2,000 per year (annual withdrawal) and still grows to be worth $242,726 (future value), after 30 years, that would require an annual ROR of 13.47%.
I know I said that cash flow is my favorite earning vehicle, but it’s not because leverage is a slouch. Leverage doesn’t only enhance the ROR impact of any appreciation enjoyed on the property, it also enhances the impact of cash flow.
Remember, the $2,000 monthly cash flow is in the very first year you own the property. But, if the market value is increasing at a steady 3% per year, isn’t it reasonable to expect that you will be able to increase rents at a similar rate? Granted some of your expenses, such as property taxes and maintenance, will increase, as well, but the largest monthly cash outflow is, hands down, your mortgage payment.
Being the smart investors we are, knowing that we are going to keep the property for 30 years, we would have likely secured a 30-year fixed mortgage. This means that our largest cash outflow will remain fixed, allowing us to see increases in our net cash flow, over time. If our cash flow increases at an annualized rate of 2% per year, the cash flow in our 30th year will be approximately $3,600 per year. Averaged over the 30 years, we will collect about $2,800 per year, in cash flow, resulting in the following tax benefits.
PILLAR 4: TAX BENEFITS
While it’s always wise to consult your tax adviser, for your specific circumstances, the real estate tax benefits are consistent with what I and most real estate investors have experienced. Due mainly to depreciation, this average cash flow of $2,800, over 30 years, can be enjoyed on a completely tax-free basis.
That means, assuming a 28% federal income tax and a 6% state income tax, that $2,800 of tax-free cash flow is worth about $4,240. In other words, another investment that produces an annual cash flow, would have to earn $4,240 per month for you to have spendable income of $2,800 per month. And here is the impact it will have on your ROR.
So there you have it, a simple understanding of the many ways your real estate will love you, and why you should love it back.
Stay tuned for a follow-up discussion on combining these four money-making methods to the incredibly powerful cash management tool of Infinite Banking. We will add several more simple ways to keep your investment dollars working best for you.