Did you know that buying and holding real estate can help you build wealth in multiple ways with one property? Most real estate investors or want to be real estate investors focus on the cash flow(rent minus expenses) and forget about the other ways that really build wealth. I’ve benefited - as have hundreds of our clients with our property management company - from the five ways landlords can make money in Chicago. You read that right. Five. From the same property.
How? Most people only look at the one obvious way that adds money to their bank account each month (rent). But the rent checks offer only one slice of the value investment properties provide their owners. To understand its real value, you have to consider the additional benefits of holding onto real estate.
1. Cash Flow
Like I said, this one is the most obvious, so let's get it out of the way first. Every real estate investor has income coming in from rental properties. Of course, they also have operational expenses that come with owning a building. These include things like maintenance, landscaping, utilities, cleaning, and loan payments. At the end of the month or year, rental income minus all the expenses equals the cash flow.
Hopefully, you have a positive cash flow number. But, if an owner breaks even or loses a few bucks, they still build wealth from the same property. The four other wealth drivers make it profitable. Let me explain how.
2. Principal Paydown Of Loan
Mortgage payments, which factor into operational expenses, include principle, interest, taxes and insurance (PITI). Interest, taxes, and insurance all add up as expenses (which you can still benefit from - more on that later). But the principle part of your payment pays your loan down. And that actually amounts to a wealth building driver.
When you buy a property or take out a bank loan, you have to repay it. But instead of paying that from your personal bank account, you pay down the loan with rent money. A typical 30-year loan builds the principle into the monthly loan payment. Eventually, that principle owed gets down to zero.
I find this amazing because you can buy a $250,000 property with a $240,000 loan. But after 30 years, you have a loan balance of $0. If you do it right, you turned a small $10,000 down payment into $250,000, plus any property appreciation. (We’ll talk about that later too.)
Plus, you can use different strategies and hacks to pay off your loan faster. How? If you have extra cash flow or funds to put towards your mortgage loan, the principle owed shrinks much faster. Sometimes, you can even cut the time to payoff by a third.
Options to pay off your mortgage faster include:
Pay extra each month
Make bi-weekly payments instead of monthly (i.e., 13 months of payments instead of 12 each year)
Make one additional payment a year when you have the extra cash
I recommend you research these as strategies to incorporate into your overall investment plan.
3. Income Tax Liability Reduced
When you receive rental income, you can deduct certain expenses from that income on your tax return. For example, you can deduct mortgage interest, property tax, operating expenses, specific item depreciation, and repairs.
You can also deduct the ordinary and necessary expenses that come with managing and maintaining your rental property. Necessary expenses include leasing commissions, maintenance, utilities, management fees, and insurance. Under certain conditions you can deduct costs for certain materials, supplies, maintenance, and repairs made to the property to keep it in good operating condition. Be sure to discuss with your CPA larger capital expenditures that may help you in a different way on your income taxes in the long run.
The IRS outlines the specifics on their site. Fair warning: their site isn’t especially riveting or user friendly. We always suggest property owners discuss deductions and appropriate IRS forms with their CPA. And if you don’t have one, we highly suggest you get one. Even if you’re a financial wizard, is this the best use of your most precious commodity (time)?
4. Hedge Against Inflation
Recently, many people have been anxiously biting their nails as they watch economic forecasts. Will we experience an economic downturn or another recession? While you may feel the pinch at the grocery store checkout, most feel the inflation pains in their retirement funds.
If you own rental property, you give yourself a buffer against these effects. Income-producing properties can make inflation work in your favor. Owners raise rent over time in alignment with the market demand (and legal restrictions, of course).
Typically, that rent increase percent keeps pace with or surpasses inflation rates. With a fixed-interest loan that has unchanging mortgage payments, rising rent costs build the cash flow from that property.
Of course, it helps to already have property with a low fixed interest rate. Buying new property, especially with soaring interest rates, can get a little tricky. But it’s still possible to create a favorable return with a carefully assessed rent rate. Plus, when interest rates inevitably fall again, you can refinance and boost those returns even more.
5. Property Appreciation
This brings us to the last wealth driver: property appreciation. During the height of the pandemic, the housing market frenzy drove selling prices well over owners’ asking prices.
As a seller, you relished the bidding war outcomes. But anyone buying property, especially profitable rental property, is probably still growing out some bald spots from tearing their hair out.
You can see how even owners who hung onto their properties benefited as their investment appreciated with the comp prices. But, even when the madness died down a bit, the housing prices still sat far higher than before.
That’s a hallmark of well-maintained property: it almost always increases in value just by existing.
I love this because as you pay down the outstanding principle on any loans, you create equity. An increase in home value means the same property has even more equity without you doing a thing.
Of course, homes can depreciate as well, which is why you need to make sure you carefully select investment property. The location, condition, and economic forecasts of an area should all factor into a buying decision. An experienced investment real estate agent and a stellar property manager can offer valuable input on properties with the highest potential.
Passive Means Passive
Four of these five drivers - the ones talked about less frequently - happen fairly automatically. Everyone talks about cash flow, but that one driver can experience the most circumstantial change. Poor decision making or circumstances outside an investor’s control can drastically impact this driver’s ability to build wealth.
The other four drivers? You can pretty much set ‘em and forget ‘em. They’ll continue to build wealth while you sleep. At some point, you’ll wake up owing much less on your loan and have a lower income tax liability. You’ll also have protected yourself against inflation and watched your property appreciate in value. All without really trying to do more than find a great CPA and property management company!
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