Thinking Beyond Cash Flow: 3 Underappreciated Real Estate Wealth-Builders
No one buys rental properties or invests in real estate to lose money. Losing money should never be a goal for any investor in any asset class. Although we are in a very different economy than we were the past few years, the strategy is still the same: Preserve capital and grow your investment.
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Most people will look at what the cash flow is on their rental property and think that’s all there is to it: cash flow. But this just isn’t true. There are (at least) three additional ways that real estate pays off.
3 Overlooked Real Estate Wealth-Builders
Appreciation is usually a great long-term play, but in this market, it is proven possible to be a short-term play also. Appreciation is the value of your property whether through upgrades, market cycle, or location. Depending on your market, real estate can go up in value from as little as 1% per year to 10%-plus per year, just by holding on to it.
Of course, the economy has a lot to do with appreciation, as does the individual market. Strategically selecting the property’s location is big way to play the appreciation game. Say you bought a house in an area of town that is on schedule for some community development, such as a shopping center or other attraction. This can amount to a huge payout for you, as more than likely people will want to live closer to such amenities.
And there are several other factors in the appreciation equation, as well. Forcing appreciation is usually done by flipping or adding value to the property. Updating your kitchen, bathroom, etc. can dramatically increase a home's value.
On larger multifamily properties this can be accomplished by increasing rents, changing the tenant base, and improving property management. Anything that you can do to increase the net operating income, or NOI, of the property is forcing appreciation. This is because usually commercial multifamily properties are priced based on a cap rate derived from net operating income. The higher the net income, generally the higher the property value.
For single-family homes, this is typically done by using comparable properties in that neighborhood. Increasing the square footage, updating the finishes and fixtures, and improving the curb appeal can boost appreciation. House flipping, in particular, is based solely on forced appreciation.
Real Estate Tax Benefits
Owning real estate has huge tax incentives. The depreciation schedule alone can have a massive impact on your end-of-year tax returns. As of this writing, you can depreciate the price of your rental property over 27.5 years. That comes out to a 3.636% depreciation rate per year.
There are also 1031 exchanges that you can use to defer your capital gains and purchase bigger properties.
And let's not forget about the little-known secret of cost segregation. Cost segregation is a tax strategy that allows real estate investors to use accelerated depreciation to increase cash flow. This is done by breaking down and reclassifying certain interior and exterior components of a building. These components are depreciated over 39 or 27.5 years for commercial and residential properties, respectively.
Having a great accountant on your team is paramount. Be sure to choose an accountant that is familiar with the tax advantages of owning real estate. There are many tax advantages and tax writeoffs that people are surprised to know about. Buying supplies—from printer paper to a cell phone—can all be used as tax writeoffs. From upgrading the flooring in an apartment to putting on a new roof, all of this has tax advantages.
Principal Paydown of Loan
If you have a loan on your rental property, this is a huge piece of your wealth. Your tenants are not only paying to live in your property every month, they are also making your loan payment for you. If your loan is on a principal and interest schedule, then a portion of your monthly payment is going toward the principal. (This just means the bank is taking a little for themselves and putting a little towards your principal.)
If your loan is interest-only, or I/O, this just means the bank is taking all of the payment (and usually for a short period of time—typically between six months to three years, depending on the property and lender). The payments are smaller than principal and interest payments, but none of it is going toward your balance.
You may utilize these types of loans when buying a property that needs work, such as rehabbing or increasing the quality of tenants. Having a large vacancy at closing or because you plan on removing a majority of the tenants can be another reason for wanting to use an interest-only loan.
Principal paydown is probably the second most important part of a real estate deal behind cash flow. Your debt today is your income tomorrow. If you have a mortgage payment of $1,200 per month for the next 20 years and your average monthly cashflow is $300, your net income once that property is paid off is going to be $1,500 per month! This is why I don’t always just pay attention to cash flow.
Owning a large apartment building with a $13,000 per month mortgage can literally be your retirement in 20 years. Just imagine owning two or three large properties and a handful of single-family rentals. Paying off these mortgages will catapult you into wealth you've only dreamed about.
The Bottom Line
Real estate is one of the best investments a person can make in their lifetime. The historical returns and wealth-building powers of owning property are what can set you apart from the average person.
Cash flow is by far the most important part of running your numbers. It determines the value of the property and whether or not it can be leveraged against. But educate yourself on the other advantages of real estate, and you will set yourself up to make the most of this investment type.
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