Five Ways To Make Money In Real Estate Investing.

Five ways to Make Money in Real Estate Investing.

So you want to know how to make money in real estate? I’ll show you how we do it. I should first clarify that by investing, we are not flipping, wholesaling, or selling real estate as a broker. Optimal real estate investing is the buy, improve, hold, and rent business model.

Here’s a bread and butter, single-family deal:

-3 bedrooms

-2 bathrooms

-2 car garage

-Built after 1978 (Lead paint was banished in 1977. We don’t prefer properties built before 1978.)

-After Repair Value (ARV):     $100,000

-Repairs needed:                   $14,000

-Purchase Price:                    $55,000

Monthly Income

Rents for:                               $1250

Monthly Expenses

Mortgage Principal/Interest:  $264

(30 year at 6% interest)

HOA:                                      $25

Property Tax:                         $250

Property Insurance:               $104

Total Expenses                      $643

Our down payment is 20%, or $11,000, of the purchase price. We never, ever pay more than 20% down if not required, and we always use 30 year terms. Real estate amateurs will either pay all cash or use 15 year terms, but you’re not here to be an amateur are you? Shake your head side to side. No, you are not. Thank you.

Cash Out of Pocket (COOP):

Down payment:    $11,000

Closing Costs:      $1,500

Repairs:                $14,000

Total COOP:        $26,500

1. UNREALIZED CAPITAL GAINS. This is the first way we make money in real estate investing. We always buy a property below its market value, or we simply don’t do the deal. In this case, the market value, or ARV, is $100,000. After repair value is the same as market value. We just use the term ARV if the property needs repairs. If not, we call it market value.

To calculate the Unrealized Capital Gain we use the following formula:

ARV – (Purchase Price + Closing Costs + Repairs)

Unrealized Capital Gain = $100,000 – ($55,000 + $1500 + $14,000)

Unrealized Capital Gain = $29,500

We just captured $29,500 in this deal!

To calculate our return we use this formula:

Unrealized Capital Gain / Cash Out Of Pocket

$29,500 / $26,500

Return on Capital Gain = 111.32%

How do ya like them apples! And guess what? We’re just getting started!

2. CASH FLOW. My favorite word in finance! Cash flow, baby. Now that we purchased this property we need to quickly rent it out. Our monthly expenses are $643, and the house will rent for $1250. That means we are profiting, or cash flowing, $607/month!

Cash on Cash Return (COCR) = Annual cash flow / Cash out of pocket

25.6% = $7284 ($607 x 12) / $26,500

Cash on Cash Return = 27.5%

3. PRINCIPAL PAY-DOWN. The rent covers and exceeds our mortgage payments. This means our tenants are paying down our principal. In this example, our monthly principal contribution is an average of $45, or $540 annually.

Return on Principal = Annual principal / Cash out of pocket

2% = $540 / $26,500

Return on Principal = 2%

It’s not much in the beginning, but it does increase each year.

4. APPRECIATION. Appreciation is only icing on the cake. Professionals never, ever invest for appreciation. Appreciation is speculation. However, in this example we will assume an annual 3% appreciation.

Appreciation = 3% x ARV or Market Value of Property

$3000 = 3% x $100,000

Appreciation = $3000

Return on Appreciation = Appreciation / Cash out of Pocket

11.32% = $3000 / $26,500

Return on Appreciation = 11.32%

Nice.

5. Tax Advantages. Tax advantages are technically savings, not earnings. However, it’s okay to think of them as earnings. Due to our favorite accounting word, depreciation, we are legally entitled to pay little to zero in taxes. Always consult a tax professional for tax advice. In a nutshell, the IRS will allow you to depreciate a single family rental home over a 27.5 year term. To do this, you subtract the land value from your ARV, or market value, and divide that number by 27.5. That is the annual depreciation. For this example, let’s assume the land value is $10,000.

$100,000 - $10,000 = $90,000

$90,000 / 27.5 = $3273

Annual depreciation = $3273

Our annual profit, or cash flow, is $7284.

$7284 - $3273 = $4011

$4011 is the taxable amount in this example.

Assume we pay 15% in taxes, we will pay $601 (15% x 4011).

Without depreciation we would have been taxed on the full amount, $7284. That would have been $1093 (15% x $7284).

That’s a tax savings of $492, or 6.75%.

I should re-mention the disclaimer about consulting with a tax professional, as that is not me. They can show you more creative ways to further reduce your tax obligation. Always choose someone very familiar and experienced with real estate investing.

There is another little tax incentive for real estate investors called a 1031 Exchange. If you decide to sell this nice single family home in the future you can roll it into a 1031 and defer all taxes on your capital gain. There are some important terms to research, and once again, consult with a legal professional.

If you always use a 1031 in your investing career you will never have to pay taxes on your capital gains. That’s tremendous savings!

So let’s add up your annual investment earnings and see how we did.

Unrealized Capital Gain  $29,500 / 111.32%

Cash Flow / COCR         $7,284 / 27.5%

Principal / Return            $540 / 2%

Appreciation / Return      $3000 / 11.32%

Total                                $40,324/ 152.14%

Now, that is a real estate deal! We took $26,500 and created $40,324 for a return of 152.14%!! Where else are you consistently making money like that!

Want to know something that will make your head spin? You are not going to believe it, but it gets even better than that. Much, much better. Have you ever heard of a hard money loan?

With a typical hard money loan the lender will cover 70% of the After Repair Value. Using the single-family example from above that means the lender would cover $70,000. What does that mean? It means that we could have purchased this house with $500:

Cash out of Pocket with Hard Money = 70% ARV – (Purchase Price + Repairs + Closing Costs)

Cash out of Pocket with Hard Money = $500

70% of ARV:        $70,000

Purchase Price:    $55,000

Repairs:                $14,000

Closing Costs:      $1,500

Total                      $70,500

So what kind of returns would we have generated with $500 out of pocket?

Unrealized Capital Gain $29,500/  5900%

Cash Flow / COCR         $7,284 / 1456%

Principal / Return            $540 / 108%

Appreciation / Return     $3000 / 600%

Total                                $40,324 /8065%

If this doesn’t blow your mind then I probably can’t assist you. You may need serious help.

For the record, we would have certainly used a hard money loan on this deal.

Let me try one more on you. Can you believe it can get even better than that? How could it possibly!! I know!!

Let’s now assume that your repairs came in under budget at $13,500. Now, how much would the house cost you out of pocket? Yep, you guessed it. ZERO. ZIP. ZILCH. NADA. It cost you no money at all to purchase this house. What kind of returns would we produce with zero out of pocket? The answer is infinite. By definition, any return generated on a deal that cost nothing is infinite.

Friends, it can’t mathematically get any better than that.

Something to remember is that we invest purely for cash flow, unrealized capital gains, and tax advantages, but mostly just for cash flow. Principal and appreciation is only icing on the cake. Yet, I can’t tell you how many times I overhear people discussing improper real estate investing business models.

So that’s that. That’s a glimpse into the world of real estate investing. If you were unsure how it all worked then I hope this cleared it up. See why I love real estate?

If you’re jittering with excitement, and ready to get out there and start investing please remember one thing. Go get educated FIRST. Do not, I repeat, do not do this alone. Real estate investing is a team business. The best thing you can do is join a real estate investing group in your city. Seek out a mentor, or advisor. Fortunately for me I live in Houston, home to Lifestyles Unlimited, which I believe to be one of the best in the business.

Go join a real estate investment group and start enhancing your education today.

I look forward to hearing about your real estate deals down the road. Please keep me in the loop.