How to Make Money with Real Estate
interested in investing in real estate, but don't know where to
begin? Or wondering how investors actually make money? The real
estate industry is complex, but in a simple way. Nearly all of the
complexity stems from a few simple fundamentals. When you start with
these basics, the more complex subjects are much simpler. We'll
start with cash flow and appreciation — most investing strategies
are centered around one or both of these.
When you rent a house or an apartment to a tenant, they send you a monthly check. The amount left over after setting aside money for future repairs (CapEx) and paying the mortgage and all other expenses is the cash flow. It's cash in your pocket every month, it's easy to estimate accurately and, over the long-term, it's a stable source of income. For many investors, cash flow is their bread-and-butter.
value of a property increases over time (at a rate higher than
inflation), it's called appreciation. It's helpful to differentiate
between two types of appreciation — natural and forced.
If you renovate a property and increase the value by more than
the cost of the renovation, that's forced appreciation. Essentially, you've forced the value of a property higher by remodeling. This can be
quite profitable, but it requires a learned skill — you must
accurately estimate the cost of the renovation as well as the
post-renovation property value.
demand increases in a market over and above inflation, that's natural
appreciation. When appreciation simply matches inflation, it's
inflation, not appreciation. Historically, real estate has done just
that — matched inflation. That's good for providing a hedge against
inflation, but not so much for getting rich. But it's not quite that
United States has thousands of individual real estate markets
(cities, towns or neighborhoods) that are largely independent of each
other. In each of these markets, real estate prices simply follow
demand. When demand is increasing in a city or neighborhood, real
estate prices increase. In areas that are falling out of favor with
people, demand decreases and prices stagnate or fall. At nearly any
given time, there are hundreds of markets moving in both directions.
When you see U.S. real estate as thousands of smaller markets instead of one big one, you see appreciation. Cities like San Francisco and New York have been outpacing inflation for years.
By now, the
other side of the appreciation coin should be obvious. If the U.S. real estate market is roughly tracking inflation and there are markets that are appreciating, there have to be markets depreciating somewhere.
which markets are which is harder than it looks. Determining
appreciating real estate is a learn-able skill, but it is much more
difficult than estimating cash flow. Appreciation is an important
component, but it's one that must be respected.
Principal Pay-down and Tax Savings
pay-down is often described as another way to make money in real
estate, but it's not really. Mortgage payments are a liability — an
expense. But they do come with a bonus. As you make mortgage payments over the lifetime of a loan, you go from having 20%
equity (or whatever your initial down payment was) to owning the
property free and clear. The principal portion of these payments is
converted to equity and can be recouped later.
lifetime of a mortgage, this can be a nontrivial sum of money. You can avoid paying a cent of it from your own pocket if the the
property is cash flow positive.
expenses like repairs, property taxes and the interest portion of
mortgage payments can be deducted. Deductions improve the bottom
line, but they're not exactly something to build an investing
strategy around. There are two tax benefits with a significantly
larger impact on the bottom line — 1031 exchanges and depreciation.
exchange allows you to defer capital gains when you sell a
property by trading it for similar one. This is perfect if you have experienced significant appreciation, but want to sell
without having a large tax liability. For many investors, this is an
important part of their strategy.
properties and the cost of their improvements can be depreciated.
Depreciation is basically a deduction that is spread out over many
years (for most residential real estate it's 27.5 years). This is
over-simplified, of course. As with most IRS codes, there's more to
it than that. (Here's one example: Only the cost of the buildings can
be depreciated, not the cost of the land.)
The short version is that you can depreciate (slowly deduct) the cost of improvements and the building itself, but to ensure you're compliant with the IRS, work with an accountant.
Thoughts on Leverage
estate is expensive. In many cases, leverage allows people, who
otherwise couldn't afford it, to buy property. But there's a more less obvious benefit to leverage.
without any appreciation, you can profit from inflation by
using leverage. As we discussed above, when a property with no
mortgage moves lock-step with inflation, it's not really
appreciating. It's experiencing inflation. The owner's equity is a
higher dollar value, but he's not wealthier,
imagine the same property with a mortgage on 75% of it. This leaves
25% equity for the owner, a 4:1 leverage ratio. If both the
property's value and inflation increase by 3% one year, that 3%
increase translates to a 12% increase in equity — 9% after
inflation. Of course, high appreciation rates can yield even bigger
equity increases. But there's a dark side to this.
Financial leverage is a force multiplier, but it works both ways. A property that is leveraged 4:1 and decreases in value by 25% leaves it's owner with no equity. In fact, unless inflation is nonexistent, they're underwater.
Leverage is a sharp tool. Wield it carefully.
Master the Basics to Master the Complex
There is a lot more to understand about real estate than I've listed here, but these are some of the most important principles. They are the foundation for many of the more complex strategies. If you really want to master the complexities of real estate, master the basics and the rest will follow.