Think rental properties are ONLY good for cash flow?
If you have a buy-and-hold strategy with real estate — in other words, if you are the proud owner of a rental property — you may think that the only money that you earn is through monthly cash flow.
If your property grosses $1400 per month, for example, and you net $200 after expenses (including your mortgage), you may view that $200 per month as the cash return on your investment.
While that’s true, cash flow isn’t the only way in which landlords earn their money. Rental property investors derive returns through both cash flow and equity appreciation. In this article, I’d like to talk a little bit more about how a buy-and-hold investor builds equity.
If you’re holding on to your properties for several years, you’ll build equity in three ways:
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1. Initial Appreciation.
I’m using “appreciation” in a very broad sense of the word. The initial appreciation that you earn from your investment is the immediate equity gain that you enjoy the moment you sign the closing documents. In other words, this “appreciation” happens on the day you buy the house.
If you’ve purchased the house correctly, then you’ve bought the property at a discount relative to comparable properties. In other words, if every house on the street is a three-bedroom, two-bath brick ranch selling for $100,000 and you’ve bought the house for $90,000, then you’ve bought it at a 10% discount relative to comparable properties, and by extension, you’ve immediately enjoyed 10% instant appreciation on the day that you made the purchase.
Why would a seller offer a house at a discount? There are plenty of reasons. Perhaps the seller needs to move out of state in a hurry, and just wants to get the house off of his hands. Perhaps he’s a distressed seller who is in financial difficulty, and needs to cash out right away. Perhaps you picked up the house at a foreclosure auction or an estate sale.
Whatever the reason, there are plenty of houses that are available at discount relative to comparable properties, and this forms the first piece of appreciation that you’ll receive.
2. Equity Growth Over Time.
One of my favorite facts about rental property ownership is that not only do you receive monthly cash flow from day one (if you’ve bought correctly), but also your property will appreciate in value as time goes on. This appreciation is the icing on the cake. You buy for the cash flow, and you enjoy the appreciation as a bonus.
At a minimum, your property should appreciate at the same rate as inflation. In other words, real estate — by its very nature — is an inflation-protected investment.
Of course, there are exceptions. Some cities or towns that are heavily reliant on one employer or one industry. If that employer or industry dries up, these become ghost towns, and the real estate crashes along with it.
However, assuming that your property isn’t located in an area that experiences one of these unfortunate exceptions, you should be able to expect equity appreciation that at a minimum proceeds at the rate of inflation, or in the best case scenario, proceeds much faster than that.
3. Debt Pay-Down.
Your equity growth will come from both immediate appreciation as well as appreciation over time, but those aren’t the only two sources of equity gains.
Let’s not forget that tried-and-true, old-fashioned way of building equity, which is by paying down debt. The more you pay down the debt on your existing properties, the more equity you’ll gain, and if you choose to, you can borrow against this equity for future real estate purchases.
You’ll have to make a strategic decision as to whether you want to apply your free cash flow towards accumulating more properties or paying down the debt on the properties that you already own. There’s no right or wrong answer. Your decision will depend on market conditions, your risk tolerance, and your personal goals.
Regardless, however, the fact remains: Debt pay-down, if you choose it, is one of the safest and best ways to gain equity in your properties.
These are the top three ways in which buy-and-hold investors gain equity in their portfolios. But at the end of the day, equity is only secondary. Cash is primary.
Equity is nice, but it’s not the reason to hold a real estate portfolio. The reason that we hold is so we can enjoy the monthly cash flow — the passive income — that comes from the rent on our properties. Buy a property that cash flows nicely, and then, as a bonus, enjoy those equity gains that come along with it.
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