I was sitting with one of my mentors a couple days ago, and I was talking about one of the rental properties I own and how I lost so much money on it because it had a bad year a couple years ago. My mentor looked confused and asked me how I thought I had lost money on it. I said, “Well, it had a crazy amount of vacancy and had some repairs during that time and… ugh.” He said, “Didn’t you just refinance the property, though?” I said I had, yes.
He asked the basic numbers on the refinance, and suddenly the conversation went full-swing into the analysis of this rental property that I swore I had lost money on. The analysis provided such a cool understanding for me in terms of where the financial benefits with a rental property really come from. This was such an interesting and uplifting understanding that I want to share it with you here in case you are toying with the idea of buying rental properties or trying to better understand for yourself where the financial awesomeness is with rental properties.
I want to first start by explaining the sources of income you can expect to see when you own a rental property. I’ll finish off with telling you some specifics about the property I own that started this whole conversation in the first place, so you can have a real world example to further illustrate what I’m talking about.
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Rental Property Income Sources
How many of you truly know the ins and outs of rental property math? What makes a rental property profitable? Can you lose with a rental property? Where all does rental property income come from?
Monthly Cash Flow
This is one of the most common sources of rental property income that people strive for. Monthly cash flow is the amount of money you pocket each month after all expenses on the property are paid (taxes, insurance, repairs, mortgage, etc.). A word to the wise if you are shopping for a rental property: More properties than not don’t actually cash flow!
I want to be very clear about this cash flow thing. This is potentially one of the biggest flops that happens to new investors — they don’t know how to do the math. If you’re like me, you may have grown up believing and hearing that if you just own a rental property, that is financially smart. Wrong. Learn how to actually do the math! To learn the math for monthly cash flow calculations and how to determine if a property is expected to provide monthly cash flow, check out “Rental Property Numbers So Easy You Can Calculate Them on a Napkin.”
The only time monthly cash flow should not be a part of your consideration when shopping for a rental property is when you are specifically buying a property with hopes of appreciation. This is most common in the California cities, especially Los Angeles and San Francisco. Properties in either of those won’t allow for positive monthly cash flow by any stretch of the imagination, but those cities are known for gigantic bouts of appreciation.
Because of this, a lot of people are willing to not only forego positive monthly cash flow but actually have to pay out each month in expenses — all while waiting on the expected appreciation. I’ll hit more about appreciation in a second, but understand that receiving monthly cash flow should seriously be in your plans, unless you are purposefully going for the appreciation attempt (but don’t do that if you aren’t highly educated on that method of investing because it is, in fact, speculation).
Appreciation is awesome. As I said above, there are cities that are known for extreme appreciation. On the flip side, there are cities that are very stable and don’t appreciate much. Then, of course, there are cities that decline. But for the most part, appreciation is a pretty consistent trend — the value of a house typically goes up. This is more or less an inflation thing. But in this case, inflation is working in your favor rather than against because you get to take advantage of the increased value, regardless of how much less you paid for it. Shazam!
As I mentioned in the monthly cash flow section, investing just for appreciation is an actual method of investing. I can’t personally speak to it because I’ve never done it, but there are cities and markets out there that have pretty stable trends for insane amounts of appreciation. Timing is critical for this method of investin. Purchasing for cash versus financing is a huge consideration, as well as knowing that investing solely for appreciation is, in fact, speculation (ask all of the investors who bombed in 2009 what they think about speculation). Therefore, the risk is pretty high.
A last note about monthly cash flow and appreciation: Most markets are some kind of combination of monthly cash flow and appreciation. Some markets have only monthly cash flow and no appreciation potential. Some are good for only appreciation potential and no monthly cash flow. Some allow for good monthly cash flow with a good chance of some level of appreciation, and some may offer neither. Understanding market fundamentals is key because each variation of monthly cash flow potential vs. appreciation potential poses a different level of risk.
This is a hidden bit of income awesomeness that people don’t realize about rental properties. Tax benefits may sound lame and negligible, but they actually aren’t! Why are they relevant? Well, let me back up. Rental properties, as far as the IRS is concerned, fall under the category of “passive income.” This is important because “passive income” is taxed very differently than “active income.” You know how you get your paycheck from work and there is a huge chunk taken out for taxes? Well, that income you earned working is “active income,” and that income is taxed significantly. I mean, 30% ballpark for average tax brackets — that’s a lot of money you lose out to taxes! Well, what if you didn’t have to pay that amount in taxes? Think about it.
Enter passive income, stage left. Without getting into the details of how all the calculations work, after all of the write-offs you get on your rental properties, your rental property income essentially becomes tax-free. Passive income just doesn’t take the same level of tax hit as active income. It’s just like if you suddenly didn’t have to donate 30% out of each paycheck. Whoa!
It’s even possible to earn extra money due to the write-offs, in addition to saving on what taxes you otherwise would have had to pay! This is due to depreciation. Depreciation assumes that your property experiences wear as time goes on, and the IRS allows for you to write that wear off. I’ll show you one of these calculations here in a minute when I tell you about my own property, but know that the depreciation write-off is especially significant when it comes to how much you get to pocket in tax benefits, in addition to any monthly cash flow and appreciation you get.
One of the coolest things about a rental property? It depreciates and appreciates all at the same time! What other asset can you think of that you get to earn income in two completely opposite directions like that?
Applying These Income Sources to an Actual Property
My reason for writing this article is not so much to just explain to you all the ways you can earn income on a rental property, but rather to use that information to circle back around to some of the things you should be considering when you start shopping for a rental property. The first consideration should always be the numbers, and the second thing should be risk levels. Each combination of monthly cash flow versus appreciation will pose different risk levels, and then of course property type and location and all that will contribute as well. For now, though, I’m sticking with the numbers.
I’d like to introduce you to one of the properties I own. I think this beaut has shown her face in a previous article or two, but she’s one of my favorite ones to talk about because of how much I’ve learned from her. She also happened to be the subject of my recent conversation about numbers with my mentor.
As I mentioned earlier, my claim was that I had lost a lot of money on this property due to extreme amounts of vacancy and some repairs. But then some other things came into play that threatened to argue this claim. So I’m going to lay all the numbers out for you here, and then we’ll discuss. Here is a picture of the actual scratch sheet of paper we did this on (sitting in the airport in Costa Rica):
A Quick Summary of the Numbers
Purchased in 2012 for $95,000 with a 50% down payment ($47,500). Refinanced in 2015 with an appraisal of $130,000 and a 30% down payment ($39,000). You can see both of those at the top of the sheet. On the right side, you then see where when I refinanced, the $47,500 in original loan had to be paid back so that is subtracted from the now $91,000 loan (if no loan had to be paid back, I would have pocketed the entire $91,000). That left $43,500 in profit, and that’s what I walked out with in my pocket.
To be fair, however, the down payment amounts were different between the two loans, so to calculate my true profit, I needed to subtract the $8,500 difference from that $43,500. That leaves me with $35,000 pure profit in my pocket (which also happens to be the amount of appreciation gained on the property in three years, as seen by looking at the difference between my purchase price in 2012 and the appraisal in 2015).
Now, let’s look at this. If you’ll notice, this $35,000 (in only three years) in profit isn’t even taking into account any monthly cash flow I was receiving during that time. This chunk of profit is solely due to appreciation. What about the tax benefits? Depreciation is only calculated on the structure, not the land, so roughly $82,500 is depreciable. The tax calculation calls for this number to be divided over 27.5 years (don’t ask me why), so that equals $3,000 per year. This is the amount that gets written off each year on my taxes.
What does that translate to in terms of cash in pocket? Well, let’s say you are in the 33% tax bracket (we’ll round it to 30% for calculation purposes). This would mean you profit $1,000 (1/3 of the $3,000). So in three years, you could add $3,000 in tax benefit income to the $35,000 in appreciation income. So $38,000 cash in pocket! Again, that’s not including any monthly cash flow from the property, of which it gets about $200/month.
There are some variables left out of all of this that are present in real-life. The first one is fees to finance and refinance. The second is that since the loans were newer, the majority of the mortgage payments I was paying out during those vacancy periods (i.e. lost monthly cash flow months) was interest, which is an additional expense that should be taken out of that profit. But then in my favor, I also left out the additional write-offs on the property for all of the expenses that happened on it. But let’s be conservative again and say all of the left-out expenses totaled $10,000. That is still $28,000 in my pocket, in addition to any monthly cash flow I got.
So did I really lose on this property when it had a bad year? Not even close!
Here’s what I really want you to understand after reading all of this. There are multiple ways to earn income on a rental property, and the best risk mitigation you can do in buying a rental property is to buy a property that has a good chance for income in all of these areas. Why? So if any one stream of income fails, you have the others to help keep you afloat.
I thought I was in the negative with this property because of a bad year that caused it to basically tank on the monthly cash flow. However, appreciation and tax benefits took charge and not only kept me afloat, but also allowed me to graciously pocket a pretty penny.
What if you were to buy a property that had no hope of monthly cash flow and only appreciation, and the appreciation ended up not happening? You’d be way into the negative! What if you buy a property that projects having monthly cash flow but it is in a declining market, so instead of appreciating, it actually depreciates, and something happens to your monthly cash flow? You’re in the negative. Tax benefits won’t save you from either of those situations.
What is the best thing you can do? Buy a property that pencils out to provide positive monthly cash flow and is in a growing market (hopefully at the beginning of the “proven” growth cycle). Then you have a good chance of both monthly cash flow and appreciation, so if either of those have hiccups, you don’t suddenly end up in the hole.
And then imagine carrying out this theory of risk mitigation to the strategy of owning multiple rental properties. So we determined one property has three sources of income, so if you have two properties, you have six sources of income. What if one of those properties is a duplex or a fourplex? Add additional monthly cash flow streams for each door. The more doors you have, the more streams of income you have, and the more you can continue to profit if any one of those streams flunks out for some period of time. Holy mother of risk mitigation! Then just make sure you are buying a smart property in terms of quality, price, and location — and you suddenly own the golden egg!
What is your experience with the numbers on your rental properties? Anyone have major cash flow or appreciation wins they want to share?
Let’s talk in the comments section!