What a deal! Real estate pays you in 6 different ways! Yep, that’s a lot of streams of income. So even if your property is “cash flow neutral”, which I would definitely try to avoid, you’re still making money in at least some of the other 5. And here they are in no particular order.
Cash flow is simply the money that goes into your pocket each month. It’s income minus expenses. When you’re buying a property, this is the metric you should use to evaluate whether or not it’s a good deal. Remember, cash flow negative properties CAN make you money, but if you buy one, you’ll have to subsidize if for a while from other income. I only buy properties that are at least somewhat cash flow positive.
Appreciation (Market Appreciation)
Aside from the bubbles that have occurred lately in real estate, houses and apartments typically appreciate at slightly above the rate of inflation nationwide and in some markets, much more. I never count on a proprety appreciating in value because I consider this more in the realm of “speculation” and I’m not a good speculator. When my properties do appreciate in value (which they always seem to do), it’s a bonus.
Appreciation (Forced Appreciation)
If a $500 upgrade (say, new paint and carpet) allows you to raise the rent by $100 / month ($1200 / year), you have just increased the value of your asset many times the amount spent. As a property owner (unlike the owner of other investments), it is in your power to make these improvements. Your $500 investment pays itself back through increased cash flows ($1200 a year in this case), and through increase property value which can be accessed by selling the property or taking a loan out against it or using it as collateral for buying other houses.
When you buy a property, you will (hopefully) not buy it at full market value. If you buy an $100,000 property for $80,000, you have just added $20,000 to your net worth. Like Forced Appreciation, this $20,000 isn’t immediately available to you in cash. However, some investors will immediately refinance properties like these at the full market value ($100,000 in this case) to pull out their cash for another deal.
If your property is financed with a land contract or bank loan, part of the rent each month will go toward principle paydown. Your liability (debt as a mortgage or land contract) will eventually paid off as you make your loan payments. Paying off a liability increases your net worth by increasing your debt. A few notes on principle paydown … the first is that you have to pay taxes on principle paydown. The second is that is does not show up on Quickbooks’ Profit and Loss report, only on the balance sheet. When you make a mortgage payment, part of that payment goes to interest (which can be counted as an expense) and part goes to principle (asset account to asset transfer rather than expense).
If you considered investing in real estate through a REIT, don’t do it! You may take advantage of market appreciation (through an increase in share price) and possibly cash flow (through dividends) but that’s the end of it. You don’t get any of the awesome tax advantages that real estate provides. For starters, any and all expenses (including mortgage interest and meals with prospective buyers or sellers) can be written off of your income or “expensed”. Furthermore, and this will merit it’s own entire post, is depreciation. The IRS allows you to take 1 / 27.5 of the value of the property (building only, not land) and consider it an expense. That’s right, you can expense something that didn’t come out of your pocket and write it off of your income at tax time.
Not every property will always pay you in all 6 ways although if you buy a house using a loan and rent it out, it will as long as the market is going up and you make some improvements. Flippers or folks that buy properties using cash (as opposed to loans) may not get the benefits of one or two of the six but still benefit way more than what is possible with bonds or equities or other “paper investments”. Just know that when you start buying property (even if it’s just one rental house), you will start a snowball of income that will increase exponentially and very quickly relative to your other investment choices.