For those of you who have been regular readers, you know that I’m starting to get a little more involved in the real estate world with rental properties. As of this posting, I have a single-family home that I’ve been renting out for several years now and I recently purchased a duplex. I think that owning rental properties is not only a great way to start an income stream, but it’s also a hedge against having almost all our eggs in the stock market basket with our 401(k)s and Roth IRAs.
Although I’m now on my second property, I’m only now starting to get just how profitable investing in rental properties can really be.
So without further ado, here are the four ways to make money with rental properties…
# 1 Cash Flow
Most people who start investing with rental properties do so because of the possibility of cash flow. This is the passive income that we’re all familiar with… monthly rent from tenants. Do it right and you can put yourself on the road to success with cash regularly flowing into your bank account. Do it wrong and you can be losing money every month.
Like most newbie investors, I thought that cash flow was basically your rental income minus your mortgage payment. Sounds easy enough, right? Ok, well not so much. What about repairs? What about vacancies? What about planning for capital expenditures (CapEx) like a new roof or furnace that will inevitably need to be replaced?
I didn’t know better and never took those things into account when I bought my first house and started renting it out and I’ll admit – I got lucky. I don’t lose money on it, but I’m not really banking much on it every month. Once it’s paid off though, it will become a much better investment.
On the duplex that we bought, I had my financial mentor help me out and we did much better. We’re about to get the second side rented out and then we should be making a few hundred dollars a month even after taking into consideration the 50% rule. This is a definite win.
Here’s what I didn’t get before – you can figure out your cash flow almost to the dollar before you even buy a property. Whether you do it manually or use a calculator, you can pretty accurately figure out where you’ll stand with each property. This can help you whittle down your properties before you even look at them. If you think about it, cash flow is really the reason most investors are after property, so don’t fall in love with a property… fall in love with the numbers.
As a side note, think about this… if you have a fixed loan on your property, that payment stays the same on your loan, but market rent tends to go up year after year. So over time, your cash flow continues to increase until the property is paid off. Then you should really start rocking and rolling since you can take that payment out of your expense equation.
Most of us are aware of appreciation. In fact, if you own your own home, that might be something you periodically keep an eye on…
Hey, guess what honey? Our house is now worth $50,000 more than we paid for it… we’re rich!!
Homes usually go up in value over time – that’s appreciation. So if you pay $150,000 and sell it for $200,000, it appreciated $50,000.
In the rental world, appreciation is kind of like the icing on the cake. Although cash flow is king, if you decide to sell your property down the line, you obviously hope it sells for more money than you bought it for so you can bring home a nice chunk of change.
I’ve talked about my rental house not being in a good neighborhood and I can tell you that, even though I’ve owned the property for 13 years, Zillow shows it worth about $4k less than I bought it for – that’s not an example of good appreciation. You will generally want to buy in an area where property will likely appreciate, but again, I was pretty naive when I bought this one. However, I’m pretty content with renting it out, so I’m not too concerned with the lack of appreciation right now.
Our duplex, on the other hand, will probably show better appreciation over the years. It’s not going to skyrocket, but it should do better than the house has done.
#3 Tax Shelter
It’s taken me a lot of years to understand how a tax shelter works and why this is a big deal. The government tends to favor the landlording community because they’re providing (and hopefully fixing and improving) homes for people. So the tax code tends to give some good breaks to us.
Here’s a good example… so we talked about appreciation and about how homes tend to go up in value. However, the IRS lets you depreciate your rental property under the assumption that it will be worth less over the years. This is a nice deduction that you are able to take every year on your income-producing property (but not the land) for a set number of years (each of mine are good for 27½ years).
Also you get the mortgage interest deduction that you have on the property, which, if you own your own house, you know how helpful that is when filing your taxes.
And, you can deduct so many things that you do for the property. Picking up a rent check? Write off the mileage. Fixing something at the property and need a special tool for it? You can probably deduct the cost of the tool as well. I’m not a CPA, so please make sure to talk to yours first, but do understand just how valuable this can be for you.
Think about it this way…
Even though you may be making money on your rental property every month, you may still be able to show that you lost money over the year on it and get back a heftier refund.
I’m still learning the ropes on this and want to be sure that I do everything by the book, but at the same time, you need to understand how beneficial this can be. This was a huge reason why I finally hired a CPA – to learn how to best use tax strategies to my advantage.
When you get a bank loan, they will give you a schedule of how much you will be paying back over time until the loan is paid off. This is a loan’s amortization schedule.
One of the best things about rental property is that, assuming you’ve figured out your costs correctly, the tenants pay down your loan.
Although my rental house isn’t a big monthly revenue generator, I’ve had tenants paying off the loan for 7 years!!! That house will be paid off in just a handful of years and most of the loan has been paid by other people.
Since I don’t need the cash flow as much right now, I’m using some of the cash flow on the rental properties to get the loan paid off even sooner. This will then circle back to give an even better cash flow around the time I quit my job since I won’t have the mortgage payment on the rental house. The duplex will then be paid off a short time later.
BONUS #5 Leverage
Although not technically a way you are making money on rental property, think about how important leverage is in this equation. If you wanted to buy $100,000 worth of stocks, you better come up with $100,000. But, if you want to buy a house that costs $100,000, you can use other people’s money to make this happen. A bank or other lender will generally give you 75% or more toward this investment… and you get to keep ALL the profits it makes!!
So you can utilize leverage to get more bang for your buck than you can in any other investment (at least that I can think of)!! Using leverage properly – without overextending yourself – can be the biggest key to financial freedom.
Hope you enjoyed these… am I missing any or are there any that maybe you weren’t already thinking about?
Thanks for reading!!