Making Money From Real Estate: What Are Your Sources of Income?

September 7th, 2021 by Matthew Fraker

You have decided to start investing in real estate, which according to The College Investor, is responsible for creating the wealth of 90% of the world’s millionaires. If it’s done using tried-and-true principles, real estate can be a very profitable venture. 

So, what are the types of returns that make real estate a good investment? I should preface this by saying that it’s not as simple as buying a property and hoping to rent it for more than the mortgage payment. While this is undoubtedly part of the equation, it’s essential to have a greater understanding of how you make money and grow wealth. I like to remind myself that money, while part of wealth, does not equal wealth. When you collect rental income, you receive cash, which could eventually develop into wealth combined with equity growth. 

As mentioned in previous posts, it’s also important to reiterate that building wealth through real estate investments takes time! While it is possible to realize relatively quick and enormous equity gains through appreciation—as seen in Charlotte, NC lately—I don’t rely on it. According to Canopy Realtor Association, Charlotte saw a 16.9% increase in average sales price year to date, compared to 4.9% during the same period in 2019. I like to think of appreciation as a bonus on top of the other sources of income. That’s not to say that many investors don’t speculate, hoping for massive appreciation. Sometimes it works, but if the market takes a turn, you could lose money. Numerous websites outline the dangers of speculation citing the losses investors suffered during the Great Recession in 2007-2009. 

So, what are the sources of real estate returns?

Cashflow:

You will collect rental payments from your tenants when you rent a property, also known as your gross rental income. Cash flow is the difference between a property’s gross income and expenses. Keep in mind that each property will have a different set of expenses. When doing an in-depth analysis, cash flow can be further broken down into baseline cash flow and cash flow growth from performance; however, I will refer to the income as a cash flow to keep this simple. If you have positive cash flow, then your earnings should exceed the cost. When I represent investors, I try to identify return percentages achieved through a cash flow stream earned over years of owning a property.

Appreciation:

Appreciation is an increase in value resulting from numerous factors, one of which is a decrease in supply, leading to a rise in demand. There is only a finite amount of land in the world, and once developed, additional acreage can’t be added, a problem that a steadily increasing population has compounded. I purposely separate land and structures because structures will depreciate over time due to three primary causes, which I outlined in a previous post here. That is not to say you cannot or should not make improvements to a property. Specific enhancements could increase in value. This is called forced appreciation, and a good investor will typically look for opportunities there. Location is also a demand driver that can have a considerable impact on appreciation. Many facets of a good location, such as amenities and schools, can impact appreciation. Investopedia has an informative article on the home value found here.

Amortization:

Amortization is one of my favorite sources of real estate income. Amortization is defined by the reduction of debt through a regular payment schedule. In other words, you are making regular payments (e.g., paying a mortgage once a month) to pay off a debt. When you get a mortgage from a bank, it will generally include principal, interest, taxes, and insurance, or PITI for short. For the first half of the mortgage term, the payments will typically be weighted towards interest. Ideally, your rental fees should cover the property expenses and mortgage, leaving you with cash flow. Amortization is a huge benefit of investing in property because if the math is correct, your tenant will pay off the property for you, increasing your equity or ownership stake on top of cash flow! I will illustrate the power of amortization in a property I recently analyzed.

The starting loan balance was $195,000. Remember that this doesn’t include the down payment, usually 20-25% of the purchase price. So, with a 30-year loan of $195,000 at an interest rate of 4.5%, your monthly payment will be $997.61. After five years of paying down the mortgage, you will only owe $177,514. You will have gained $17,486 in equity due to the mortgage payments alone. Not too shabby!

Tax Advantage:

I want to preface this paragraph by letting you know I am not a CPA, and it’s always best to check with your CPA regarding the tax benefits of investing. In any event, there are tax benefits to investing in real estate, such as depreciation deduction. Another tax-related perk is the 1031 exchange which allows you to exchange like-kind properties while deferring capital gains taxes and depreciation recapture tax. A 1031 exchange requires an intermediary or a company that can facilitate the process. As a broker, I have represented investors in finding properties for 1031 exchanges. It can be tricky to find suitable investments for a 1031 exchange as the investor has only a certain amount of time after selling a property to identify replacement properties. In any event, it can be a good option for investors. Again, it’s paramount that you check with your CPA regarding which decision makes the most sense for your situation. In the meantime, Forbes has an excellent article titled about tax benefits found here.

The content published in this post and other posts on this site are for informational purposes only and should not be interpreted as investment, tax, financial, or legal advice.