7 Ways Rental Properties Make Money

The 7 Ways You’re Making Money

Investing in real estate has been a time-proven method for ordinary people to build massive wealth and historically outperforms many other investment options. What makes this investment class so unique is it’s multi-dimensional nature – offering seven diverse ways that rental properties make money.

Let’s dive into each of these streams and explore what they mean to your bottom line:

Cash Flow

The term cash flow refers to the money left over from rental income after all expenses have been paid. It’s also often referred to as net income, which is the income remaining after deducting expenses from the gross income, the total income before expenses.

Cash flow can either be positive or negative. Positive cash flow means there is excess income after covering all expenses, resulting in a profit that goes straight into your pocket. On the other hand, negative cash flow occurs when expenses exceed the income, requiring you to cover the shortfall out of your own pocket.

To calculate your cash flow, it’s important to choose a specific timeframe, such as monthly or yearly, for analysis. Next, sum up all the expenses incurred during that period and subtract this total from the overall rental income. The resulting amount will represent your cash flow.

For example, let’s say you purchase a $150,000 rental home. If the rental income is $1,500 per month and your expenses and mortgage payment (PITI) are a total of $1,300 per month, your net cash flow is $200 each month or $2,400 per year.

While cash flow may not provide the highest profit margins, it serves as a critical foundation for successful rental property investing. Positive cash flow can offer stability and financial security, allowing you to weather market fluctuations and make informed decisions about your property investments. By understanding and managing your cash flow effectively, you can set yourself up for long-term success in the rental property market.

Appreciation

Appreciation can be broken into two different types; natural appreciation and forced appreciation. Both can add significantly to your bottom line net worth.

Natural Appreciation

Natural appreciation refers to the natural value increases in real property over time. Unlike consumer goods such as vehicles and electronics, real estate is considered an appreciating asset. According to the Freddie Mac House Price Index report, average home prices in the U.S. have increased more than 37% over the past five years.

That means that if your purchased a home for $200,000 in 2018 it would be worth roughly $274,000 today, equating to a $74,000 gain in appreciation alone. Now, appreciation can vary widely in differing markets but on average, in the United States, homes appreciate at roughly 4.3% per year. The mad rush on housing at rock bottom interest rates in the last couple of years have skewed those rates much higher.

Forced Appreciation

The process of rehabilitating a property can lead to appreciation, and in most cases, the value of the property after the rehab will exceed the total expenses incurred to complete the renovation.

As an example, let’s consider a scenario where an investor purchases a property for $200,000 and invests an additional $40,000 rehabilitating it. Upon completion, the property’s value rises to $270,000. But here’s the takeaway: despite spending a total of $240,000 ($200,000 for the purchase and $40,000 for rehab), the property’s current value is now $270,000. Which means those improvements equate to an additional $20,000 in value, essentially representing a profit that was generated by the rehab process.

The term used to describe this type of appreciation is “forced appreciation.” It earns this name because it stems from the deliberate efforts made by the investor to enhance the property’s value. This is in contrast to “natural appreciation,” which we referenced above and refers to the increase in a property’s value over time due to market factors without any active intervention by the owner.

Principal Pay-Down

One of the greatest financial advantages to owning rental property is the potential for your tenants to literally pay down your mortgage. In an ideal scenario, the rental income should exceed the mortgage payment, as well as all other expenses, leaving you with additional income (cash flow).

Let’s paint a picture to understand how this works: Suppose you purchased a rental property valued at $200,000 and make a 20% down payment, which amounts to $40,000. This means you have a remaining loan balance of $160,000, which includes interest payments over the life of the loan.

Over the course of a 30 year term, the rental income you receive from your tenants helps to pay down the mortgage balance every month. Gradually, as the years go by, the $160,000 debt is reduced until, at the end of the 30-year period, the entire mortgage is paid off, and you become the outright owner of the property. Which means you’ve just turned $40,000 cash into $200,000 in equity and that’s even before appreciation is considered.

Tax Benefits

*Disclaimer: We are not tax experts. You should consult your CPA for all tax matters involving your real estate investments.

Rental properties offer considerable advantages within the IRS tax code, potentially leading to tax-free income if managed correctly. And while it may not appear as immediate profit, let’s examine the impact on your regular income tax.

If you find yourself in the 24% tax bracket, you could end up paying a substantial $24,000 in taxes on a $100,000 income. Now, imagine if you could retain that $24,000 instead. That’s a significant amount of money saved, and you remember the whole ‘a penny saved, is a penny earned’ phrase, right?

The primary way rental properties offer tax breaks is through write-offs. When you deduct an expense, it lowers your taxable income, ultimately reducing the amount you owe in taxes. If you have enough valid write-offs to substantially decrease your taxable income, it could significantly lower or even completely eliminate your tax liability.

Write-offs for rental properties primarily stem from two sources:

By taking advantage of these expense and depreciation write-offs to lower your taxable income, you can significantly reduce your annual tax liability. Ultimately, this translates into real profits in your pocket, making rental properties a compelling and financially advantageous investment choice.

Hedging Against Inflation

Owning real estate is a nearly flawless way to hedge against inflation. Since 2016, the annual rate of inflation in the U.S. (save for THIS year) is about 2% per year, according to the Federal Reserve. On the other hand, real estate prices in the U.S. have grown an average of almost 11% per year over that same period. That means that house prices have outpaced inflation by a factor of almost 5.

Let’s stretch this comparison out a little further: Since 1970, housing prices have eclipsed the national inflation rate by 150%. To put that into dollars – if home prices grew at the same rate as inflation during this time, the median home price today would be just $177,788 instead of over $408,000.

Amortization

The single most unique facet of investing in real estate that sets it apart from all other investment vehicles is amortization. The fact that you leverage debt to ‘get into’ the investment for less than it’s value makes it unique. What other investment class do you know of that you can buy into for as little as 3.5% down?

Could you go to your Fidelity advisor and tell them that you want to buy $100,000 worth of Apple stock and ask them to finance $96,500 over 30 years? With real estate you can. And these smaller buy-ins allow you to invest in multiple properties – each of which is putting money in your pockets in the same seven ways.

Self Funding

Last but not least, investing in real estate becomes self-funding when you use what experienced real estate investors call the BRRRR method – buy, rehab, rent, refinance, repeat. Here’s how self-funding for real estate investors works. 

Assume you buy a single-family rental property today and put all of your monthly net cash flow profits into a special reinvestment fund. After a few years – thanks to the combination of your savings plus appreciation and amortization – you’ll have enough equity to do a cash-out refinance to raise the down payment to buy another single-family rental property. 

After another few years, you can do the same thing, over and over again. With forced equity, the savvy investor could even accelerate their purchases.

Bringing it all together

Knowing how rental properties can generate profits is truly exciting, especially considering that these profits come from seven distinct sources. As an investor, gaining a comprehensive understanding of these profit centers is one of the best strategies you can employ. Applying this knowledge to your analysis when evaluating potential rental properties will greatly enhance your decision-making process.

By recognizing and harnessing the power of these profit centers, you can maximize the financial benefits and set yourself up for successful and rewarding rental property investments.