Mrs. LifeOnFIRE and I jumped into single-family real estate investing for financial independence a little over two years ago. We funded our first few deals by cashing out our $80k Roth IRA. Since that time, we have invested a total of $240k of our own money, generating a $26.5k net cash flow and capturing $244k net equity!
If those results are surprising to you then you are in for quite a shock, as cash flow and equity are just two of the five ways you make money by investing in real estate! In this post, we’ll unpack the five ways starting and ending with the most important and impactful dimensions respectively!
1. Cash Flow
You may have heard it said that “cash is king.” Well, I humbly disagree… I say cash FLOW is king! The primary thing investors should be evaluating when prospecting a property is the cash flow potential.
My investment criteria when I got started was a 20% cash-on-cash return. This meant, if I were to put $25,000 of my own money into the deal, I should expect $25,000 * 20% or $5,000 a year in net cash flow. Those numbers, of course, are very market dependent. For instance, in my market, we are currently seeing returns closer to 10%.
2. Equity Capture
In real estate, you make your money when you buy, as opposed to when you sell. This is because investor’s target “distressed properties,” which are homes in significant disrepair or that are owned by a seller that needs fast money to resolve a financial situation. As a result, you can often buy these properties at a deep discount.
When you do get a property below market value, the difference between the purchase price and the value of the property is called equity. For several of my properties, we claimed $20,000 or more in equity with the purchase. Compared to a $25,000 down payment this is an instant 80% return on your money! I have one property where I made a 373% percent return on equity. These are rare, but they happen!
3. Principle Pay-down
Provided your property is rented, the renter pays your mortgage for you! In doing so, they help you cover the following obligations:
- Property Taxes
Property Taxes and Insurance are recurring expenses. Principle and Interest, in contrast, are reduced as the mortgage is paid over time. Early in the amortization of your loan the principal payments amounts are smaller but do still move the needle. If you look, you’ll see that the principle is reduced $100-200 each month, creating $1,200-2,400 per year in equity!
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Another way you make money in real estate is value appreciation. On average, you might expect 3% inflationary growth on both property values AND rents! It can be more, and it can be less. Keep in mind that appreciation is a form of speculation (or gambling) and should NEVER serve as a basis for your purchase decisions.
As with the stock market, the key is to buy conservatively and stay the course. Contrary to popular belief, rents actually go UP when the real estate market drops. The reason being, people are forced into the rental market, thus driving prices up!
5. Tax Advantage
This section arguably deserves its own post as there are several deductions, write-offs, and allowances that the IRS grants for real estate investors. Some of the basic tax advantages include:
- Tax Deductions: examples include property tax, insurance, mortgage interest, repairs, capital improvements
- Depreciation: optionally reduces your taxable income by your cost basis / 27.5 each year
- Sale proceeds taxed at lower capital gains tax vs ordinary income
- 1031 Tax-free exchanges can be used to sell one property and buy another tax-free
- Passive income and pass-through deductions if owned in a qualified business entity
The combination of these five areas makes real estate is one of the heaviest tax-subsidized business/investment models. Let me provide a scenario below, which helps clarify the many tax advantages and how they inter-relate:
- Purchase price: $130,000
- Down payment: $26,000 (20%)
- Gross Rents: $15,600 ($1,300 * 12 months)
- Expenses: $12,000 (Mortgage, Property Tax, Insurance)
- Net Income: $3,600 (Gross Rents – Expenses)
In this scenario, your depreciation would be $130,000 / 27.5 = $4,727. Note: It is important to understand that depreciation is a fictitious number. It only shows up on your tax filing and is a number the IRS uses to acknowledge losses due to wear and tear.
Now, since the depreciation exceeds your net income by $4,727 – $3,600 = $1,127 so on paper you have a loss. This means, you can earn $3,600 in income, pay NO taxes on it, AND the remaining $1,127 can be used to offset additional non-real estate income. This means you will pay little to no income taxes!
As you can see, we find real estate to be an excellent investment vehicle. If you are on the path to financial independence, I recommend you take a close look at real estate as a means to accelerate your journey!
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