The good news about real estate investing is that most people can earn a fairly substantial amount of wealth over their lifetime if they educate themselves and make better decisions when purchasing property. The bad news is that contrary to all the TV shows about flipping houses and people making money, or turn-key hassle-free rental properties, real estate is actually really hard work, it’s time-consuming and it can be a risky place to invest your money.
Here are some tips from Professor Baron that should help you earn real estate wealth. By the way — it’s a marathon, not a sprint.
Think long term (skip get-rich-quick schemes)
Long-term ownership is the key to real estate wealth. If you buy decent properties and hold them forever, that’s going to provide the highest likelihood that your real estate will have significant equity down the road. Also, if it sounds too good to be true, it always is — especially in real estate. Drop the idea that there is fast and easy money to be made in real estate. It’s just not true. Sometimes people get lucky, but you don’t have to worry because that “lucky” person will never end up being you.
Cash flow positive properties
A significant portion of investors buy properties that are cash-flow negative or have very low investment returns. That means the buyer puts in their equity cash capital when they purchased the property, and they are still investing additional funds each month, which could go on for decades depending on how bad of a deal they purchased. The better way to invest is to buy properties where the rents minus all the expenses, including the mortgage payment, provide positive cash flow that you can deposit in the bank. So if you collect $1,200 in monthly rent, then subtract expenses of ($400) and a mortgage of ($500) you will have $300 per month left over. Nice job!
Simple analysis tool: The 1 percent rule
A simple way to do a quick analysis is to take the conservatively estimated monthly rental income and divide it by the purchase price of the house. You still need to pencil out your deal with rents and actual conservatively estimated expenses, but this back-of-the-napkin test is a quick and easy test to see if it makes sense.
• Example of a good deal: If you can collect $1,600 per month in rent and you paid $200,000 for the property, you are collecting rent that is 0.8 percent of the purchase price (0.8 percent = 80 basis points in financial terms). And that’s probably a really fair deal.
• Example of a bad deal: If you can collect $1,600 per month in rent and you paid $400,000 for the property, you are collecting rent that is 0.4 percent of the purchase price, or 40 basis points. And that’s not a really good deal.
Find good quality properties
Smarter investors work hard up front to find the good areas where the rents provide a nice positive cash flow and investment returns, low crime rates, better schools, and decent amenities nearby like parks or retail. Coupled with good tenants who have excellent credit, you also create low vacancy rates. Smart investors also buy properties that are in decent shape, although every property needs paint, carpeting and some plumbing and electrical work from time to time. Do that hard work upfront and spend the money to put your properties in very good shape, you’ll get a little more rent and probably have a bigger pool of interested tenants from whom you can then choose. Lastly, do your homework, talk to other investors, read guides and books, shop properties, pencil out deals and have a long term ownership plan. Hopefully it will translate into a nice cash flow retirement picture.
5 Reasons to Invest Income Property
An income property is a property bought or developed to earn income and get out of the Rat Race. Keep in mind that while there are many advantages of investing in real estate, there are also significant risk factors to consider. Here are 5 reasons why an income property can be such a lucrative investment.
1. You Are the Boss of the Income Property
When you decide to invest in an income property, you become your own boss. You choose what property to invest in, what tenant you will rent to, how much you will charge in rent and how you will manage and maintain the property as a whole.
In the average 9 to 5 job, you are subject to the wishes of your boss and the company infrastructure in general, such as adhering to a dress code. As your own boss, you can wake up whenever you are ready.
2. Potential Appreciation of a Highly Leveraged Asset
Leverage, in layman’s terms, means you invest a relatively small amount of your own money, and borrow the rest, often four to twenty times more, from a lender. I’m not a huge fan of leveraging but if you do it in moderation you will be successful. If you purchase a property using significantly more debt than equity, the investment is said to be “highly leveraged.”
Let’s look at an example of how leveraging an asset can increase your potential return:
If you have $10,000 to invest in a property, you can then use leverage and borrow $90,000 from a bank. By combining your money with the bank loaned money, you are now able to buy a $100,000 asset.
We will assume that each year, for 10 years, your investment property will appreciate by 5%. Here is where the ability to leverage benefits you. The appreciation is on the entire $100,000 asset, not only the $10,000 of your own money.
Year 0: $100,000
Year 1: $105,000
Year 2: $110,250
…Year 10: $162,889
So, after 10 years, your property value would have increased by almost $63,000 dollars. Thus, you would have turned your $10,000 investment into over a $60,000 appreciation profit simply by utilizing leverage.
3. Rental Income Is Money in Your Pocket
Assuming that you are investing in an income property to occupy it with tenants, you will be able to receive rental income.
Suppose you have one tenant. You charge that tenant $1,100 a month in rent. Your PITI mortgage payment is $700 a month. Thus, subtracting $700 from $1100 will leave you with $400 to go into your pocket each month, right? Not exactly.
From this $1,100, you will want to assume about 5% in monthly maintenance costs and 5% in vacancy costs. Therefore, you will put $110 into a designated bank account each month to deal with maintenance issues and potential vacancy costs. When all is said and done, you will have about $290 each month going directly into your pocket!
$1,100 (monthly rent)
-$700 (monthly PITI mortgage payment)
-$110 (for maintenance and vacancy issues
=$290 (your monthly passive income from the rental property)
4. Your Tenants Will Amortize Your Mortgage for You
The most popular type of loan is a 30-year fixed rate mortgage. It has an interest rate that will remain the same for the entire 30 year term of the loan. In the beginning of the loan, significantly more money is paid to interest than to principal, but by year 15, it is close to a 50/50 split. Therefore, the longer you hold the property, the more of the loan principal your tenants are paying down and the more wealth you are creating for yourself.
Say you have a $90,000 bank loan with a monthly mortgage payment of $500. In year one, approximately $385 of this payment will go towards paying the interest, while $115 will go towards paying down the principal on the loan.
$115 (monthly principal payment) * 12 (months) = $1,380 (principal reduction for the year)
$90,000 (original loan)
– $1,380 (principal payments after 1 year)
= $88,620 (loan balance after 1 year)
By year 15, approximately $270 of the monthly mortgage payment will go towards interest, while the remaining $230 towards the principal.
$230 (monthly principal payment) *12 (months) = $2,760 (principal reduction for the year)
Every year that you own this property, you are using the tenant’s money to pay off your debt. By reducing the amount of your loan, you will be building wealth as you will eventually be able to access this money either by refinancing your loan or by selling the property.
5. Huge Tax Write-Offs for Income Property
As a rental property owner, you are entitled to huge tax deductions. You can write-off interest on your mortgage or on any credit cards used to make purchases for the property. You can write-off your insurance, maintenance repairs, travel expenses, any legal and professional fees, and even your property taxes. You can see a more extensive list at Nolo.com
On top of all of these deductions, the government also allows you to depreciate the purchase price of your property based on a set depreciation schedule, even if your property is actually appreciating in value.
Using our above example, you receive $3,480 in rental income for the year ($290 each month * 12 months). If you made this money at a regular job or in the stock market, you would lose a significant portion of it to pay income taxes. However, by owning a rental property, you can offset the $3,480 income with the depreciation expense for your property, thus being able to reduce or completely eliminate the amount of taxes you have to pay on this rental income.
One last note: Speak to an accountant to determine all of your specific tax write-offs and remember being an income property owner is a huge commitment, but, if handled properly, that huge commitment can bring equally large financial rewards.
How To Calculate ROI For Real Estate Investments
By Marc Davis
Return on investment (ROI) is an accounting term that indicates the percentage of invested money returned to an investor after the deduction of associated costs. For the non-accountant, this may sound confusing, but the formula may be simply stated as follows:
But while the above equation seems easy enough to calculate, a number of variables including repair and maintenance expenses and methods of figuring leverage – the amount of money with interest borrowed to make the initial investment – come into play, which can affect ROI numbers.
The article below explains the two methods by which ROI calculations are made:
The Cost Method and the Out of Pocket Method
The Cost Method
The cost method calculates ROI by dividing the equity by all costs.
As an example, assume a real estate property was bought for $100,000. After repairs and rehab of the property, which costs investors an additional $50,000, the property is then valued at $200,000, making the investors’ equity position in the property 200,000 – (100,000 + 50,000) = $50,000.
The cost method requires the dividing of the equity position by all the costs related to the purchase, repairs and rehab of the property.
ROI, in this instance, is .33 % – $50,000 divided by $150,000.
The Out of Pocket Method
The out of pocket method is preferred by real estate investors because of higher ROI results.
Using the numbers from the example above, assume the same property was purchased for the same price, but this time the purchase was financed with a loan and a down payment of $20,000. Out of pocket expense is therefore only $20,000, plus $50,000 for repairs and rehab, for a total out of pocket expense of $70,000. With the value of the property at $200,000, the equity position is $130,000.
The ROI, in this case, is .65 % – $130,000 divided by $200,000. The result is just one percent less than double the first example. The difference, of course, is attributable to the loan – leverage as a means of increasing ROI. (To gain more knowledge about leverage, read: Leverage: Increasing Your Real Estate Net Worth. )
Equity Is Not Cash
Before the ROI, cited above, may be realized in actual cash profits, the properties must be sold. Often, a property will not sell at its market value. Frequently, a real estate deal will be consummated at below the initial asking price, reducing the final ROI calculation for that property. Keep in mind, also, that there are costs associated with selling a real estate property – again, there may be expenses needed for repairs, painting or landscaping. The costs of advertising the property should also be added up, along with appraisal costs and the commission to the real estate broker.
Both advertising and commission expenses may be negotiated with the service provider. Real estate developers, with more than one property to advertise and sell, are in a better position to negotiate favorable rates with media outlets and brokers. ROI on multiple sales, however, with varying costs for advertising, commission, financing and construction present complex accounting issues that are best handled by an accountant.
Property Cash Flow
An investor may have $30,000 in equity in a commercial rental property for which he paid $10,000 for an ROI of 300%. The property also yields $500 a month in rentals, for a total of $6,000 annually. That’s a 60% ROI on the property’s cash flow – $6000 divided by the $10,000 cost of investment.
Complications in Calculating ROI
Complications in calculating ROI can occur when a real estate property is refinanced, or a second mortgage is taken out. Interest on a second, or refinanced, loan may increase, and loan fees may be charged, both of which can reduce the ROI, when the new numbers are used in the ROI equation. There may also be an increase in maintenance costs and property taxes, and an increase in utility rates if the owner of a residential rental or commercial property pays these expenses.
Complex calculations may also be required for property bought with an adjustable rate mortgage (ARM) with a variable escalating rate charged annually through the duration of the loan. (To know more about ARM, check out: Mortgages: Fixed-Rate Versus Adjustable-Rate. )
The Bottom Line
Calculating ROI on real estate can be simple or complex, depending on all the variables mentioned above. In a robust economy, real estate investments, both residential and commercial, have proven to be very profitable. Even in a recessionary economy, when prices fall and cash is scarce, many bargains in real estate are available for investors with the money to invest. When the economy recovers, as it invariably does, many investors will reap a handsome profit.
For income tax or capital gains tax purposes, however, real estate property owners are urged to get professional tax advice from a reliable source before filing. Property tax is another factor in the equation when calculating return – if a property owner believes a property tax assessment is too high, in most cases, the assessment may be challenged and often a judgment is made in favor of the challenger.