Do you actually know all of the ways you profit from a rental property? You might have a basic feel for them, but I bet you don’t realize all of the ways you profit from a rental property. Even if you do, it never hurts to review a summary of the income streams to reignite excitement for your rental property!
I’m going to end the summary of rental profit centers with a really cool note about why having 5 profit centers is extremely amazing, by the way.
The 5 Profit Centers of a Rental Property Investment
Just to be clear, “profit centers” mean each of the ways you gain income. It’s not my favorite term, but it’s the shortest way to explain income streams. OK, well maybe “income streams” is just as short, but something about “profit centers” really seems to ring it in.
1. Monthly Cash Flow
This one should happen, but unfortunately people oftentimes don’t know how to run numbers on an investment property (or they just don’t), so it’s common that a property doesn’t produce this primary stream of income. The monthly cash flow is the money you pocket each month after all expenses are paid. The majority of properties that exist won’t actually produce positive monthly cash flow, so you want to make sure you know how to really shop for properties and run numbers.
The keys to look at are the amount of expenses on the property (including expenses related to buying the property) and the amount of rental income. You want the income to surpass the expenses. If this happens on average, you should be good for positive monthly cash flow.
This income is passive, revolving, and if you build enough of it, you can start thinking about getting out of the rat race! In relation to this profit center, I want to offer you two supplemental articles to check out. The first is just about running numbers. In order to be able to determine what you should expect for monthly cash flow on a property, check out “Rental Property Numbers So Easy You Can Calculate Them on a Napkin.” Then to keep your excitement going about monthly cash flow and how it can begin to supplement your income in really cool ways, check out “Gaining Financial Freedom is Easier Than You Think.” Despite the perks of monthly cash flow, though, a lot of people buy properties with negative cash flow. Then where can they expect to see income? Well, hopefully they bought something in the wave of…
Most people are familiar with this one, if not the most familiar with it! The general trend of housing prices increases over time. Whatever appreciation happens to the value of your property is free cash to you. In order to see the actual cash profit from appreciation, you either need to refinance the property, take out a home equity line, or sell the property, but either way, the money is yours as long as it’s there.
Some markets appreciate in crazy-high waves, while other markets stay fairly neutral with minimal increase or decline in values, but in general, real estate typically does move upward in value. Some people buy investment properties solely for the appreciation potential. Be careful if you do this because banking on appreciation is essentially speculation, and as we know from 2009, speculation doesn’t always pan out in our favors. However, appreciation has also put some pretty pennies in people’s pockets. For more information on investing for cash flow versus investing for appreciation, check out “Investing for Cash Flow or Appreciation — What’s the Difference?” There are ways to invest in a property with good hopes for both cash flow and appreciation, but some properties are either/or (or neither, but stay away from those).
3. Tax Benefits
As I continue down the list, I’m going to get progressively less obvious with the profit centers. The tax benefits of owning rental properties is fairly obvious by itself, but what isn’t as obvious are the actual income numbers the tax benefits will put in your pocket. The thing to know with rental properties is that the IRS considers them to be “passive income,” which allows for substantially more benefits in the taxation department than “active income” (like W2 income, etc.).
I will tell you that I’ve never had better tax returns than I have since I started investing in rental properties. Without even going into detail, I can tell you that the biggest tax perk with rental properties is that typically the income you receive from the property ends up being tax-free (the cash flow, at least — not necessarily the appreciation/equity unless you 1031 exchange it on the sale, which I do recommend). For details on what in the world I’m talking about and how this is all possible, check out “One of the Biggest Financial Advantages of Owning Residential Rental Properties.” The tax benefits on rental properties are so strong that I highly recommend you not try to do your taxes yourself and rather work with a CPA who specializes in real estate. The laws are changing so often and the available perks can be very hidden, so, in my opinion, it’d be almost impossible for you to maximize the tax benefits from your property on your own.
4. Equity Build via Mortgage Payoff
Here we go with getting less obvious. If you buy a cash-flowing rental property that experiences appreciation and you are getting mad tax benefits all the while, there is still something else that is happening along the way. It’s related to appreciation in that it is equity-related, but it’s in addition to appreciation.
Assuming you bought a property that the expenses are covered by the rental income, your tenants are paying down your mortgage for you. Hear that? Your tenants are paying that for you. And as a mortgage gets paid down, that is just more money to your name. Let’s say you own a rental property for 30 years and experience absolutely no appreciation on it, but the rental income has been covering your mortgage all that time. Now you own a property free and clear, and all of that equity is yours to use. Thanks, tenants!
Obviously, this profit center is dependent on having purchased the property with financing, so bear that in mind. Some might try to argue against tenants paying down the mortgage because that would otherwise be money in your pocket if you didn’t use a mortgage at all, especially with the interest, but that then becomes a discussion as to whether you are a bigger believer in leveraging investment properties versus paying cash for them. Personally, I prefer to leverage because the returns end up being higher in the end. If you are contemplating this question for yourself, though, check out “Leveraging vs. Paying Cash for Rental Properties: A Look at the Infamous Debate.” There’s no wrong way to do it, but know that if you do decide to leverage, then you will get the equity pay-down/off bonus.
5. Hedging Against Inflation
Here’s a fun one. This profit center doesn’t present itself in exactly the same manner as the rest — cash-in-your-pocket style — but it is a creative one. Let’s say you buy a property in 2016 with a mortgage. Over the next however many years, inflation goes bonkers. What happens when inflation kicks in? The dollar is worth less as inflation goes up.
Let’s say, then, 10 years down the road, you are still paying that mortgage. The amount of the mortgage hasn’t changed since you borrowed with it in 2016 dollars, but now you are paying it back with dollars that are worth less than they were in 2016. See what I mean?
Rental properties are one of very few investments that actually get better with inflation! It’s kind of like — imagine this. In 1912, maybe you could buy a really nice house for $20,000. What if you could own that same house right now for $20,000, when it’s probably more of today’s equivalent of $450,000? May be a stretch on the numbers, I don’t really know, but those are great to explain how inflation is awesome in this case. Maybe you buy today in 2016, and later in 2032 you still own the house at the 2016 cost. OK, I’m going to stop before I start confusing myself with scenarios, but if you want more information on how hedging against inflation with rental properties works, check out “Real Estate as a Hedge Against Inflation.”
Now, a last and final thought to conclude the awesomeness of all of these profit centers. Having 5 profit centers is awesome, no doubt about it. But here’s something to keep in your mind as you think about them and start pursuing owning rental properties. One of the major advantages of having 5 profit centers is it gives you some room to get in a pickle with one of the centers and still come out profitable on your property.
I can give you an example. One of my rental properties in Atlanta went through a long phase of being vacant for some reasons I couldn’t have guessed would have been an issue. I was stressing out over missing out on the cash flow all that time, all the while paying the mortgage out-of-pocket, and I have an investor partner on it so I was stressed about whether he was going to be irked or not. Between all that vacancy time and some repairs, I felt like I was really in the hole. However, the next year, I was able to cash-out refinance that property and put $40,000 in my pocket from appreciation. So while the monthly cash flow was in the hole, and since I didn’t have tenants paying the rent so I wasn’t getting any equity pay-down either, I was still earning income from appreciation and tax benefits.
What if you have a property on the flip side? What if, as is the case with the majority of properties around the country right now, you aren’t expected to see a lot of appreciation in the near future like I did on my Atlanta property back in the day? Well, make sure your monthly cash flow is in place. If you never see a lick of appreciation on a property, you still can have monthly cash flow, tax benefits, equity pay-down/off, and it can be a hedge against inflation.
The moral of the story? Be smart and buy a property that is scheduled to see both positive monthly cash flow, and appreciation, so you are set up to earn from all 5 profit centers. That way, you have some room for things to not go as expected in some areas, and you can still remain profitable.
Experienced rental property owners — how have your profits looked? Have you seen income from each of the 5 profit centers I list?
Let me know with a comment!
This post was originally on BiggerPockets, written by Ali Boone.
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