In some prior blog posts I have hinted that you can profit in multiple ways by investing in single-family rental property.
Today, I’d like to outline and briefly cover what all those potential ways to profit are. I recently found an acronym to help remember all the ways to profit. IDEAL.
I = Income, or the net monthly operating cash flow.
D = Depreciation, or the non-cash tax deduction you can use to offset against your passive income in the “I” above.
E = Equity Amortization, or the benefit you get by your renter basically paying down the principal on your mortgage creating an increase to your equity.
A = Appreciation, or the benefit of the long-term increase in market values of residential housing.
L = Leverage which allows you to multiply the return on your investment.
Recurring Cash Flow
First is recurring cash flow; the “I” above. I always make sure I get into a property that pencils out to current positive cash flow at the beginning of the investment as well as a strong potential for increasing monthly cash flow over time. If the current monthly rent doesn’t cover all the operating expenses, including a vacancy allowance, property management, property taxes, insurance and repairs and then still have enough cash left over to cover the mortgage payment and enough to put into maintenance reserve, then I’m not going to invest.
From a financial perspective, this is always my first hurdle. This hurdle generally keeps me investing in houses priced below $200,000 and often much lower than that. The main reason is that the price of the house drives most of those cash flow costs. However, in most marketplaces, as house prices drop, rental rates do not drop as fast. So often times, the lower you go in housing prices, the better the cash flow. The caveat here is that I don’t want to move into high crime areas or just less desirable areas. So, I have other guidelines to keep me out of those areas and will cover these in future posts.
The second way that you can profit from this investment, or the “D” above, is the ability to tax a non-cash tax depreciation expense, which can be used to offset your taxable net operating cash flow in the “I” above. This can often completely eliminate any taxes on your cash flow. Many people do not realize how good the tax benefits associated with this type of investment are.
The third way to gain from rental property; the “E” above. When you apply leverage through a mortgage, the net operating cash flow covers the mortgage payment and leads to a decrease in the principle of the mortgage and a resulting increase in the net equity in the investment. At some point, the equity will be a large enough percentage of the market value of the property that you can borrow it out by refinancing the mortgage and taking cash out. This cash can then be used to fund new investments. A cash-out re-finance is a more efficient way to get cash out then selling the property and cashing out. The later method results in tax gains and a large tax bill.
Potential for Long-term Appreciation
The fourth way to profit involves the long-term appreciation of market values; the “A” above. The national average appreciation over multiple decades is about 2% per year. I want to be in growing markets which usually leads to a higher rate of market price appreciation over time. By growth I am mostly referring to strong job growth in multiple industries in a city that leads to long-term population growth in that area.
If you combine this with the mortgage balance decreasing over time, your equity value can grow quite nicely. And this happens while someone else pays for it through their rents.
When I make sure I invest in areas with strong long-term job growth, I am not only reducing the risk that market prices will decrease, but that I have a stronger opportunity to experience equity growth on my investments.
The “L” in IDEAL stands for leverage, which allows you to experience the equity amortization through rents paying down the principle and magnifies your equity appreciation.
There could be other ways to profit, but these are the ones that I focus on. For me, my priority is in order – positive monthly and annual cash flow, tax benefits to reduce taxes (taxes are the largest expense in most people’s lives and reducing them helps you keep more cash) and finally potential for the equity appreciation over time.
So, for me, those are the basic economic reasons for investing in this class of real estate. If done right, I can easily get over 20% annualized return on my investment which is way better than I can expect in the financial markets.
What do you think?
Are there other benefits that you see as significant?
Please comment below. I’d like to hear your thoughts.
Thanks for taking the time to read this. Have a great day.
Stay tuned for more topics related to investing in real estate.