A Review of The Five Profit Centers in Owning Rental Real Estate
Cash flow, cash flow, cash flow.
Most investors demand it.
And in some cases, investors flat-out need it.
It’s certainly understandable. Cash flow is the life-blood of any business and real estate investing is no different.
Indianapolis used to be that classic “cash flow market” where investors could purchase a home – a pretty nice home, in fact – and immediately begin cash flowing.
Those days are nearly gone now.
Finding a cash-flowing property, especially one that’s in a decent area, is getting harder and harder to do.
But, is cash flow the only measure an investor should consider?
Not by a long shot.
When assessing a property to purchase, and running it through various models, cash flow should hardly be the only metric involved.
Real estate, unlike many other businesses, provides many more profit centers than simply cash flow and each deserves consideration.
By understanding the different profit centers, and running prospective properties through these models, you’ll have a better understanding of the properties overall profitability.
And, in the process, not obsess too much over cash flow.
Let’s dive into these a bit…
1. Cash Flow
Might as well start with the most popular one.
And the most simple one.
Cash flow is simply the amount of money left over after all your expenses are paid.
Don’t assume the home will always be occupied either.
Finally, please understand that your property taxes could take a significant jump if you purchase the property with a homestead exemption in place.
To help cash flow, there are a few levers you can pull.
You might decide that there are some things that you, the Owner, should pay for and some things the Resident should pay for in order to decrease expenses. An example could be requiring Residents to pay for their own utilities, lawn care, snow removal, HVAC filters, etc.
2. Tax Savings
Currently, the tax benefits available to real estate investors are major.
Let’s divide these into two buckets:
- Annual Depreciation: This is such a wonderful deduction for investors. The IRS assumes that your property depreciates over 27.5 years, or the properties “useful life.”
If you do the math, you get a deduction equal to 3.63% of the asset’s cost. So, for example, if you spend $150,000 for a property, you’ll get a depreciation write-off of $5,454 each year.
- General Operating Expenses: All expenses surrounding your investment could be tax deductible as well. This includes things like property management fees, mortgage interest, landscaping, maintenance issues, and pest control.
We strongly suggest working with a CPA to determine all the appropriate write-offs and establish your depreciation schedules. Laws change, so this is one area where hiring an expert will pay off.
3. Principal Pay Down/Equity Building
This profit center obviously relies on the fact that you have a mortgage.
Assuming you do, the rent your resident pays each month allows you to pay your mortgage payment. So, essentially, your resident is paying your mortgage. It’s pretty amazing, really.
After your home has been rented out for so many years, you will eventually be able to own the property completely with no outstanding debt on that investment.
Having your principal paid also increases your cash flow.
Owning rental properties is almost always going to be a long-term investment and with returns like principal pay down, you are able to start seeing that long-term investment truly pay off.
4. Home Price Appreciation
When you purchase a property, the value of that home could increase over a period of time depending on the condition and location of the property.
Price appreciation not only benefits the Owner of the property when they are ready to sell, but it can also benefit the Rental Property Owner to earn more on their rentals by having the ability to increase the monthly rent rate.
As a home appreciates, an Owner will be able to make a larger profit as long as they keep that property. They also have the option of selling the property for more than they purchased it for, and then using what they earned to put into other investments.
5. Inflation Hedging
Real estate is an inflation-hedging investment. It means that as inflation increases, your investment will be protected and will likely increase in value.
Let’s assume that you get a fixed-rate loan for 20 years. In this case, the monthly cost of that mortgage will not increase.
Yes, your taxes and insurance will go up (if those are escrowed and part of your monthly payment) but the cost you are paying for the actual mortgage will not change until you either refinance or pay it off.
So, if you took out a 20-year mortgage for a home in 2005, the cost of that payment today is lower (in some cases, much lower) to the comparative value of the property.
Meaning, if mortgage payment was $750 in 2005, that $750 is actually much less in relative dollars today than in 2005 and, along the way, the asset is worth much more.
The five measures of return above are there to help us understand your finances better when it comes to your investments.
Not only do they help us take into consideration what properties to invest in and what the rental properties should offer Residents, but also how we can use investing to our advantage when it comes to growing your return and your portfolio.
Should I Buy A Home That’s Breakeven Or Even Cash Flow?
Understanding your cash flow, from a proforma standpoint, is obviously important and still a very worthy exercise.
But, what if your proforma shows neutral, or slightly negative cash flow?
Is it a deal-breaker?
Well, that depends on a lot of factors, including:
- Your personal cash situation: Can you afford to chip in a few bucks a month to cover that shortfall?
If you are struggling to pay your regular bills on a monthly basis and don’t have a nice savings to pay for unexpected expenses, then, no, don’t do it.
But, if you have plenty of discretionary income and also have a nice savings account established, it’s definitely worth considering.
- Your overall real estate holdings: Let’s say that you already have 10 properties and they cash flow relatively well. If you locate another property and like everything about it – other than it may not cash flow initially – you are in a stronger position to take it on.
- The property has upside: Let’s face it, some landlords are lazy and cheap. They own a home, but don’t want to raise the rent for fear of losing the Resident and, in the meantime, fail to make improvements or maintain the property in a way that its value is diminished.
In, this case, you might be able to swoop in, make improvements and raise the rent significantly. The result? Cash flow deficit solved and equity gain… a win-win.