Understanding Real Estates Incomeand Wealth Producing Potential

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Compared with most other investments, good real estate can excel at producing current income for property owners. So in addition to the longer-term appreciation potential, you can also earn income year in and year out. Real estate is a true growth and income investment.

The vast majority of people who don't make money in real estate make easily avoidable mistakes, which we help you avoid.

The following list highlights the major benefits of investing in real estate:

✓ Tax-deferred compounding of value: In real estate investing, the appreciation of your properties compounds tax-deferred during your years of ownership. You don't pay tax on this profit until you sell your property — and even then you can roll over your gain into another investment property and avoid paying taxes. (See the "Tax advantages" section later in this chapter.)

✓ Regular cash flow: If you have property that you rent out, you have money coming in every month in the form of rents. Some properties, particularly larger multiunit complexes, may have some additional sources, such as from coin-operated washers and dryers.

When you own investment real estate, you should also expect to incur expenses that include your mortgage payment, property taxes, insurance, and maintenance. The interaction of the revenues coming in and the expenses going out is what tells you whether you realize positive operating profit each month.

✓ Reduced income tax bills: For income tax purposes, you also get to claim an expense that isn't really an out-of-pocket cost — depreciation. Depreciation enables you to reduce your current income tax bill and hence increase your cash flow from a property. (We explain this tax advantage and others later in the "Tax advantages" section.)

✓ Rate of increase of rental income versus overall expenses: Over time, your operating profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than the rate of increase for your property's overall expenses. What follows is a simple example to show why even modest rental increases are magnified into larger operating profits and healthy returns on investment over time.

Suppose that you're in the market to purchase a single-family home that you want to rent out and that such properties are selling for about $200,000 in the area you've deemed to be a good investment. (Note: Housing prices vary widely across different areas but the following example should give you a relative sense of how a rental property's expenses and revenue change over time.) You expect to make a 20 percent down payment and take out a 30-year fixed rate mortgage at 6 percent for the remainder of the purchase price —

$160,000. Here are the details:

Monthly mortgage payment $960

Monthly property tax $200 Other monthly expenses (maintenance, insurance) $200

Monthly rent $1,400

In Table 1-1, we show you what happens with your investment over time. We assume that your rent and expenses (except for your mortgage payment, which is fixed) increase 3 percent annually and that your property appreciates a conservative 4 percent per year. (For simplification purposes, we ignore depreciation in this example. If we had included the benefit of depreciation, it would further enhance the calculated returns.)

Table 1-1 How a Rental Property's Income and

Wealth Build Over Time

Table 1-1 How a Rental Property's Income and

Wealth Build Over Time

Year

Monthly

Monthly

Property

Mortgage

Rent

Expenses

Value

Balance

0

81,400

81,360

8200,000

8160,000

5

81,623

81,424

8243,330

8148,960

10

81,881

81,498

8296,050

8133,920

20

82,529

81,682

8438,225

886,400

30

83,398

81,931

8648,680

80

31

83,500

81,000

8674,625

80

Now, notice what happens over time. When you first buy the property, the monthly rent and the monthly expenses are about equal. By year five, the monthly income exceeds the expenses by about $200 per month. Consider why this happens — your largest monthly expense, the mortgage payment, doesn't increase. So, even though we assume that the rent increases just 3 percent per year, which is the same rate of increase assumed for your non-mortgage expenses, the compounding of rental inflation begins to produce larger and larger cash flow to you, the property owner. Cash flow of $200 per month may not sound like much, but consider that this $2,400 annual income is from an original $40,000 investment. Thus, by year five, your rental property is producing a 6 percent return on your down payment. (And remember, if you factor in the tax deduction for depreciation, your cash flow and return are even higher.)

In addition to the monthly cash flow from the amount that the rent exceeds the property's expenses, also look at the last two columns in Table 1-1 to see what has happened by year five to your equity (the difference between market value and mortgage) in the property. With just a 4 percent annual increase in market value, your $40,000 in equity (the down payment) has more than doubled to $94,370 ($243,330 - $148,960).

By years 10 and 20, you can see the further increases in your monthly cash flow and significant expansion in your property's equity. By year 30, the property is producing more than $1,400 per month cash flow and you're now the proud owner of a mortgage-free property worth more than triple what you paid for it!

After you get the mortgage paid off in year 30, take a look at what happens to your monthly expenses (big drop) and therefore your cash flow in year 31 and beyond (big increase).

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