As a sophisticated investor, I review every aspect of an investment before jumping in. The top 3 things I study are how the investment will be profitable, the risks involved and possible exit strategies.
Today, I like to focus on how investment in real estate can generate profits. Now most of us already know the 2 main ways real estate generates a profit – increase in property value (appreciation) and positive cash flow. However, did you know that there are 5 additional ways real estate can put money in your pocket? If your answer is “No”, please keep reading and you will be amazed to learn that there are actually 7 ways to make a profit in real estate.
Folks, only after learning that real estate can be profitable this many ways, I was able to come to the decision that real estate was an investment that I should be involved in.
1. The first one is
Equity. Equity is basically the current market value of a property minus the mortgage amount owed to the bank. So how do you increase equity and therefore your profit on your real estate? When buying, you can negotiate and secure a lower purchase price (below fair market value) and when selling, you may be able to get top dollar for your property. If you do both things correctly, you can make thousands of dollars in profit. I will discuss ways to accomplish both in another article.
At Real Experts Inc, buying below current fair market value is a cornerstone of our strategy and so we always try to find deals at a discount. All of our properties have been purchased at least 10% below market. In today’s market, if you do your homework, you can find deals like that in many places – just make sure those areas are growing and have good long-term prospects.
2.
Leverage is the power of using the bank’s money to fund your real estate purchases. By using the bank’s money to fund the majority of the property’s purchase price, you can now buy more property. Let me give you an example. Let’s say you have a $100,000 in cash to invest and there is a property that you would like to buy, also worth $100,000. Now you have two options:
a) Use all of your money to fund this purchase or
b) Use the bank’s money to fund the majority of this purchase and very little of your own money.
So now let’s look at the impact of both of these strategies:
a) If you use all of your money to buy this $100,000 property, you’ve bought 1 property with no debt but now you have run out of money to invest in other properties!
b) If you go and get a mortgage with the bank, say for 80% of the purchase price ($80,000) and pay the rest yourself 20% ($20,000), you have only spent $20,000 of your cash. This leaves you with another $80,000 to invest in other properties!
One word of caution, if you are borrowing from the bank, make sure that your property generates enough monthly rent/income to cover the mortgage payment as well as all the other costs (property taxes, utilities, insurance, property management fees etc).
3.
Appreciation simply refers to the increase in market price of your property. Based on conservative estimates, real estate has appreciated an average of 3-5%/year over the past 25 years. So does that mean you’ve only made 3-5% on your investment? Absolutely not!
Let me illustrate an example. Say you purchased a property worth a $100,000 and made a down payment of $10,000 and financed the rest with a mortgage from the bank. Your actual out of pocket investment is only $10,000. Let’s also assume that the property went up in value by 5%. What’s your return on investment? Well it 50%!
How is this possible? Well, if you take the increase in property value which is $5000 (5 % x 100,000) and divide it by your out of pocket investment $10,000 this equals 50%. This is the power of appreciation and leverage in real estate!
4.
Principal Reduction. This is one of the sure fire ways to make money in real estate. Every month you are going to be collecting rent from your tenants. You will use that rent to pay your monthly mortgage bill. As we all know, part of your mortgage payment goes towards the interest on your loan, but the other part goes towards the principal amount that you owe. So this means you have now got someone else paying down your loan and in time your mortgage balance will be zero!
5.
Positive Cash Flow. Positive cash flow simply means that your total income on a property is greater than all the expenses related to that property. Positive cash flow is a key fundamental in real estate investing. You only want to purchase property that is positive cash flow. At a minimum, you want to make sure that the property breaks even and that you don’t have negative cash flow.
All of our properties generate positive cash flow and have allowed us to live a better lifestyle and not rely on a company pay cheque all the time. In most cases, positive cash flow coupled with principal reduction of your mortgage is your ticket to generating predictable returns in any real estate market (especially when the market is correcting).
6.
Tax Benefits. When you are in real estate you have to treat this as an investment and a business. Therefore, you can now write off all of your expenses associated with owning that investment or operating that business. So for example, you can write off things such as your mortgage interest on your investment property, utilities costs, property management costs and so on. However, on the flip side, you have to declare your rents as rental income. Please make sure that you speak to a professional accountant about what is considered rental income and business expense.
7.
Refinance/Equity Re-investment. To illustrate this point, let’s go back to the original example. Consider the following scenario. So let’s say the property that you bought for $100,000 went up 5 % every year. Now 4 years later, the house would be worth about $121,000. Now during that time let’s say your mortgage balance went down to $80,000.
You can borrow against the new value of your property (refinance) usually it can go up to 80% of the property value. So how much cash can you pull out of your current investment and how is that calculated?
You take $121.000 (property value) x 80% and subtract $80,000 (your mortgage balance) this equals about $17,000. This means that a few amazing things have happened:
1. You have cashed in on the increase of your property without having to sell it!
2. You didn’t have to pay a hefty commission to the real estate agent (often 5% of selling price) – you saved $6,050 on commission alone.
3. You get to keep the property where your mortgage is still being paid down by the tenant’s rental payments.
4. If you have a positive cash flow property, you can still profit from that and benefit from any future increase in property price (appreciation)
5. Now you have $17,000 in cash that you can use to buy a similar property and repeat the process. This is how you build your real estate portfolio and multiply your income.
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