A couple of months ago, I read “What Every Real Estate Investor Needs to Know About Cash Flow” by Frank Gallinelli. This was a great book to learn about the numbers involved with investing in income properties. In the introduction to the book, he discusses what he calls the four basic investment returns. Gallinelli states that these four ways are how you make money with income producing properties and that every investor should have a grasp of each one of these concepts. In today’s post, we will summarize these four investment principals and show examples of how these numbers might work for an investor in Ventura County.
The first investment return, and probably the most basic, is cash flow. In its simplest terms, cash flow is the money that comes in from an investment property subtracted by the amount of money that goes out from an investment property. Some people also like to express it as Income – Expenses = Cash Flow. If you are bringing more money in than you are spending on a property, then you will have positive cash flow. Conversely, if your expenses are more than the income you are bringing in, you would have negative cash flow (A.K.A. you will be losing money). The biggest mistake newer investors make is thinking that their mortgage is the only expense that they have. In order to truly calculate your expenses, you need to factor in property taxes, insurance, HOA fees, maintenance, etc. If you do not correctly include all of your expenses, this could mean the difference between making money and losing money on an investment property.
In today’s market, cash flow is pretty difficult to find in Ventura County due to the price of homes. Since the mortgage is usually the biggest monthly expense, the rent that you can charge for a home in Ventura County often will not even cover the mortgage. The more cash that you pay for the home, the lower your mortgage will be and the more cash flow you will achieve. Especially for newer investors without a ton of cash, making a large down payment is not always doable.
The next concept is also fairly easy to understand and to calculate. Appreciation is the increase of the price of your home over time. Although homeowners like to tell their friends how much their home has appreciated since they bought it, you don’t actually enjoy the benefits of appreciation until you sell your home. Some may argue that refinancing can be a benefit of appreciation, but that comes with a different set of risks. In order to calculate appreciation, you subtract the purchase price of a home from the sales price of a home. In other words, if you bought a home for $500,000 and sold it for $600,000, your appreciation would be $100,000.
Keep in mind that housing prices do not always appreciate. As many will recall from back in 2008, housing prices can and will go down at some point. Historically speaking though, housing prices should continue to rise on average over the long term.
Loan amortization is the pay down on your loan. For every monthly payment you make, the amount of your loan decreases. For example, if you have a 30 year loan with a traditional bank, at the end of 30 years, you would have paid off the entire amount of your loan and own the property free and clear. Where this comes into play with income producing properties is that you are now having someone else pay down your loan. If you have positive cash flow on a rental property, not only are you pocketing the cash flow, but your tenant is paying down your loan for you. In essence, your tenant is helping you buy the property. Another powerful benefit that comes with having your tenant pay down your loan is that you are now free to use your cash to buy other rental properties as opposed to if you would have used all of your cash to buy the one property free and clear. One thing to remember is that even if you have a tenant paying you rent, you are still ultimately responsible for the mortgage payment. If your tenant stops paying you or the property is vacant, you still need to continue paying the bank your monthly payment. That is why it is best to always have money in reserves to cover unexpected vacancies.
The final benefit that Gallinelli discusses is tax deductions. There are many tax benefits that real estate investors can take advantage of that are not available to those who only earn a W-2 wage. Since tax laws can change and the deductions you can take will vary from individual to individual, we will not go into much detail about taxes here. Just in case you are curious though, some of the tax benefits include depreciation and the ability to take advantage of 1031 exchanges. If you do own income producing properties, make sure you consult with a qualified CPA to ensure that you are taking maximum advantage of the tax benefits. Not all CPAs are created equal, so it behooves you to find a CPA who is familiar with working with real estate professionals. You may be thinking that you can save yourself money by doing your taxes yourself, but any CPA worth his/her weight should be able to save you more in taxes than you are paying him/her to file them for you.