Real estate provides the investor with many ways generate returns. It involves what I call the four-pronged approach; principle pay down, cashflow, appreciation, and tax advantages.
Principle pay down
This is where the loan amount gets paid down each month from the mortgage payment. The mortgage is paid by the rents collected from the tenants, and the owner’s equity is increased every month because the loan principle is being reduced. Over time, the loan can be paid off in its entirety. The owner takes out the loan, but the tenants end up paying back the loan!
Cash flow
This is the profit that the owner pockets after paying all the expenses and mortgage. Each month rents and other income are collected, and expenses are paid(tax, insurance, repairs, utilities, management fees, etc). Then the mortgage is paid, and what’s leftover is cashflow. Cash-on-cash returns is the ratio between the annual cashflow and the amount invested, expressed in percentage. If the cash flow is $30,000/year and $300,000 was deployed as the downpayment for a $1,000,000 property, then the COC return is 10% (30,000/300,000). A good cash flowing property can generate 8~10% or more COC returns. The savvy investor can have a direct impact on the cash flow by implementing several methods – increasing the rents by making improvements or creating additional sources of income: assigned parking, storage, laundry, vending machine, pet fees, or billing the tenants for utilities, etc. He/she can also boost cashflow by reducing vacancies through better marketing and also reducing the down time of units when tenants moves out. The owner can also reduce expenses by hiring the most competitive vendors and streamlining the operation.
Appreciation
This is where the value of the asset increases and yields a profit for the investor. It is worth noting that there are two different types of appreciation; market appreciation and forced appreciation.
Market appreciation is the one that most people may be familiar with. It’s simply dictated by the supply and demand, thus the name. Historically, real estate has gone up about 3% each year. But in some coastal cities like San Francisco, over 10% increases are not uncommon. This may seem weak compared to the stock market which has historically appreciated 10%/year, but one has to consider the effect of leverage. Usually if an investor wants to buy $1M of stocks, he/she deploys that exact amount to own the shares. If an investor were to buy $1M property, it is typically acquired using a loan. The investor may only deploy $200,000 as a down payment for the $1M property. The property appreciation is applied to the full value of $1M, so $30,000/year. When we consider that we only deployed $200,000, the $30,000 appreciation ends up being 15% gain on the invested capital.
Forced appreciation is less commonly understood, but is one of the more exciting facets of real estate. Market appreciation depends on the market conditions, which is outside of anybody’s control. Forced appreciation allows the investor to better dictate the performance of his/her asset. Commercial properties(4+ units) are valued based on the income that it generates. The more income it generates, the higher it is valued, etc. There is a specific formula for calculating the market price based on the income. This makes the valuation of the asset standardized and predictable. Compare this to residential property where the price is based on what similar properties in the neighborhood sold for. The commercial valuation gives the investor more control over the profitability of the asset. The amount the asset appreciates is directly in proportion to how much income the investor can generate. As mentioned above, the increase in the performance of the asset is only limited by the investor’s imagination. Forced appreciation can be quite substantial where a $100 rent increase in 100 unit apartment can result in $1.7M increase in value! So the investor can raise rents, generate additional income, and reduce costs to increase his/her cashflow, but that will also result in significant appreciation of the asset. An underperforming asset presents a great opportunity for the savvy investor to improve the performance and generate massive profits.
Tax advantages
There are many strategies for tax mitigation/shielding that is uniquely available to the real estate investor. Among many, depreciation is worth discussing on a high level. The IRS allows the investor to deduct taxable income by claiming depreciation of the asset over a set period of time; 27.5 years or 39 years. For example, if the asset is worth $1M, then using the 27.5 year depreciation schedule, the investor can deduct his/her taxable income by $36,363/year. The irony is that the value of the asset is not actually depreciating, but appreciating! So the property is depreciating for tax purposes, but appreciating in the market. There are also ways to supercharge the deprecation schedule so that the investor can deduct much more than $36,363 in the above example. It’s called accelerated depreciation, and the investor can engage in this by doing a cost segregation study on their property. In the above example, it is possible for the investor to deduct up to $350,000 in taxable income on year 1 in some cases! Another common tax advantage is the 1031 exchange. Normally, when an individual buys an asset and sells it for a profit, he/she owes tax on the gains to the government. For real estate, the IRS allows the investor to keep all the profits if the investor rolls the entire proceeds from the sale to acquisition of another property. In other words, the government allows tax-free sale if the investor exchanges his/her asset for another asset. Technically, it is tax-deferred and not tax free, but on a practical level the investor can end up paying zero taxes. There are many rules to follow to qualify for the 1031 exchange, but it is a powerful tool to grow one’s portfolio in an exponential rate.
The four-pronged approach of return generation is powerful. Even if profit lags in one area, the other 3 can compensate. As an example, a property that’s suffering from little to zero cash flow will still be gaining equity from principle pay down, enjoying appreciation, and various tax advantages. These are unique to real estate and what makes it lucrative and exciting.
By: Ki Lee