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Four Ways to Profit in Realestate




I talked about risk mitigation earlier. Real estate, unlike almost any other business or investment, has a unique risk mitigation quality already built in: It offers you, the investor, four different ways to make money. If one doesn't pan out, the other three may save the day.

Cash Flow
Cash flow is simply what's left over after all expenses are paid at the end of each period. It's the simplest "metric" of all. Many investors will tell you, and I agree, that you should not buy a property if it doesn't cash flow, at least a little. The cash flow is what you'll use (instead of your savings or paycheck from a job) to pay for extras that aren't in the budget. Cash flow may be what you're counting on to pay your living expenses, now or in retirement. How much cash flow you get varies from situation to situation. I think it's ok to buy a building with less cash flow if that building is in a good area, is well maintained, attracts good tenants, or has any number of positive features that make it otherwise profitable or valuable. In other words, you don't need as much cash flow if you really are convinced it's a good deal, or it will appreciate, or you get great buying terms.

The way you'll measure your cash flow in a meaningful way is a metric called "cash-on-cash return." Cash-on-cash return, or "COC" is the amount of cash flow each year, divided by your cost of acquisition, or the money you initially put into the property. For example, if you buy a $100,000 triplex, put $25,000 down and your initial improvements and closing costs are $5,000, then your investment is $30,000. This is the amount of your actual cash that came out of pocket and into the deal, the same as if you'd put $30,000 in a mutual fund, CD or stock. You need to know what you're making so you can compare it to alternate investments. If you're up all nights, getting ulcers and working out the perfect murder in your head, you need to know you're getting compensated for that! If you find you're making 2%, and you can make the same thing on a CD and not worry about expensive medications or prison time, your answer is clear. If you don't know what your return is, you can't make intelligent decisions.

Cash flow is not the same as profit. Profit is on paper, cash flow is real. For example, the principal portion of your mortgage is not an expense. That gets deducted from the liability account of the mortgage, reducing that liability and making you incrementally wealthier each month. However, it does reduce your cash flow. I like to run both a profit and loss statement as well as a cash flow statement every month just to see how they compare. You can have a profit on paper but still have a negative cash flow. It's important to know both. Many a "profitable company" has gone broke!

Appreciation
I'm not talking about the kudos you get from your boss or spouse; I'm referring to when your building goes up in value. It can really push your return skyward. For example, let's use the previous example of the $100,000 triplex that cost you $30,000 up front to own. It cash flows $3,000 per year, which is an annual 10% return on your $30,000. Not bad, just by itself. Now imagine you decide to get out of the business. Nearly three years have gone by and your agent tells you to list it for $130,000. The economy has turned around, you bought wisely, and your three-unit has a nice owner's apartment, which may appeal to a young couple just starting out who want to do an owner-occupied situation. You end up getting $120,000. Deduct 8% from commissions and other selling costs and your final tally is $110,400. You haven't paid much down on the principal, maybe $5,000, so when you pay it off, you walk away with just over $40,000. That's an extra 25% return on your money over three years. That represents an additional 7.5% compounded per year and on top of your 10% yearly cash flow, a total of 17.5% return on investment per year.

Appreciation is a bonus. The longer you hold your real estate the more likely it is to happen, but it's not guaranteed. In my opinion, you should not use any appreciation assumptions to decide whether or not to buy a particular building. Leave it out of the equation entirely with one exception, which I'll talk about in the analysis chapter. Leaving appreciation out of your analysis will give you some extra padding and margin of error for the mistakes you'll make somewhere else!

Debt Pay down
Did you know you can make an additional 6.2% on your money, year after year, just by virtue of your tenants paying off your mortgage? This is a neat benefit of using a mortgage to buy a property. Let's go back to our 100k triplex to illustrate the point: We know our initial outlay is $30,000, putting 25% down and kicking in another $5,000 for expenses. We get a twenty-year investment property mortgage for 4.5%. Now, let's also assume that everything else is break-even. We don't make any cash flow, so we can't quit our day job, but we don't need to take money out of our savings to buy oil or fix the roof. We sell the building exactly twenty years after we bought it, the day the mortgage is paid off. The building appreciates only enough to cover our selling expenses, so we walk away with exactly $100,000 at closing. What did we make on our money all those years? As it turns out, we earned a 6.2% average annual return for twenty years. Here's how I figured this: If you take $30,000 and put it in the bank, you need to earn 6.2% annual interest to turn it into $100,000 over twenty years. This is exactly what you've done with this triplex. When you add this to a situation where you have great cash flow and appreciation, your total return can be huge. 6.2% might not seem like much compared to other possible investment returns, but this is a sure thing. Paying down a mortgage for twenty years after putting 25% down gives you a guaranteed return of 6.2% on your money. The only risk is time; you have to stick with it for the whole twenty years. If you have an ample cash flow, and you want to pay off your debt faster, your return increases. Here's how your return increases just by shortening the length of the payback time by five and ten years respectively.

15 years: 8.30% per year
10 years: 12.75% per year

Keep in mind that you still have to have "neutral" cash flow to keep the above examples true. If you pay your mortgage off in fifteen years, but it puts you in the red by a hundred bucks each month, you have to deduct that from your 8.3% return.

Caveat: You have to hold the mortgage the whole twenty years to enjoy this benefit: Because you're paying mostly interest the first few years, your return is lower in the early years, higher in later years for an "average" return of 12.75% but it washes out if you follow through with the plan.

Depreciation
When you buy a building, the IRS allows you to deduct a certain amount of the cost of the building each year. Even though real estate traditionally appreciates, the IRS considers it a business asset and as such, we are allowed to deduct a portion of its cost from our income each year. Currently, that amount is the cost of the property, minus the value of the land, divided by 27.5. So for example, the value of our $100,000 triplex consists of $75,000 for the building and $25,000 for the land. You can find this breakdown in the assessor's office or online if your town has such a thing. Here in Winslow and Waterville, we have a system called Vision Appraisal. If you're in Maine, here is the link:
http://vgsi.com/vision/Applications/ParcelData/ME/Home.aspx

Land is not depreciable, but the building is, so we'd divide $75,000 by 27.5 years and you get $2,727 per year as a depreciation deduction. This is good stuff because if we go back to our original example triplex, let's say our actual profit was $3,727. Let's also say we live in Maine, we're in the 15% tax bracket for federal and 7% for the state. We calculate that our next dollar earned will be taxed at 22%. So our $3,727 in profit will cost us $820 in federal and state income tax, whittling our profit down to $2,907. But, when we deduct our depreciation, our profit is only $1,000. Taxes on that will be $220, leaving us with a "real" profit of $3,507, and a $600 difference. And this example is for the lowest tax bracket. The savings is much rosier if you're in one of the higher brackets. Multiply this by several buildings and you can quickly save yourself a ton of money.

There is one caveat here. This write-off is really a loan of sorts from Uncle Sam. It's yours as long as you own the building, but if you sell, the government wants you to do something called a "recapture." Let's say you've had your $100,000 triplex for 10 years and written off $27,270 in depreciation. You decide to sell and you quickly find a buyer. It's appreciated nicely and you get $135,000 for it. Now you have a $35,000 capital gain, which is taxable at the long-term capital gain rate of 0%-20% depending on your tax bracket. However, because you got to deduct your depreciation against your income these past ten years, you have to add it back as ordinary income when you sell the building. In this case, you've "earned" $27,270 extra dollars to add to your income tax return. The only ways I know of to avoid this are to use a 1031 exchange, which can be a complicated thing to do, or do a seller financing, in which case you only pay taxes on the amount of principal you receive from the buyer each year.

There are some other aspects of depreciation you can use to your advantage. For example, you can depreciate things like stoves and refrigerators over shorter periods of time. And you don't have to worry too much about recapture here because you're most likely going to dispose of them or sell them for pennies on the dollar, thereby "locking in" your depreciation on those items. It may be worth looking into this because it takes at least some of your depreciation off the recapture table. For more information, Google "real estate depreciation recapture".

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