Four Ways to Profit from Real Estate

Most people probably don’t want to hear about real estate at the moment, but now is the time to begin thinking about investing in real estate—when property prices are down.  Eventually, supply and demand will return toward equilibrium and while others were paralyzed into inaction, you were planting the seeds of profit.  Most people can name a few ways to profit from investing in real estate, but in fact, there are four ways!

This one seems fairly straight forward. Buy a piece of property and collect rent. But there is a lot more to it than that. You have to know the area or be working with someone who does. It is important to have a grasp of the location where you are investing. Is the area growing or in decline? What is the vacancy rate? Do you know what the real estate taxes are and what is their trend? You need to factor in all the components that will affect your revenues such as rental rates, vacancy rates, projects under construction that might affect supply, employment trends and population growth. You also need to consider your expenses like financing costs if you are not using solely cash, insurance and taxes, maintenance costs both ongoing and potentially large repairs that you might incur relatively soon. All of these factors will determine your cash flow.

However, one of the most important factors that will ultimately determine your cash flow is the purchase price. Just as in other areas of investing, the goal is to buy low (as low as possible) and sell high (as high as possible). Too many people forgot this during the real estate bubble and were willing to forgo cash flow profits instead counting on another area of profit—appreciation.

Unfortunately, if you pay too high a price for your property, you may not only give up your potential for cash flow, you may also give up the opportunity for appreciation. I like to think of two different types of appreciation. First, there is the appreciation that occurs based upon macroeconomic circumstances. This can be do to an area that is growing or where people are wanting to live. Demand is out-stripping supply. There can also be appreciation from systemic inflation or cheap financing. This type of appreciation is passive. There is really nothing that you are doing to cause this appreciation; you are just hanging on for the ride.

Another form of appreciation is forced appreciation. This occurs when you actually do something to the property to add value. Purchase a foreclosed, beaten-down property, clean it up, make repairs and sell at a profit is forced appreciation. You can also think of developing raw land as forced appreciation. No matter what appreciation you are talking about, you don’t profit until you either sell the property or borrow against it. It is like paper profits and can be lost.

This profit is actually a result of the tax code. Depreciation is defined as a non-cash expense that reduces the value of an asset as a result of wear-and-tear. The assumption is that you are putting aside money on a consistent basis to eventually replace the asset (in this case real estate). The value of a building is divided up and a portion of its value is subtracted from any earnings that you receive. The result is a tax deferral that can essentially be used to generate tax free earnings until you are forced to recapture the depreciation. There are certain techniques that can be used to maximize the value of this portion of the tax code. Consult your accountant or tax attorney.

If you purchased your property with the help of financing, each and every payment decreases the amount of the outstanding loan. Provided you paid attention to your purchase price and understood your potential revenues and expenses, you will be gaining equity in the property and increasing your net worth slowly and surely. Eventually, you will own an asset that you can sell for a profit. Hopefully, a significant portion of that profit has been provided to you courtesy of your tenants.

Owning real estate has been a very profitable investment for many people in the past and will continue to be so in the future. The important thing is to do your homework and know where you stand to profit from your real estate investing.