I’ve been reading What Every Real Estate Investor Needs To Know About Cash Flow, and it outlines the four ways to make money in real estate investment:
- Cash Flow – Money earned each month after mortgage, taxes, insurance, maintenance, and other expenses.
- Appreciation – Money earned by selling the property for a higher price than you paid.
- Loan Amortization – Money paid each month by your tenants towards the principal on the loan (not the interest).
- Tax Shelter – Money saved from various deductions including mortgage interest, maintenance, and depreciation.
I expect to go into each of these in more detail in future posts, but it’s important to understand these basics, and it’s interesting to evaluate a given property along all four dimensions. I might also add a fifth dimension, which is hedge against inflation — if you have a fixed-rate mortgage and the price of EVERYTHING goes up, then you’re getting even more money in rent/appreciation, but paying relatively less in mortgage.
Different investment strategies might emphasize different dimensions: for instance, a fix-and-flip strategy would focus on appreciation. I’ve been focusing on single family residence rentals, and here’s an evaluation of my properties along these dimensions:
- Cash Flow – I’m getting some cash flow each month, though much of it gets eaten up by periodic repairs. This will grow over time, as rents go up but my mortgage payments stay the same. I would never want a property with negative cash flow; it would become a burden to pay every month and I wouldn’t enjoy it.
- Appreciation – I don’t expect any appreciation any time soon in the current economy, but I’m not planning to sell any time soon either. This could be a major plus when the economy turns around.
- Loan Amortization – My loans are new, which means that most of the payment is going to interest rather than principal, so I’m not getting much value in amortization yet, but this will change over time.
- Tax Shelter – The flip side of my mortgage payments being mostly interest is that I can deduct all that interest. I can also deduct things like insurance and repairs, and I also depreciate the value of the house and any improvements. In my first year, I didn’t end up paying any taxes on the income earned from my tenants due to these deductions.