Two Ways to Make Money from Real Estate
Owning and managing real estate can be an extremely beneficial venture. There are several ways to make money from the real estate you own. Take advantage of the cash flow provided by your property and explore the pros and cons of refinancing or paying down your debt. The following is adapted from “Loopholes of the Rich” by Diane Kennedy, CPA.
Cash Flow from the Property
The first, and I think the most important, benefit of real estate ownership is the cash flow. Cash flow is the money you get from the property from rent after subtracting all regular expenses. Typically, we look at the cash-on-cash return from a property. The cash-on-cash return is calculated by first calculating the annual cash flow, then dividing it by the cash that you have invested in the property.
So, as an example, let’s say that you have a property that has annual rents of $10,000. Your annual expenses (mortgage, property tax, insurance, repair allowance, and the like) total $8,000, so you have an annual cash flow of $2,000.
The cash invested (comprised of the down payment, settlement costs, repair costs, and the like) totals $20,000.
The cash-on-cash return in this case is 10 percent. That is calculated by dividing $2,000 by $20,000.
The cash-on-cash return is generally calculated when you first purchase a property. But if you want to have velocity on your real estate investing, regularly assess a new cash-on-cash return.
If you refinance to pull more cash out of the property, what would be your new cash-on-cash return? Or, assuming you do not refinance, divide your current return by the amount of money you now have invested in the property after it has appreciated.
Using the previous example, this time assume that the property has gone up in value by $100,000. That means that the cash you really have invested in the property is $120,000. (I’m assuming that there hasn’t been any debt pay-down.) Now, if your cash flow from the property is $2,000 you have an effective cash-on-cash return of only 1.7 percent ($2,000 divided by $120,000).
If you refinanced the house, the cost would go up, but you would also be able to pull cash out for another investment.
By the way, I’ve seen people try to play games with cash flow by putting large down payments on a property or by paying off a property completely. In my book, if a property can’t be justified using traditional financing, it’s not a cash-flowing property. If your strategy with it is something else (planning for appreciation or development), then be sure you’re comfortable with it and you’re clear with yourself and your advisors that this is your strategy.
Debt Pay-Down
Until recently, mortgages that included principal and interest were the only types of loans readily available. In the beginning of the loan, the principal pay-down is a small amount of the payment. As the loan ages, the principal portion increases significantly. I think that the small amount going to pay down the debt at the beginning makes people forget to calculate the debt pay-down portion as building equity.
Owning and managing real estate can be an extremely beneficial venture. There are several ways to make money from the real estate you own. Take advantage of the cash flow provided by your property and explore the pros and cons of refinancing or paying down your debt. The following is adapted from “Loopholes of the Rich” by Diane Kennedy, CPA.
Cash Flow from the Property
The first, and I think the most important, benefit of real estate ownership is the cash flow. Cash flow is the money you get from the property from rent after subtracting all regular expenses. Typically, we look at the cash-on-cash return from a property. The cash-on-cash return is calculated by first calculating the annual cash flow, then dividing it by the cash that you have invested in the property.
So, as an example, let’s say that you have a property that has annual rents of $10,000. Your annual expenses (mortgage, property tax, insurance, repair allowance, and the like) total $8,000, so you have an annual cash flow of $2,000.
The cash invested (comprised of the down payment, settlement costs, repair costs, and the like) totals $20,000.
The cash-on-cash return in this case is 10 percent. That is calculated by dividing $2,000 by $20,000.
The cash-on-cash return is generally calculated when you first purchase a property. But if you want to have velocity on your real estate investing, regularly assess a new cash-on-cash return.
If you refinance to pull more cash out of the property, what would be your new cash-on-cash return? Or, assuming you do not refinance, divide your current return by the amount of money you now have invested in the property after it has appreciated.
Using the previous example, this time assume that the property has gone up in value by $100,000. That means that the cash you really have invested in the property is $120,000. (I’m assuming that there hasn’t been any debt pay-down.) Now, if your cash flow from the property is $2,000 you have an effective cash-on-cash return of only 1.7 percent ($2,000 divided by $120,000).
If you refinanced the house, the cost would go up, but you would also be able to pull cash out for another investment.
By the way, I’ve seen people try to play games with cash flow by putting large down payments on a property or by paying off a property completely. In my book, if a property can’t be justified using traditional financing, it’s not a cash-flowing property. If your strategy with it is something else (planning for appreciation or development), then be sure you’re comfortable with it and you’re clear with yourself and your advisors that this is your strategy.
Debt Pay-Down
Until recently, mortgages that included principal and interest were the only types of loans readily available. In the beginning of the loan, the principal pay-down is a small amount of the payment. As the loan ages, the principal portion increases significantly. I think that the small amount going to pay down the debt at the beginning makes people forget to calculate the debt pay-down portion as building equity.