It is easy to assume that people buy rental properties because they want to make money, but what exactly does that mean? There are 4 potential financial benefits to owning an investment property:
In a recent blog, we outlined what homeowner’s equity is and how changes in home prices affect it. Generally, home prices increase 3-5% per year. In some cases, though, the appreciation can be much higher. Whatever the case, over time, a real estate investment will increase in value, thus increasing the owner’s net worth.
2. Cash Flow
The difference between the rent received and all the costs associated with the property is the cash flow. Note that this is not rent minus the payment. Investors must take into account property management fees, vacancy, repairs, savings for capital improvements, utilities, etc.
3. Tax Breaks
Mortgage interest is tax deductible for either up to a $1 million home loan or up to a $750,000 home loan, depending on when it was obtained. This tax deduction lowers a taxpayer’s gross income, thus lowering the amount of taxes owed. Note that the tax break benefit is only realized if the taxpayer itemizes, which is not as common as it was prior to the Tax Cuts and Jobs Act because that act raised the standard deduction quite a bit.
4. Loan Pay Down
Every month, when a property owner pays their mortgage payment, a portion goes to principal, interest, taxes, and insurance. Early on, the amount of interest being paid far outweighs the amount of principal, however, there is some. Rent collected and used to pay the lender decreases the liability (loan) outstanding and increases the owner’s net worth.
Real estate investors may have a philosophy on which one of these economic benefits they’re most trying to achieve. It also can vary from property to property. For example, one investor may buy a property that only cash flows $100 per month, however, they anticipate annual appreciation to top 10%. Another investor may buy a property not believing it has much appreciation potential, but cash flows $1000 per month. Whether or not the investor pays cash or takes out a bank loan heavily impacts cash flow, and of course the tax break and loan paydown as well.
Our duplex is a cash flow and appreciation play for us. We bought it near downtown in an area we hope will gentrify. We also paid cash for it, which allows us to get good cash flow from the property. In paying cash, however, we’re sacrificing the tax-deductible interest and loan paydown benefits.
Which benefit of real estate investing most appeals to you?