Investing in real estate is an excellent way to diversify any investment portfolio. There are four major benefits when investing in income property. And over time, each of these benefits become more and more valuable. We’ll cover how each aspect can reap great rewards for your real estate investment.
Capital appreciation is the increase in value from the price of the real estate increasing. In other words, as the property rises in value your investment value also rises. Add to that increase the effect of leverage and real estate can offer large returns. For example, suppose you purchase an apartment building for $500,000 and take out a loan for $400,000. Now, assume that in five years the value of the apartment increased by $100,000 to $600,000. The capital appreciation on your investment is $100,000. The return is $100,000, which equates to a 20% increase in value. However, the real return is actually 100%, because you only invested $100,000 and borrowed the rest. The combination of capital appreciation and leverage (the increase in returns due to debt) can account for significant returns from your real estate.
In addition to the value of the property increasing, you also get the benefit of paying down your debt. Every dollar you pay down on your debt goes directly to your equity in the investment. Using the $500,000 apartment building from the example above, your starting equity is $100,000. If, after five years, you have paid down $50,000 on your loan, then you would have $150,000 in equity. Now add the capital appreciation of $100,000 and your portion of the real estate investment is now worth $250,000, which is a 150% return on your initial investment.
Monthly Cash Flow
The third benefit of income property is the income itself. Most properties have very little positive cash flow when purchased. As rents grow the monthly cash flow from the property also grows. Let’s use the previous example and assume that the initial rents just covered the monthly property expenses. That means your beginning cash flow was at zero. Now, let’s assume that the initial rents were $4,000 per month and that after five years they grew by 15% (3% a year). Assuming all of your other expenses stayed the same, you would be earning $4,600 per month and your monthly cash flow would now be $600. So, what started out as a $100,000 investment five years ago is now worth $250,000 and pays you an effective dividend of $600 per month, or $7,200 per year.
The final benefit that buying income property has is in tax benefits. There are two main tax benefits that real estate provides. The first is that it defers recognizing income in the initial years. By depreciating your property the initial tax income will likely be negative and you won’t have to pay a heavy tax burden in the early years. The second tax advantage from real estate is that all of your investing related expenses are deductible, including the big things like mortgage interest and property taxes. However, the small things are deductible too. If you subscribe to investing magazines, use your phone to transact business, or use the Internet to communicate with tenants, then at least a portion of these expenses are tax deductible. Being creative with your taxes means that you can reap the benefits of many real estate tax advantages.