The Four Ways a Rental Property Pays You
Cash flow is one of them. Here is how the other three add up.
The Four Pillars of Rental Real Estate Profits:
1. Cashflow – Cash flow is the lifeblood of rental real estate. It’s the income generated from rents minus the various expenses and mortgage payments. Imagine your tenant pays $1,000 a month, and your total monthly expenses, including mortgage, amount to $800. This leaves you with a $200 surplus—a direct addition to your pocket. The goal is to accumulate such properties, steadily increasing your passive cash flow, ultimately enabling financial freedom.
2. Appreciation – While appreciation is the talk of parties where homeowners boast about doubling their property value, it’s a hidden benefit that materializes only upon selling the property. Appreciation involves an increase in property value over time. For instance, a $100,000 home appreciating by 5% results in a $5,000 equity gain. Though not a focus in our calculations due to its speculative nature, it can contribute to overall returns.
3. Tax Benefits – Treat your rental property as a business, and if your expenses hover around 50% of your rental income, you might run a nearly zero-profit business on paper, leading to minimal taxable income. Real estate offers the unique advantage of depreciation, allowing you to deduct a portion of your property’s value each year, further reducing your taxable income. This can result in significant savings, contributing to your overall return.
4. Principal Reduction/Debt Paydown – As your tenant pays rent, a portion goes towards reducing your mortgage, building equity over time. While this gain is realized only upon selling or refinancing, it adds to the overall return. For instance, a $100,000 home with a 25% down payment might contribute $1,800 per year to principal paydown—a 6% return.
The Numbers Game
Let’s put it all together. Here is a simplified example for a small single-family rental, not a large apartment syndication. Your numbers will be different:
- Cash Flow: 12%
- Appreciation: 16%
- Tax Benefits: 2%
- Principal Reduction/Debt Paydown: 6%
- Total Return: 36%
In this example the four add up to 36% on a small single-family rental, and most of it never shows up in your monthly cash flow.
Appreciation: The Double-Edged Sword
While appreciation can be a windfall, it comes with risks, as seen in market downturns. Focusing on cash flow, which is more resistant to economic changes, provides a more stable long-term strategy. The total return without appreciation still stands at a respectable 20%, surpassing stock market returns.
Other Hidden Avenues
Equity Capture: Buying a property below market value can create instant equity. However, this often requires significant time and effort.
Inflation Hedging: Having a mortgage can act as a hedge against inflation, a concept evident when looking at historical home prices compared to mortgage payments.
The IDEAL Investment
Rental real estate can be summarized by the acronym IDEAL:
- Income: Generating consistent cash flow.
- Depreciation: Leveraging tax benefits through property depreciation.
- Equity: Growing equity through mortgage payments by tenants.
- Appreciation: Considering appreciation as a bonus rather than a primary focus.
- Leverage: Responsibly using leverage to enhance returns.
In conclusion, rental real estate stands as a time-tested wealth-building tool. By understanding and leveraging the four pillars—cash flow, appreciation, tax benefits, and principal reduction—investors can unlock substantial returns. So, whether you’re a seasoned investor or just starting, rental real estate might be the IDEAL investment you’ve been searching for.
About the author
Lane Kawaoka, PE, is the founder of The Wealth Elevator and the author of two Amazon bestselling books, The Wealth Elevator and Simple Passive Cashflow. He spent 12 years as an engineer, bought his first rental in 2009, and left his job in 2019. He built his base in real estate and today is a general partner, operator and fund manager working with a community of accredited investors across real estate, oil and gas, and private companies. His track record: $2.1B of past real estate acquisitions, 10,000+ units acquired, 65+ projects, and $230M+ raised.
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