Four Ways to Make Money in Real Estate
Updated: May 31, 2019
4 Ways to Make Money in Real Estate
People ask me all the time, “Why Real Estate?” There are numerous reasons, many of which I’ll write about in the coming weeks, but one of the first answers that pops to mind is the fact there are a variety ways to make money in real estate. My group focuses on buying value-add apartment communities that cash flow from day 1. Therefore, we will focus on this type of asset throughout the article.
Let’s dive in and take a look at the top 4.
1) Cash Flow
This is the monthly distribution you can expect for your real estate holdings. At a minimum, we look for 7-10% in a cash on cash return. For example, assuming an asset we're targeting has an 8% CoC return, if I invest a $100,000 I would expect a monthly check of $666.67 hitting my account. Yes, you get paid while holding the asset! BOOM!
In our world, this is FORCED appreciation. One of the many benefits of investing in apartment communities is you can control the value of the asset. Apartment communities are valued based on the Net Operating Income they generate. If I can increase revenue, or decrease expenses (or both!!), then the value of my asset increases.
For example, let’s say we bought a 200 unit apartment community for $10,000,000. The NOI at time of acquisition was $600,000, giving us a cap rate of 6%.
For the sake of simplicity, let’s assume 100% occupancy and $500 rent per month per unit.
500 * 200 = $100,000 in monthly rental Income, or $1,200,000 per year. In addition, and sticking with the simple math, let’s assume we had a 50% expense ratio, which gets us back to the $600,000 NOI.
$1,200,000 in revenue - $600,000 in expenses = $600,000 NOI
Our competitors across the street are getting $675 per month with recently renovated units. Our value-add business plan is upgrade the interiors of the units with luxury vinyl plank flooring, refacing cabinets with a modern shaker look, re-glazing countertops, updating appliances and light fixtures, and finally a fresh two-tone paint job. During due diligence, we received bids from our property management company and know the renovations are going to cost $6,000 per unit.
$6,000 * 200 = $1,200,000 renovation budget.
Over the course of the next 18 months, we implement our business plan and get all residents to the $675 per month.
Now, our rental income is 675 * 200 = $135,000 per month or $1,620,000 per year.
Assuming this same 50% expense ratio, our new NOI is $810,000. (As a side note, expenses would actually be less as they don’t increase proportionately with increased rents.)
What’s that make the new value of our asset?
Value = NOI / Cap Rate
$810,000 / 6% = $13,500,000
We are all in at $11,200,000, but our asset is now worth $13,500,000. Over $2MM in equity by executing our value-add business plan!
Imagine a world where someone else pays your bills? That’s exactly what happens in real estate investing!
Our tenants pay down our mortgage over time, and it’s a beautiful thing. Let’s take a quick look at the impact this could have.
Back to our previous example, we bought a $10,000,000 apartment community and put 25% down. The bank gave us a mortgage for the remaining 75% or $7,500,000. We have a fixed note at 5% for 10 years, with a 30-year amortization.
A quick look at a mortgage amortization schedule and we can see that after 5 years, our tenants have paid off over $600,000 of the principal amount we owe.
Let’s pretend we did no value add, broke even every month, and the paying down of the principal was all the benefit we received. Since I made the assumption we didn’t add any value, let’s pretend we don’t have any fees at time of sale either. Therefore, our total return from simply principal paydown would be:
$600,000 / $2,500,000 down payment = 24%
That’s about 4.8% per year on average. (Yes, I realize you pay less principal in the early years, let’s not be too nitpicky). This is a massive benefit that can often be overlooked and highlighted the power of leverage.
In any real estate deal, you wouldn’t see this benefit hit your pocketbook until a liquidity event, whether that’s a sale or re-finance, but it is important to keep in mind. The paydown of principal is one component that would factor into an Internal Rate of Return.
If you’ve invested or studied up on real estate, you know the tax benefits it provides you. Many of our deals will give you cash flow each and every year, but you’ll show a loss on your annual K1 statement. This is what we call a “paper loss.”
How is that you ask?
It’s because of the benefit of depreciation. You will make money, but not pay taxes until sale (and you can defer that by a 1031 exchange, which I’ll save for another day). You can also use the loss on your K1 to offset other passive income that you may have in that year, or it will carry forward forever until you have passive income that it can help offset.
The government, in all their glory, does reward real estate investors through depreciation. There are ways to accelerate depreciation through a cost segregation study, but that’ll take its own blog post
In conclusion, investing directly into real estate where you have direct ownership allows you to make money at least 4 different ways. Pretty cool stuff, eh?