The 7 Profit Centers of Owning Real Estate
When most people think of making money in real estate, they think of the obvious: 'appreciation' (the increase in value of the property over time). The truth however, is that real estate can bring profits and financial benefits in 7 different ways. This is the foundation of investing in real estate for profit.
1. The first profit center is EQUITY. Equity is defined as the fair market value minus the debt service (mortgage). If you are able to purchase a property below market value, you will have additional equity right from day one. Let's look at an example:
Property List Price at Market Value: $307,500
Purchase Price: $300,000
Downpayment (25%): $75,000
Bank Financing (75%): $225,000
Your equity is not just the $75K you paid down, but also the additional $7,500 you purchased the property for below market. Your equity is actually $82,500, and in this example you've already made 10% on your investment the day you completed the sale!!
2. The second profit center is LEVERAGE. This is the ability to buy more with less money. In the above example, you are able to acquire a $300,000+ home for only $75,000 of your own money. The higher the LTV (loan to value) financing, the more leverage you have, and leverage is one of the most important concepts of successful real estate investing. Let's say you had $300,000 available to invest. Without leverage, you could buy one house such as the one above. By leveraging your money with 75% LTV financing, you could now potentially purchase 4 of these same homes!!
3. The third profit center (as mentioned above) is APPRECIATION. Let's say your $307,500 home (which you purchased for $300K) appreciates 10% per year. After one year your home is now worth $338,250. You've made an easy $30,750 in appreciation alone. Remember though, that your investment was only $75,000. Your return on investment (ROI) from appreciation alone is a whopping 41% in one year!
4. The fourth profit center is PRINCIPLE REDUCTION. An investment property will most likely have tenants who in turn, through their rent payments each month, will be paying off your mortgage for you.
5. Fifth is CASH FLOW. Your tenants, as well as other revenue streams (laundry, garage rental, etc) each month bring you income. When your income is greater than your expenses, you have positive cash flow. Let's say, as an example, you have a tenant in your $300,000 home paying rent of $1250 per month. Let's also assume that your expenses each month, including debt service, total $1000. This brings you positive cash flow each month of $250, or $3000 per year. This translates into an additional 4% cash on cash return.
6. A sixth profit center are the TAX BENEFITS that come with investment property. Regardless of short-term up and down fluctuations in the market, real estate will always appreciate over time. And yet accounting practices allow a 3% - 4% capital cost allowance to compensate for the 'depreciation' of your property. Even though the property is actually appreciating, you can use that allowance as a tax write-off. (Keep in mind though that this allowance needs to be repaid upon sale of the property). Additionally, just like in any business, expenses are tax-deductible. Your expenses associated with your investment property are tax write-offs, and this includes the interest expense of your mortgage. Both of these tax benefits allow you to keep more money in your pocket, and this means more money to re-invest...
7....which brings us to the seventh profit center, REINVESTING YOUR EQUITY. In keeping with our example above, your house which you paid $300,000 for, appreciating at 10% per year, is worth about $370,000 two years later. Your mortgage, which initially was $225K, is now down to about $220K. You therefore have $150,000 equity after 2 years! Most banks are willing to lend 75% of the value of your property, and so in this case they would lend you about $275K. Subtract your existing mortgage loan from that amount, and you're left with an additional $55,000 that the bank is now willing to lend to you. Reinvest this amount at 75% LTV, and you can now purchase another investment property valued up to $220,000
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These 7 profit centers are based on the principles taught by July Ono and Selena Cheung, founders of RENG (Real Estate Network Group), as well as Don R. Campbell, founder of REIN (Real Estate Investment Network) and Darren Weeks of Fast Track to Cash Flow. Utilizing these principles they have each built massively successful multi-million dollar portfolios of real estate holdings. It is important for all real estate investors to understand these profit centers in order to maximize their returns. While ideally you would like to have all 7 profit centers present in your deal, in some markets it just might not be possible. As an example, in an extremely hot market it becomes more difficult to find positive cash flow properties. But the high appreciation rates will more than make up for it. (Property appreciation of $50,000 more than makes up for a negative cash flow of say -$5,000). The important thing is to understand all 7 profit centers in order to clearly analyze and predict your total potential returns.