Let’s begin by taking a look at hedgehogs. How do hedgehogs demonstrate how to make money in real estate? Hedgehogs are fascinating creatures. They have prickly spines that protect their soft little bodies from predators. When faced with danger, they curl into a ball making them an unappetizing meal for their predators. In addition to this survival tactic, hedgehogs, as their name implies, often live in hedges. Hedges provide a safe place for them to rest. In addition to shelter, hedges also happen to be a fantastic place for hedgehogs to find food like mice, worms, and other insects.
So what does this have to do with real estate? As you can see, hedgehogs are masters at playing defense–they know how to find food and shield themselves against harm, just like sophisticated investors know how to make money while protecting their assets. This kind of strategy has been crucial for investors during the economic uncertainty of 2020 and 2021. When it comes to protecting yourself with a good defense, real estate is one of the best options out there.
So, how do investors make money in real estate while protecting the value of their investments?
Here are six of the most common methods:
- Enhancing cash flow by way of market rent appreciation
- Appreciation through economic improvements;
- Appreciation through physical improvements;
- Appreciation through supply and demand;
- Tax deductions and incentives; and
- Leverage and loan principal reduction.
Let’s break down each of these methods.
Enhancing cash flow by way of market rent appreciation
We’ll start with cash flow. For a majority of investors, the principal reason for investing in real estate is cash flow. It’s important to distinguish between earned income and passive income. Earned income is generally developed by trading time for money: earning a wage for your labor. For example, an office worker at ABC Industries working 40 hours per week for $20.00/hour is receiving earned income. Passive income, on the other hand, is income that requires minimal labor to earn and maintain, often generated from investments or properties, including real estate. It has been said that an income property is a gift that keeps on giving. Both earned and passive income contribute to your cash flow.
In its simplest form, cash flow is the amount of money that is left over after paying all of your property expenses, including payments on debt. In the real estate lending industry, this is often referred to as “excess cash flow” or “cash flow before taxes.” You may also hear the term Net Operating Income or NOI. NOI is simply the rental income after expenses but before payments on debt.
Now that you’ve had a refresher regarding cash flow, let’s look at how investors are able to enhance their cash flow by way of market rent appreciation. At its core, this begins with one thing: establishing expectations. For example, let’s say that you purchase a 20-unit apartment building that is fully occupied. You acknowledge that the previous owner neglected to raise rents for the last 15 years, resulting in the units being rented well below the current market-rate rent. A tactful approach to enhancing your cash flow on this property would be to increase rents over time as the property experiences vacancies. Some investors prefer to raise rents all in one swoop as soon as they acquire a property. In either case, it is in the best interest of the landlord and tenant to have properly set expectations around rent increases. This should be written in the lease agreement.
Annual rent increases can be a fixed amount like $25 per unit, for example, or a percentage like 2.5% per year. You can even index rent increases to inflation. No matter what your approach is, good communication will result in a win-win scenario for both landlord and tenant. This will allow you to watch your rental cash flow grow nice and steadily over time. And, cash flow is just the tip of the iceberg.
Appreciation through economic improvements
Many investors are only interested in cash flow but one of the great things about investment properties is that the value of the property often increases as your cash flow increases. How crazy is that! You can put more money in your pocket at the same time as your property goes up in value.
Here’s how it works. When you make economic improvements to a property, you are enhancing its value. You can make an economic improvement to a property by increasing its income or by decreasing its expenses. Both routes will get you to the same place. In general, the value of an investment property is derived from the income it generates. This is why there are investors that specialize in underperforming properties where they can easily adjust property income or expenses. What a great way to force equity into a property!
Appreciation through physical improvements
Another way that investors can develop equity is to make physical improvements to a property. If you’ve ever seen one of those shows where a lovely couple buys an ugly property, fixes it up, and sells it for a profit (all in a 30-minute episode), you know exactly what I’m talking about. If only it were that easy! The reality is that it takes a lot of work. Investors have regular challenges with contractors, suppliers, lenders, and partners. But, if you’re willing to put in the time and establish systems to deal with the challenges, the outcome may be rewarding.
One of the solutions to successfully adding value to a property is to know where to spend your time and money. You’ll want this to have a direct correlation with the property’s income and expenses. However, there are times where the supply and demand of the market may do work for you.
Appreciation through supply and demand
Supply and demand is an interesting concept. I’m sure many of you have heard the old Mark Twain quote, “Buy land, they aren’t making it anymore.” In New Mexico, the availability of land has been an ongoing challenge for developers. Construction costs have also been prohibitive for building and have caused many projects to be put on hold. What this means is that supply has been slow while demand has been rapidly increasing. This has caused real estate prices (values) to go up. If you’re a property owner, you’ve been increasing your net worth all from the comfort of your couch. Of course, this works both ways. As supply increases and demand slows down, values will also slow down or could even decrease. The good news is that property values have always gone up in the long run.
Tax deductions and incentives
Many investors prefer to place their capital in real estate because of the tax benefits that they receive. This certainly is a notable area where real estate investing outshines alternative investment options. The 1031 exchange, cost segregation analysis, and net operating loss carryovers are just a few of the many tax strategies that investors use to protect their investments. These tax strategies can be complex and it’s best to discuss them with your tax professional–having good legal and tax professionals on your team is a key ingredient to your ongoing success. So, make sure that you find a good one.
Leverage and loan principal reduction
Finally, let’s look at the real estate investing concept of financial leverage. Financial leverage allows investors to amplify their returns. Let’s say, for example, that you have $200,000 to invest. You look at stocks, bonds, and mutual funds all as viable options to place your money. You’re super excited because you found a fund that has an 8% yield. You run some quick calculations and find that you’ll make about $94,000 in five years. But, you remember that you have a good friend that is a commercial real estate broker. They tell you that they can find you a $1 million investment property with the same $200,000 as a down payment. So, you agree to check it out. Your real estate friend calls you and says that they found something that meets all your requirements.
Here’s what the numbers look like. The property has a sales price of $1 million. It generates $100,000 per year after expenses. You call your lender to get a quote and they tell you that they can lend you $800,000 on this property. They go on to say that your annual loan payments will be approximately $50,000. You do some quick math in your head ($50,000 x 5 years = $250,000). You get a big smile on your face because you know that you’ll more than double your original investment of $200,000 in 5 years. That 8% investment fund doesn’t sound so good anymore, does it?
This is exactly how financial leverage works. As an investor, you share the risk with your lender. By combining your money with the lender’s money, you are able to purchase a much larger investment. Yes, the lender takes a small piece of the pie in the form of interest, but you will walk away with the profits. And keep in mind that the lender took on 80% of the risk, $800,000.
A perk to using a local lender is that they will walk you through the various nuances of the borrowing process, such as qualification, valuation, title work, and much more. You should think of your lender as a financial partner. They will serve as another layer of defense and set of eyes for you as they go about their due diligence process.
To wrap it all up, there are many ways to make money investing in real estate. Real estate can be a great way to grow your personal cash flow and net worth safely over the long run. Physical and financial property improvements give you a great deal of control over your investments. Rent increases, for example, allow you to hedge against inflation. The tax benefits that are derived from real estate can be substantial, as well. These will allow you to keep more of your money. Lastly, the desirable financing options currently available for real estate allow you to amplify your return on investment. And, we didn’t even mention that someone else is paying your loan for you. The reduction in your loan principal and appreciation of your property are just icing on the cake!
Whether you consider yourself to be an experienced investor or novice, State Employees Credit Union has you covered! We’re here to help you be successful. Together We Build Futures.
Gabriel Fernandez is the State ECU Commercial Lending Market Manager for the Albuquerque Metro Area. Gabriel is a New Mexico native and comes to State ECU with extensive experience in commercial real estate lending and portfolio management. He has financed a broad range of property types, such as apartments, warehouses, retail buildings, and more. Gabriel helps growing businesses and investors acquire the resources they need to prosper. Come by and speak with Gabriel about your commercial lending needs and see what he can do for your business. You can also find Gabriel on LinkedIn, by phone at (505) 983-7328, ext. 3604 or send him an email to get in touch.