1. Cash flow
Cash flow is the extra profit left over after all of the expenses have been paid on a property. For example, if my rental property produced $2,000 in income and my expenses came to $1,700, my cash flow would be $300 that month.
Now, I know a lot of you are saying, “Three hundred dollars is not going to make me a millionaire.”
Probably not. But remember, we are just talking about one of the wealth generators. There are still three more to go!
Additionally, that $300 might be from just one property. If I owned ten similar units with the same cash flow, that’s $3,000 per month. If I owned 100 units, that’s $30,000 per month. This cash flow can go a long way toward helping you quit your job — or helping you save for a future big purchase, or retire wealthier.
When I talk about appreciation, I am not referring to how much I like you (though I do appreciate you!). I’m referring to the natural rise in value that real estate experiences. For example, if you purchased a property for $200,000 ten years ago, and today that property is worth $300,000, the appreciation made you $100,000 richer!
Of course, appreciation doesn’t cause values to increase every year (consider 2007!). However, historically, real estate prices have appreciated over the long term. So, again, appreciation alone is not likely going to make you a millionaire, which is why I don’t recommend that people purchase bad deals hoping that appreciation bails of them out.
However, appreciation is combined with the other “members” of the wealth generation team, powerful stuff can happen.
3. The loan pay-down
When you purchase a rental property with a mortgage, each month you make a payment to the lender. That payment includes two parts: principal and interest. Interest is the profit for the lender, but the principal is money you are paying down the loan with.
For example, if you purchased a house five years ago for $100,000 and obtained a $80,000 mortgage (we’ll say it was a 30-year mortgage with a 5 percent fixed rate), today you would owe only $74,000. Ten years from now, you would owe only $65,000. This means that every year your equity increased (equity is the difference between what a property is worth and what is owed on it), you’d gain value, as long as the property value didn’t drop.
Of course, if you paid all-cash for a property and didn’t obtain a loan, you would forfeit this wealth generator. This is something only you can decide.
4. Tax benefits
Finally, the fourth wealth generator in real estate is the tax benefits the U.S. government gives to investors. These benefits are numerous and realized in several distinct parts of the real estate process.
- Unlike most businesses, the government doesn’t look at cash flow or appreciation as self-employment income; thus no self-employment tax is typically due.
- The income tax that is due is often offset entirely by a deduction known as depreciation.
- Additionally, when you sell rental properties, the profit is taxed at the long-term capital gains rate, if at all.
- You can often defer any tax using a 1031 exchange offered by the government as a way to trade up into bigger or better properties.