As First Gen Investors, we know a few ways of making money…work hard, work more…oh, and there was always the good ole’ reliable – spend less. Generating wealth is not something that most of us focused on as we began living our adult lives. We constantly hear about it. We see it on our Instagram and TikTok feeds, but the truth of the matter is, we stick to the old tried and true, “work harder, work more…spend less.” (Some folks have a problem with this one as we make a little more money.)
Others take it a step further and decide to invest in something. Those investments tend to look something like this:
- Getting some low interest rate from the bank
- The stock market via a 401K or brokerage account
- Cryptocurrency aka Bitcoin, Dogecoin etc.
We are taught (or figure out on our own) that saving is an important thing to do, which it is…but at least when I began to assess the things I was doing to get more money, I realized, I was throwing things at a wall and seeing what stuck.
The items I mention above can all work. My problem is…I don’t necessarily like putting my money into things that I don’t understand. I am also risk averse which is a great recipe for me not doing anything with my money.
That is why for so long, I just did what I saw the people around me do. I put my money in the bank and get a whopping .002% interest rate! I dabbled in cryptocurrency for a bit (not with too much money), but I honestly didn’t have the stomach for it. I put money in my 401K which lives in the ever-volatile stock market. My company matches a percentage of my contributions so I would never shy away from free money. I have also read enough to know that the stock market trends upward over time so I keep putting money into it, albeit less than I did when I realized what real estate has to offer.
Real estate, when purchased, financed and managed correctly gives you several ways of making money and we want to address just 4 of the ways that real estate makes you money.
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1. Cash Flow
You will find in other articles on this site and other websites that describe what Cash Flow is. When we talk about Cash Flow, we mean Pure Cash Flow. This is your “take home” from your investment into real estate. These are quick numbers, but we want to show you what we mean.
Pure Cash Flow is fun! Some call it “mailbox money” because it shows up in your mailbox every month like magic (I am oversimplifying it). For most people, this is why you get into real estate, to see an almost immediate and consistent return on your investment. With the shortage of affordable housing in the U.S., a good rental market will continue to see rents increase consistently over time. We factor in rental increases of 3%, but there are many markets where rent increases are multiple of that 3% number potentially making your Pure Cash Flow grow every year. The cool thing about real estate is that this is not the only way you make money!
2. Mortgage Paydown
One question I get asked often is “who pays the mortgage and the insurance?” Two things on that:
1. They are not considering other expenses such as maintenance, vacancies, capital expenditures or property management (more on that later).
2. When you are calculating Pure Cash Flow, the expenses have already been taken out…Including the mortgage.
What this boils down to is that the tenants pay your mortgage. Over time, you continue to build more equity in your property. Equity is the difference between the amount of money you owe to the bank on a property and the value of that property. I will use the same purchase price for the duplex above:
As you can see, because we bought the property for less than its appraised value, we actually had $4,000 in equity on the day we closed (not bad). Add the $22,400 we put in the down payment we made, we have a total of $26,400 in equity on Day 1 of the purchase.
Here is where this calculation gets fun. We conservatively assume the natural appreciation to be 3% year over year for this property. The interest we have on this loan is 5.87% over 30 years. What this means is that by the end of year one our equity calculation looks like this:
So what this tells us is that in one year, the equity in your home went up $4,608! That number might not seem like a lot, but what if I told you that over time, say 5 years, that number would be closer to $51,000. To be clear, if you buy right, there is no more money coming out of your pocket after your initial investment! Also, don’t forget that these numbers are conservative. We like to be in markets that give us better than 3%. We prefer to underpromise / overdeliver on our investments.
We briefly touched on appreciation when discussing mortgage paydown. We would like to flesh this out a little more. Appreciation is defined as the rise in value of an asset over time.
There are two types of appreciation that we would like to explain.
This is based on the increased value of an entire asset class. This can include stocks, bonds, NFTs, cryptocurrency and you guessed it real estate. This is important because this helps us see what the future holds for the overall value of our investments in each of those classes.
This type of appreciation happens when you force the value of something to go up. One of the reasons I like real estate so much is because I have a say in the value that the asset I possess has.
In real estate, if I buy with what is called a value-add business model, I am looking for a property that needs some help. What if I told you that we bought the same duplex for $112,000, but this time we added a renovation budget of $10,000? By the time we are done with it, the property would be worth $128,000. We can supercharge our valuation of a small multifamily project by finding those kinds of deals.
When we get into commercial properties, there are other ways of forcing appreciation through rent increases (I am not talking about increasing peoples rent 50% in one year), better management including energy efficiencies, adding amenities etc. This is a powerful space to be in, which as I mentioned gives me…and you…the option to make these investments better for ourselves.
I am not an accountant so I would advise that you speak to your CPA on this matter, but suffice it to say, there are many ways to offset the income that you make (your Pure Cash Flow) legally. The IRS has too many guidelines in the tax code for me to understand, but the ones I do show us we can take advantage of depreciation.
When you buy a property, the building itself will have natural wear and tear. This does not necessarily include the things your tenants might break. That natural wear and tear is why you can write off depreciation. The IRS has rules on how you can calculate this, but you will in essence, be taking a tax deduction on a “paper loss” (this is a loss that does not materialize) because the reality is that many investments actually go up in value over time. Depending on your tax situation, the building condition and your tax strategy, you can take depreciation, even bonus depreciation into the 15%-30% range (again, check with your CPA).
This article is one of the longer ones, but truth be told, whole books are written about each of these items alone. We will be exploring each of them in other articles, but we wanted to share just 4 of the ways that real estate makes you money. We have not talked about the ways it can save you money in taxes and a whole host of other benefits that real estate investing makes sense for the newby investor or the seasoned pro.
Let us know what you think. What other areas you see as possibilities to make money in real estate.
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President and Co-Founder, First Gen Foundations
Proud to be a First Gen Investor