Look Before You Leap But Leap!
In my new book “Look Before You Leap, But LEAP” I share what I believe are the remarkable 7 Profit Centres of Real Estate. They are more than just appreciation and cash flow, but those two are very important ones for sure. Here is an excerpt from the book.
It is advantageous to all real estate investors to explore and understand the 7 Profit Centres of Real Estate. Why? We are experiencing interesting times on a world scale; the stock market is volatile, interest rates on both the earning and borrowing sides are extremely low, and most people are trying to figure out how to earn a decent return from their investments.
Utilizing the 7 Profit Centres strategy is an effective way to build your wealth in real estate because it focuses on optimizing every aspect to maximize the profitability from your property investments. Real estate investing is not typically a sprint type of investment (unless you are flipping), but more of a long-term or marathon type of investment, whereby your ultimate payoff is several years down the road.
So where should we invest – to get a decent and reasonably consistent return on our money? Strategically selected real estate is a safe option.
The first three profit centres are Cash Flow, Principal Reduction and Appreciation. They have been described by some investors as the appetizer, main course and dessert, respectively. I’ll refer to this full meal deal as I discuss each of these Profit Centres. The other 4 profit centres: Equity Growth, Leverage, Re-investing your Equity, and Tax Advantages provide additional advantages and benefits, but are not always considered.
Cash Flow (Appetizer)
Cash flow is the net money left over from the rental income received from your investment property after paying all property taxes, operating and financing expenses. Cash flow is called the appetizer, as this refers to the generally modest return on the investment provided by the positive cash flow at the beginning of the investment – while the mortgage is being paid down. Cash flow really grows significantly once the investment property’s mortgage is paid off.
That being said, the appetizer is important as it sets up an enjoyable meal. Obviously, a positive cash flow is, in the long-term, most desirable for an investment property, as it is often referred to as the passive income component in real estate investing, but there may be times when cash flow is neutral or even slightly negative, such as when you’re renovating a property or experiencing higher than normal vacancy rate.
Principal Reduction (Main Course)
Principal reduction refers to the portion of each mortgage payment that goes towards paying off the principal of the mortgage versus the interest charged on the mortgage loan. We like to refer to the principal reduction as the main course – this is the part of a real estate investment that gives you the largest potential return from the operations of your investment.
As you make your mortgage payments, the percentage of the payment that is applied to the principal portion of the mortgage grows. This is why it’s important to understand your mortgage repayment schedule and to aim for a situation where the interest you’re paying with each mortgage payment is equal to or less than the amount you’re paying towards the principal, as soon as possible. During these times of low interest rates, it is easy to accomplish this goal.
Appreciation on your investment property is what we call dessert. I think of it as the icing on your investment cake. While cash flow and principal reduction will enable you to achieve a decent gain on your thoughtfully managed investment property, appreciation should be considered the bonus. It may be more difficult to control or predict than cash flow or paying down your mortgage principal, since it is, for the most part, out of your control. It can be the biggest component of return and thus the biggest positive surprise depending on when you sell or take equity out.
Equity = Asset value – Liabilities. Beyond positive cash flow, equity is the element of real estate investment where you can realize most of the gain in your investment. The rate of equity growth is determined by two things, Uncontrolled Factors (market factors that you need to research, understand, and continue to be aware of) and Controlled Factors (that you can optimize by adding value).
Real estate is an imperfect market, meaning that it is possible to buy a property at a discount or at a premium, depending on the market conditions. For instance, you could find a motivated seller who wishes to sell fast and is willing to sell for less than the normal market value in exchange for a fast closing. The reverse is also possible as you may have witnessed, properties can sell for over asking, and over what is considered (normal) market value, because of a bidding war between buyers as we have been experiencing in many markets across Canada.
In real estate, Leverage could be characterized as achieving the maximum amount of return (output) on your investment with the least amount of effort and/or capital (input).
Financial Leverage is using other people’s money to buy an investment property. No other investment vehicle has this degree of leverage available. Institutional lenders will not lend you most of the value of a paper/stock/bond investment to buy those shares. At best, they will typically look to collateralize other assets to lend you funds to buy that paper asset, and the loan-to-value ratio will typically be at a much lower percentage i.e., 50%. Unlike stocks, with real estate, lenders will loan you most of the funds as a mortgage against the property itself without necessarily tying up your other assets as collateral.
Re-investing Your Equity
Real estate investing done well, results in equity growth in your investment property. As you pay down your mortgage by a significant amount, you can use that equity to refinance and re-invest in more properties, thus making your money working even harder for you.
Real estate investment starts with educating yourself. Make sure you speak with your accountant so that you understand the applicable tax rules with respect to money realized from this type of investment.
- Mortgage interest is tax-deductible on investment properties that generate rental income
- Depreciation on specific components of your real estate investment may be tax-deductible
- Appliances in a rental property should be treated as a capital asset of the owner and subject to depreciation
- The costs of repairs and maintenance should be deductible from the property revenue if they are deemed permissible repairs and maintenance expense items and not deemed capital items by the tax authorities
“Real Estate purchased with common sense and managed with reasonable care, is one of the safest investments.” – Franklin D. Roosevelt
To explore these concepts in more detail and learn the nuances of real estate investing order a copy of my book today!