4 Basic Ways to Make Money with Real Estate

This is not investment or legal advice. Consult appropriate professionals before making your own investment decisions.

There are four basic ways to make money with real estate. These are well-known, and many others have written about them.

In this article, I’ll state the four ways with a brief description. I’ll cover each of them, as well as some related tools and topics that can be used to enhance these four ways. I’ll try to describe these and give examples from a business and investing perspective.

Keep in mind that these ways of making money are not mutually exclusive. In most cases, real estate ownership generates value in multiple ways, and commonly in all the four ways.

To begin, let’s review:

Profit = Revenue – Expenses

If you don’t come from a business background, it may not be obvious that investing in real estate is a business. You “make money” by having dollar inflows (revenues) exceed dollar outflows (expenses). I’ll use this perspective in this article and the subsequent articles.

Examples of revenues:

• rents
• fees (application, cleaning, etc.)
• sales ( the sale of a property for example)
• etc.

Examples of expenses:

• insurance
• taxes
• interest
• repairs & maintenance
• improvements
• transaction costs (commissions, legal fees, deed filings, etc.)
• property management (or other services for operating a rental business)
• etc.

The 4 Ways

Appreciation

You buy at a low price and sell at a higher price.

A simple example is to buy a house today, hold it for five years, and sell it at a higher price.

In other words, the value of the property changes ( increases hopefully!) between the buy and the sell. This can be due to market forces, or the investor can “add value” by improving the property.

Of course, “buy low sell high” is a massive simplification. Here are a few things that can affect appreciation: Location, timing and business cycles, leverage, transaction costs, zoning, taxes, economic forces at the local, regional and national level, holding costs, neighboring properties, transportation improvements, etc.

There are also ways to “force” appreciation. In a simple single family home, you could increase the value by renovating the kitchen or improving the curb appeal. In an investment property, which is valued more on the income, you could add amenities that merit higher rents.

Cash Flow

You operate a profitable business using the real estate.

A simple example is to buy a house and rent it to someone. This would be a leasing business. Your main revenue is the rent, and your expenses are taxes, insurance, interest on debt, repairs and maintenance, etc. Your profit is your revenues minus your expenses.

“Cash Flow” is the term commonly used for this, but the term Cash Flow is used in other ways with other meanings. This blurs the fact that you are operating a business.

Operating a business is non-trivial. If you self-manage a rental property, be prepared for bookkeeping, banking, subcontracting, managing keys, tenant application review, lockouts, etc. No business is completely passive. Even if you are an investor in an LLC, managed by someone else, that invests in real estate, you still have to file taxes. And you should be reviewing and monitoring the LLC.

Tax Reduction

You take advantage of legal tax incentives that are unique to real estate. (consult your tax professional)

This is a way of reducing your expenses, in order to increase your profits. Reducing expenses is not as sexy as increasing revenue, so it is sometimes overlooked.

There are three tactics: reduce, defer, or avoid.

Likely the most common example is the ability to deduct mortgage interest for your primary residence. This reduces your taxes (an expense).

A common deferring method is depreciation on your real estate. It is a way of expensing, over time, the purchase price of your real estate. This reduces your taxes each year, because one of your expenses is depreciation. However, depreciation reduces your basis. Basis is the un-depreciated portion of the purchase price. Upon sale, your capital gain will be the selling price minus the basis. And since your basis has been declining, your capital gain will be higher.

In short, depreciation lets you avoid taxes in the short term through depreciation expense, but moves the tax burden to the sale event. Essentially, you are deferring the payment of tax until a sale occurs.

A tax avoidance tactic would be to refinance and take cash out of a property, rather than selling it. Both would give you cash in hand, but the sale would create tax due, while the refinance would not.

Loan Amortization

You use some money from your business operations to pay down debt.

Loan Amortization means paying down what is owed on the loan. The key part is that you are using business revenue to pay down the principal.

This is somewhat hidden, and often under-appreciated.

It is a way that equity is increased over time. Equity is the difference between the value of the property, and what you owe. Suppose you buy a property for $100K and you take a $60K amortizing loan. Your equity is $100K-$60K = $40K.

A part of your payment is used to reduce how much you owe (your principal). Over time as you make payments, what you owe decreases. So let’s say that you are renting your $100K property and using the revenues to make your loan payment, and over time what you owe your lender is now $55K. Your equity is now $45K, even without any appreciation to the property.

You have effectively made $5K. You might say – isn’t this business operations (cash flow)? The difference is that cash flow happens in real time (maybe monthly) and is liquid, spendable cash in your hands. Debt reduction is tied up in the property, and will only become cash on a sale or refinance.

All Together Now

It is very common to make money in all four ways concurrently: Appreciation, Cash Flow, Tax Reduction, and Loan Amortization.

As a simple example, suppose you buy a single family home to rent. You put in a down payment and have an amortizing loan. Here are some of the ways you could make money:

• You profitably rent the home to someone, and have new cash at the end of each month after expenses(Cash Flow)
• You use some of the rental income to improve the curb appeal with landscaping, increasing the home’s value. (Appreciation)
• When you file your taxes, you count depreciation as an expense. (Tax Reduction)
• You also expense the landscaping, which ironically, increased the value of your property You made money, but you treated it as an expense! (Tax Reduction)
• Each month, you make your loan payment using the rental revenue. A part of that payment pays down the loan balance. (Loan Amortization)

Of course, a lot of things have to go right for the above to happen. You have to operate a business successfully. You have to buy at the right price. You have to finance properly. You have to manage expenses while maintaining the property.

I’ve only covered the basics in this article. I’ll expand on the possibilities in articles covering each of the four ways.