Making Sense of Real Estate Investment Income
Real estate is an asset and vehicle to preserve, grow and accumulate wealth. The beauty of this asset class that is income may be gained a number of ways, based on the investment strategy you chose to pursue. When considering real estate investment income as a potential revenue stream or simply as a component of a diversified portfolio, one should consider where the options fall within the real estate investment income landscape.
Real Estate Investment Income Landscape
The real estate investment income landscape illustrates our logic for thinking about real estate investment income and how income is produced. Real estate investments may be separated into short term and long term time frames; the income can be classified as either a fixed sum or variable.
The first step is to identify the region of the landscape that is most in alignment with your goals. By selecting an applicable strategy within your region of interest you will have addressed a critical component of the investment path you chose. This is just as important as the financials or numbers. These two components, strategy and financials, are partners in maximizing the return on investment. Understanding the real estate investment income landscape allows you have more insight for decision making that can make your dreams a reality.
Owning a piece of property and renting it out on a short term basis is probably the most well-known method of real estate investing. It is the most fundamental way to participate in the real estate market and is one of the most historically proven methods for gaining wealth over the long term.
Whether you choose to be hands on or hire a property manager, landlording is a definite way to real estate investment income. Owning property allows you to lease its use to tenants and receive rental income in return for the service. Rent prices are typically fixed for the term of the lease. Therefore, the income received from this genre of asset may be considered a fixed or passive income. Landlording is a strategy typically used in with a mindset towards long term investment because it does not require daily attention to receive returns.
It pays to be the bank. The next level up from leasing use of buildings and property to tenants is to own the mortgage the owner has on the property. That’s right, you can own the debt instead of the property. There are two ways to become a mortgagor.
First, you can sell a property you own outright and agree to be repaid over time. A real estate transaction involves both the sale of the asset and a lien. You can sell the property and retain a mortgage on it. In a normal transaction, the bank steps in gives the seller a lump sum and has an arrangement with the buyer to be repaid over time. In this instance, the seller would take the place of the bank and make the arrangement with the buyer directly via a mortgage.
On the other hand, you can purchase a mortgage on the open market. Mortgages, like most other business products, have a secondary market where they are traded and sold. Typically mortgages are priced based on how regularly the mortgagee pays their monthly payment and the outstanding balance. Loans, where the buyer is in default, tend to sell at a discount.
As the mortgage or lien holder, you are in the position of the lender in a real estate transaction. Similar to rental income, the mortgagor receives monthly mortgage payments from the owner. In the United States, the debt secured by real estate is typically given at a fixed interest rate for the life of the 15, 20 or 30-year loan. Because of this, the monthly payments to the lender are also fixed.
This strategy is good for persons that like the long term aspect of real estate investment income but do not want to interact with tenants or engage in other property ownership headaches.
Have you ever wished you could buy real estate like you can buy shares of a stock? If so, you’re in luck! There is a way to invest in real estate without actually buying any property and still receive monthly income without the headaches associated with property management and maintenance. We can think of dividend paying stock as the paper equivalent of rental property. You buy your shares and get a monthly or quarterly payout.
Real estate investment trusts (REITs) are publicly traded companies which own real estate as the core business and underlying assets. The IRS regulates that REITs are required to pay out 90% of income to shareholders. This payout in the form of dividend and is fixed with both short and long term aspects to real estate investment income. REITs can offer both a secure return over time as well as the quarterly payments. Investing in REITs is a more passive approach to real estate investment income.
Hard money is a term used to describe loans with high-interest rates with large recourse should the borrower default. Being in the position of hard money lender is very similar to being a mortgagor. Once again you are the bank and loan your money out for a rate of return. A key difference is that hard money lending usually delivers a higher rate of return in exchange for the short-term use of capital.
Just like all loans, the interest rates fluctuate depending on the lender. It is common to see hard money rates in the 10-15% range while bank and credit union loans are in the 3-5% range. As real estate investment income is produced through hard money lending, you are able to gain a short term return on your money with a determined or higher fixed rate of return. It is typical that the lender has many more rights to quick foreclosure proceedings in hard money than in traditional mortgages.
It is important to acknowledge that any real estate investment strategy you take will have tax consequences (or advantages). You should feel excited to be in a position to contribute productively to society. Each real estate investing approach should be paired with guidance from a certified accountant or tax preparer.
Much like the taxes charged to stock market investments, when real estate increases in value and is sold at the higher price, the owner is required to pay tax on the difference between the sales price and the original purchase price in the form of capital gains. Capital gains are at the center of our real estate investment income landscape because it influences and affects all areas of the landscape. At some point, someone will pay capital gains taxes, now or later, you or your heirs.
Depreciation in real estate ownership is the process of distributing the tax deduction over the useful life of the property. The IRS has created a specific schedule for depreciation. The building, land, and fixtures such as hot water heaters, furnaces, etc. can be depreciated over this timespan. The amount of depreciation is variable year over year and is a long term process. Depreciation takes into the reduction in value of the property due to aging and wear and tear on the property. Based on the depreciation mindset and schedule property is only viable for 27.5 years in residential real estate. Therefore, the building and attached fixtures are depreciated, the value is partially reduced annually, to account for the age.
Appreciation in real estate is the process of increasing property value. This value increase in a property gives the owner an increase in equity. Equity in real estate can lead to access to real estate investment income. Many factors affect appreciation which necessitates its position as a long-term and variable income stream in the real estate investment income landscape.
Appreciate can be thought of like capital gains. It is the gain the property owner makes when the value of the property increases. The primary difference, however, is that capital gains are locked in because they are already disbursed. Appreciation can be extracted from the property by refinancing which is not a taxable event.
One strategy that is used to avoid and reduce the tax ramifications of capital gains is the 1031 exchange. This process allows you to transfer proceeds from one real estate transaction to another transaction, immediately sheltering the tax. To be a sophisticated real estate investor, you should consider your needs for short term and long term capital prior to deal execution. Depending on your timeline for return on investment you can maximize the financial value by deferring access to short-term capital. The 1031 exchange requires you as an investor to have a real estate team whom can assist in facilitating the transaction. One key stakeholder involved in this process is the escrow agent. More up-front planning and coordination are required when executing a real estate investment transaction using the 1031 exchange.
The process of buying, improving and selling the property for a profit is called flipping. Flipping a property is usually done in a short time frame to maximize profits. Before flipping a home, a comprehensive strategy should be created before approaching this process. You could create a real estate investing business plan based on a flipping strategy. A large part of real estate investing success lies in the numbers. The financials behind each property allow you to create value and produce income. Flipping is short term income strategy which requires multiple deals to continue producing income. The strategy is short term because once the flipping stops, so does the income. The process of flipping also provides real estate investors with variable income due to changing financial goals.
Wholesaling is a strategy where the investor does not retain ownership of the property; instead, they assign or sell their interest in the property to another buyer. The difference between the contract price and what the buyer is willing to pay is called the spread. The value of the spread can vary based on transaction size and property market. A wholesaler is essentially a middle man. The wholesaler finds a severely undervalued asset, increases the price to a level that is still attractive to an investor and profits from the difference. Short term lump sum gains are possible but vary based on the number of wholesale deals completed. Income produced using this real estate strategy fluctuates. A real estate investor pursuing this strategy should beware of the legal boundaries and limitations of wholesaling. Law in some states requires wholesalers to be licensed real estate salespersons just like Realtors. Some marketing strategies and word choice in wholesaling could put you in a risk; be mindful and do your own due diligence before proceeding with this strategy.
Sourcing Money From the Right Place
Use the real estate investment income landscape as a tool to overcome analysis paralysis and empower your real estate investing. To advance from beginning investor one must take action and have a long term mindset. The landscape for real estate investment income options is dependent on the investment time frame, short term versus long term. The value of the return also changes in consistency based on fixed rate and a variable return.
Gaining experience through strategy implementation trails and error will evolve to case studies and scenario models. Sophisticated investors, advance to an expert by focusing on winning strategy before taking action. Leverage planning and strategy.