I spoke recently with a baseball player friend of mine who told me he “lost his shirt” when he invested in a small apartment building. He said the property was a great deal because he bought it for $50,000 less than the seller’s asking price. But, c’mon, what does the seller’s asking price have to do with the investment value of a rental property? Not much. Before you (or your clients) invest in real estate, educate yourself. Register for my course: Real Estate Investing: Beyond the Basics. And keep reading to learn more.
Do your due diligence
Wise real estate investors know that a rental property is a business. They will not buy until they have done their due diligence and analyzed the business from all sides, including the financial side.
Think of a rental property as a money machine—made up of three main parts:
- Income
- Expenses
- Financing
Each of these parts is important to the performance of the money machine.
Calculate the four financial benefits
The three parts—income, expenses, and financing—work in harmony to create the following four financial benefits:
1. Cash flow
Once you collect the rent then pay your operating expenses and mortgage, there ought to be some income left over. All investment real estate has income. Unfortunately it’s not always positive income!
2. Principal reduction
The loan is paid down with rent collected from tenants. The tenants are essentially buying the property for the owner. I’ll bet you know someone who has rented the same property for many years. For one reason or another, they don’t want to buy. Well, surprise, surprise! They are buying the property . . . for the owner!
3. Income tax savings
The tax rules allow owners of rental property to depreciate their cost over a number of years. The specific number of years depends on how the cost is allocated. Depreciation is used to shelter the first two financial benefits (cash flow and principal reduction) from income tax.
After sheltering the first two benefits, any leftover depreciation is reported as a “loss” for income tax purposes. For most people this loss can be used to shelter income from their job or other sources, resulting in tax savings (subject to the Passive Loss Rules).
4. Appreciation
The fourth financial benefit of owning investment real estate is appreciation (or increase in value). We all know someone who owns a property that’s worth a lot more than they paid for it years ago. It didn’t happen overnight, but over the years.
So, next time you’re considering the purchase of a rental property: STOP! Before you invest in real estate, be sure to determine the income, expenses, and financing first. Then calculate the four financial benefits to determine if the property meets your real estate investment goals.
If my baseball player friend had followed that advice, he’d probably still have that shirt he lost!
About the author
Tom Lundstedt, CCIM, is known as the funniest investment and tax guy in America! His programs for REALTORS® have entertained and enlightened thousands of audiences from sea to shining sea. He’s a former Major League Baseball player whose striking combination of humor and real world examples makes powerful subjects spring to life. He’s the author of a series of audio CDs and Study Guides on the subjects of investment real estate and taxation. Visit his website at www.tomlundstedt.com or contact him at (920) 854-7046.
More advice on helping clients invest in real estate
Many agents lose business by not being confident about working with real estate investors. Want to gain the skills and tools necessary to capture this rewarding market and help your clients invest in real estate? Register for Real Estate Investing: Beyond the Basics, a continuing education course taught by Tom Lundstedt, CCIM.
Check out the following courses, taught by author Tom Lundstedt:
