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Recognizing the Advantages of Owning Rental Property

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A great advantage to building wealth through real estate is the ability to use other people’s money (referred to as OPM in Urban Dictionary and on online real estate investing websites). You’ll likely purchase a rental property with the help of financing from a lender; then your tenants provide the monthly funds for the debt service payments and for ongoing operating expenses and capital improvements.

The wide availability and low cost of real estate financing over the past few years make real estate investing a viable, realistic option for virtually everyone. Even when commercial lender real estate loans were difficult to obtain during the financial crisis of 2008–2012, many deals still went through, thanks to seller financing.

Most people purchase real estate by using leverage gained by borrowing from the seller or a lender. Leverage is the purchase of real estate with financing; it usually consists of a cash down payment from the buyer and a loan or other people’s money. Here are the two types of leverage:

 Positive: With this type of leverage, you can earn a return on both your cash investment and the entire value of the real estate. The ability to control significant real estate assets with a small cash investment is one of the best reasons to invest in real estate. You might purchase a $100,000 rental home with $20,000 in cash and a bank loan for $80,000, for example. If the home value doubles in the next decade, and you sell this home for $200,000, you’ve turned your $20,000 cash investment into a $100,000 profit.

 Negative: Real estate enjoyed a long run of steady appreciation from the mid-1990s through 2007, but if you were unable to make your loan payments and other financial obligations as a rental property owner, the economic downturn of 2008–2012 illustrated the negative potential of negative leverage. Negative leverage can wipe out your entire investment with a 20 percent decline in the market value of your rental property. So if you buy a rental home for $200,000, with $40,000 in cash and $160,000 from your bank, only to see the economy falter or the local real estate market sour, you may have to sell your rental home for less than your acquisition price. If you sell the home for $160,000 after the costs of sale, you may have just enough to pay off the bank, and your cash down payment of $40,000 evaporates. Unfortunately, negative leverage is the experience of many investors and homeowners who aggressively purchased real estate in the early to mid-2000s with little or no cash down and learned during the Great Recession (2008–2012) that their mortgage balance exceeded the current value of their property.

Although you can purchase some rental properties without a down payment, keep in mind that you get what you pay for. The rental properties that are the best performers over the long run (high-occupancy units with stable, long-term tenants paying full-market-value rents and reasonable operating expenses) generally aren’t available with creative financing.

Despite the occasional downturn in real estate nationally, people with an incredible amount of capital have sought to acquire rental real estate in many markets, even during the pandemic that started in 2020. Though opportunities always exist for patient and persistent investors, finding really good, well-located rental properties is competitive and challenging in many urban markets.

In limited cases, you can reposition a poorly performing property in an essentially good neighborhood. Although these opportunities exist in some (generally rural) areas of the country, they’re only for highly experienced real estate investors and property managers who have a high tolerance for risk. Don’t invest in no-down-payment rental properties outside your own area or in a neighborhood you don’t know extremely well. If you do, you’ll likely be the next seller offering the property and may even be willing to pay someone to take it off your hands!

Rental real estate also offers you the opportunity to pay off your mortgage by using your tenants’ money. If you’re prudent in purchasing a well-located property in a stable area, you should have enough income to pay all the operating expenses, utilities, maintenance, taxes, insurance, and debt service. Each month, your property becomes more valuable, while your tenant essentially pays all your expenses, including principal and interest payments on your loan.

Your lender and tenant aren’t the only ones who can help you with the purchase of your rental investment property. Even the government is willing to offer money to help your cash flow and encourage more investment in real estate. The government allows rental property owners to take a deduction (or offset to income) for depreciation on their income taxes each year. Depreciation isn’t an actual out-of-pocket cash expense, but an accounting concept that provides you an allowance for expected wear and tear. Depreciation deductions reduce the taxable income from rental properties and give you more cash flow during your ownership. See Chapter 20 for an explanation of how depreciation can defer income taxes until you sell your rental property. The Tax Cuts and Jobs Act (TCJA) of 2017 also provided positive tax advantages for rental property owners, but with a major shift in politics in Washington, D.C., major changes in future tax regulations might wipe out most or all of the gains in the TCJA.

Over time, you may find that your rental income collections grow faster than your operating expenses. That’s why many economists feel that real estate is a superior investment, because historically, real estate has been a very effective hedge against inflation. With the unprecedented increase in government spending over the past several years due to the pandemic and federal economic stimulus programs, the role of real estate in preserving the value in an inflationary environment is becoming a stronger driver for demand and much higher prices for all types of income-producing real estate. After your tenants finish paying your mortgage for you, you may suddenly find that you have a positive cash flow — in other words, that you’re making a profit.

Property Management Kit For Dummies

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