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Most asset classes have one potential profit center. For example, in most cases when you buy a stock or mutual fund, all you can do is hope and pray it goes up in value. Sometimes there is a second profit center if a particular stock pays you a dividend. However, when you buy and hold residential investment property, you get FIVE potential profit centers, all working for you at the same time!
By “residential investment property” we mean single family homes or 2-4 unit properties that are leased out to long-term tenants. So, let’s explore the 5 Profit Centers that make buying and holding (not flipping) residential rental property fundamentally unique from any other asset class:
If you buy residential investment property correctly, it should always produce a passive monthly stream of income for you. It is the gross rent collected from the tenant minus all your expenses, vacancies, and repairs. If you are buying turnkey real estate, you can verify the amount of your gross rent and your fixed monthly expenses before you close. Then, you can use basic real estate investment analysis to ascertain what you conservatively expect your positive cash flow to be, prior to closing on the property.
Market Appreciation happens when you hold residential investment property over time and it goes up in value. While it is never guaranteed in the short term, you can improve your upside potential by choosing rental properties in markets where population and job growth are positive and where housing demand is outpacing supply. Also, you can buy properties in neighborhoods that are in high demand by entry-level owner occupants. This gives you a good chance of appreciation over time, and also builds in exit strategy so you can sell on the retail market to a primary resident. At Maverick, we share these types of economic indicators, real estate fundamentals, and local property cycles with you for free. We show you how to identify the best real estate markets at the time you are ready buy.
When you hold residential rental property over time, it becomes the most tax-advantaged asset class in the U.S. Your operating expenses, repairs and mortgage interest are tax deductible. Plus, the IRS allows you to “depreciate” the structure (not the land) of your residential rental property on a 27.5 year schedule. So, if you purchased a $350,000 property and you deemed the land to be worth $75,000, the property structure would be worth $275,000 and could be depreciated over 27.5 years. That would give you an additional $10,000 "paper loss" per year. And, whatever you don't use that year can be carried forward. Also, when you go to sell the property down the road, the IRS allows you to do a "1031 Exchange". That means if you re-invest the proceeds into other like-kind residential investment properties, you are allowed to indefinitely defer all of your depreciation recapture and capital gains tax. You can do this all the way until death. At that point, when your heirs inherit your property, the basis resets and nobody ever owes the depreciation recapture or the capital gains tax!
Financial institutions are more willing to lend you money for residential investment property than most any other type of asset. If you choose to use financial leverage by getting a mortgage, then your “money out of pocket” is substantially less. Down payments as low as 20% are common on conventional loans. Let's say you get a 30-year fixed rate principal and interest loan. As long as your tenant's gross rent covers your mortgage payment (in addition to your operating expenses) then your tenant is paying down your mortgage principal every month for you. This reduces your mortgage debt every month, and builds equity independent of any market appreciation. Often, when you use financing, your “cash on cash return” is higher because you put down much less money out of pocket.
Probably the least understood profit center is the way that buying and holding residential investment property enables you to profit from inflation. Property prices rise with inflation and so do rents. And you typically raise your rent each year as you renew your lease with your tenant. Plus, if you have locked in a 30-year fixed rate principal and interest mortgage then, as inflation occurs, you will profit there too. This is because you are paying the loan back in future diminished “nominal dollars” that are worth less than the “real dollars” you borrowed. Remember, if you keep your money in the bank, inflation eats away at your buying power and destroys your wealth. However, if you buy and hold residential rental property, inflation destroys your debt (and also pushes up both your property price and your rent)!
Residential investment property is a multi-dimensional asset class with 5 potential profit centers that can all work for you at the same time. Not only can this substantially increase your gains, but it can also mitigate your downside risk. Even if one or two of the profit centers doesn’t perform as expected in a given year, the others can still make the overall return on investment profitable for you that year. And that makes residential investment property a very, very unique asset class.
We are not a tax professionals, this is not tax or legal advice, and tax laws are constantly being changed and revised and may change the day after you read this. So, this is for informational purposes only, and it is your duty to consult with your own tax professional about your individual situation and the most updated applicable laws before attempting to implement any of the content in this post.
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