You'll often hear people say that they don't like real estate because if you look at the returns of the stock market, it seems to have a better return over the long-term.
Of course, when they say this, they’re leaving a few key things out.
First, when people say the stock market, they specifically mean the S&P 500 or the Dow Jones Industrial Average.
These are not the stock market. Rather, they’re indexes that include some of the leading companies in the U.S.
You'll often hear that the stock market returns anywhere from 7%-10% annually. This is really based on index returns rather than the market itself.
Second, while 7%-10% is a good profit annually for the average person, it’s not a good profit for a professional investor.
And when people stack up the profit from real estate against the stock market, they often only factor in one profit center in real estate: appreciation.
When I travel the world and speak, I often get the same question: How can I profit from real estate?
The reality is that there are four ways to profit from real estate that, when added up together, make for considerably higher returns than the stock market (and most other investments for that matter).
These profit centers are the reason that real estate is one of my favorite investment vehicles.
A word of clarification: as you read about these profit centers, realize that I'm talking about investment real estate – that’s property bought specifically to be run like a business, rather than your personal residence.
As I've said before, your house is not an asset. It takes money out of your pocket.
But your investment real estate is an asset, if you invest properly, because it puts money in your pocket, and it does it in two ways:
- Direct cash flow
- Phantom income
Before I dive into the four ways you can profit from real estate, I want to quickly touch on the difference between direct cash flow and phantom income, because real estate provides both types of income.
Cash flow is money that flows directly into your pocket on a regular basis. This can be monthly, quarter, annually, etc. but it’s realized income that’s passive in nature.
By passive income, I mean income that you do not have to work for.
It comes automatically because your asset itself creates the income. This is one of the lowest taxed incomes, and extremely powerful for building wealth.
Phantom income is a new concept to many new investors, but it’s a powerful way to build wealth.
Phantom income is not direct cash flow, but it’s savings that come to you through tax savings, time savings, etc., as well as the potential future gains.
I’ll explain more because in real estate there’s one profit center that’s cash flow-based and three that are phantom income-based.
Now, here are the four profit centers of real estate…
Profit Center #1 – Cash Flow on Operations
As the name implies, this is the cash flow profit center of real estate.
If you're holding real estate as an investment, you’ll have tenants. Each month they’ll pay you rent.
Let's say that you own a rental house and get $1,000 per month in rent. Over a year, that’s $12,000 in income.
Now, subtract out your expenses, which include things like your taxes, insurance, your property management, vacancies, turnover expense, allowances for repairs, etc. (This doesn't include your debt – more on that later).
For purposes of this example, let's assume that your monthly average expenses are $100 a month.
Your cash flow on operations, then, would be $900 per month.
That’s what’s referred to as your Net Operating Income (NOI).
Out of your NOI you pay your debt service. Let's assume for this example that you have a $200,000 property with an $180,000 loan at a rate of 3.7%. That's a debt payment of about $830 a month.
So, that would be rental income of $1,000 minus $100 in operating expenses minus $830 in debt service, equaling $70 in cash flow.
That times 12 equals $840 in cash flow per year. That $840 divided by your $20,000 equity stake would equal a 4.2% cash-on-cash return.
Profit Center #2 – Amortization
Amortization is the concept of paying down your debt service.
It’s phantom income because you don’t get the money in your pocket each month, but your equity grows with each payment you make – and because your rental income covers the debt payment, it’s income to you. Let me explain further…
Each month, when you make your debt payment (or rather your tenant makes your debt payment) out of your NOI, a portion of that goes towards paying down your principal on the loan.
When you hear somebody talk about a 30-year fixed fully amortized loan, it means that when you make all 360 of those monthly payments at the end, the loan is 100% paid off.
Because your tenant is paying rent, and that rent is covering the debt payment, the principal pay down included in that debt payment is actually profit for you.
Let's take a look at how this plays out with our $180,000 loan from above.
In the first year of the loan, you'd be paying $6,604 in interest and $3,338 in principle.
As the loan matures, the interest amount goes down each month and the principle amount goes up. But we'll use these numbers for now.
That $3,338 is profit to you. It's true equity in your property.
If we add this $3,338 to the $840 in operating income, we now have $4,178 in income for the year, a 20% return on our $20,000 invested into the property.
Plus, your interest payment is often tax deductible, so that’s an added bonus, but check with your tax advisor to be sure for your specific case.
Already, you're crushing average stock market returns and there are still two more real estate profit centers to look at.