While there are endless ways to invest your money, a 2019 Gallup poll found that 35% of American respondents say real estate is the best long-term investment option; while 27% say stocks. 1 If you have cash lying around and want to put your money to work, one investment option to consider is an income property.
Income Property Basics
An income property is a property bought and developed with the intention of earning revenue from it.
Income properties can be residential, such as single-family homes or multi-family properties, or they can be commercial properties. Owners make money through holding and renting the property while it appreciates, then selling it for a profit.
Before any investment is made, the U.S. Government advises considering the following questions: 2
- What type of earnings can you expect on your investment?
- How quickly can you get your money, if you need to sell or cash in your investment?
- What interest can you expect to earn on your money?
- How much risk is involved?
- Are your investments diversified?
- Are there any tax advantages to a particular investment?
Once, you've decided that you're ready to make an investment with your money, here are five benefits to buying an income property.
1. You're In Charge
You choose what property to invest in, which tenant you'll rent to, how much you'll charge in rent, and how you'll manage and maintain the property while renting it to tenants. You can use services like Airbnb or VRBO to provide short term vacation stays or use a property management company to help you find and service long term renters.
While investing in a stock or mutual fund gives you some freedom (as you're able to choose the stock or mutual fund you wish to invest in), you are still allowing someone else to manage and control your money.
2. Property Appreciation
One of the most unique opportunities about investing in real estate is that you can use a small amount of your own money while borrowing the rest, often four to 20 times more, from a lender. This is called leverage. If you purchase a property using significantly more debt than equity, the investment is said to be “highly leveraged.”
You invest $10,000 of your own money to buy a property and borrow $90,000 from a bank. By combining your money with the bank loaned money, you're now able to buy a $100,000 asset.
Let's assume that each year, for 10 years, your investment property will appreciate by 5%. Here is where the ability to leverage benefits you. The appreciation is on the entire $100,000 asset, not only the $10,000 of your own money.
Year 0: $100,000
Year 1: $105,000
Year 2: $110,250
Year 10: $162,889
After 10 years, your property value would have increased by almost $63,000 dollars. Thus, you would have turned your $10,000 investment into over a $60,000 appreciation profit simply by using leverage.
3. Money in Your Pocket
If you intend to place tenants in your investment property, you will be able to receive rental income. Any money left after paying your expenses will be money in your pocket.
Suppose you have a tenant whose rent $1,100 a month and your PITI mortgage payment is $700 a month. Thus, subtracting $700 from $1100 will leave you with $400 to go into your pocket each month.
From this $1,100, assume about 5% in monthly maintenance costs and 5% in vacancy costs. Therefore, you should put $110 into a designated bank account each month to deal with maintenance issues and potential vacancy costs. When all is said and done, you will have about $290 each month in gross profit.
$1,100 (monthly rent)
-$700 (monthly PITI mortgage payment)
-$110 (for maintenance and vacancy issues)
=$290 (your monthly passive income from the rental property)
4. Help With Your Mortgage
The most popular type of loan is a 30-year fixed rate mortgage. It has an interest rate that will remain the same for the entire 30-year term of the loan. In the beginning of the loan, significantly more money is paid to interest than to principal, but by year 15, it's close to a 50/50 split. Therefore, the longer you hold the property, the more of the loan principal your tenants are paying down and the more wealth you're creating for yourself.
Say you have a $90,000 bank loan with a monthly mortgage payment of $500. In year one, approximately $385 of this payment will go towards paying the interest, while $115 will go towards paying down the principal on the loan.
$115 (monthly principal payment) * 12 (months) = $1,380 (principal reduction for the year)
$90,000 (original loan)
– $1,380 (principal payments after 1 year)
= $88,620 (loan balance after 1 year)
By year 15, approximately $270 of the monthly mortgage payment will go towards interest, while the remaining $230 towards the principal.
$230 (monthly principal payment) *12 (months) = $2,760 (principal reduction for the year)
Every year that you own this property, you're using the tenant’s money to pay off your debt. By reducing the amount of your loan, you will be building wealth as you will eventually be able to access this money either by refinancing your loan or by selling the property.
5. Tax Write-Offs
As a rental property owner, you're entitled to tax deductions. You can write-off:
- Interest on your mortgage
- Interest on credit cards used to make purchases for the property
- Maintenance repairs
- Travel expenses
- Legal and professional fees
- Property taxes
On top of all of these deductions, the government also allows you to depreciate the purchase price of your property based on a set depreciation schedule, even if your property is actually appreciating in value.
Using our above example, you receive $3,480 in rental income for the year ($290 each month * 12 months). If you made this money at a regular job or in the stock market, you would lose a significant portion of it to pay income taxes. However, by owning a rental property, you can offset the $3,480 income with the depreciation expense for your property, thus being able to reduce (or completely eliminate) the amount of taxes you have to pay on rental income.