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.
Wise 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. The three parts are: income, expenses and financing. Each of these parts is important to the performance of the money machine.
The three parts 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 & 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 buy be sure to determine the income, expenses and financing first. Then calculate the four financial benefits to determine if the property meets your investment goals.
If my baseball player friend had followed that advice he'd probably still have that shirt he lost!
This material is designed to provide information in regard to the subject matter covered. It is understood that Tom Lundstedt, is not engaged in rendering legal, accounting or other professional services. Everyone's situation is unique, so – before you, or your clients take any real world action – be sure to check with the proper professionals.