Understanding the Short-term Profits in Investment Real Estate

Although real estate is really a long-term investment that requires a commitment over the long haul, and certainly is not as liquid as stocks, bonds, or mutual funds; nonetheless, despite the fact that windfall profits should not be expected to occur overnight, we can’t ignore the earnings you can look forward to in the short term in real estate investing as well as the potential of earning great returns over the entire course of a lifetime.

Cash Flow

Simply stated, cash flow is the monthly or annual cash return you receive from your investment. This is what most investors seek after the most, so they are drawn to real estate investing because there is always the opportunity to create monthly and annual cash flow with rental property. 

Since cash flow is a direct function of how much money you put down to purchase the property, for instance, if you purchased the property without the aid of a loan your cash flow would be substantial because a loan payment wouldn’t be taking a bite out of your net operating income. Conversely, a minimal down payment with the aid of a loan to cover the balance means you would be making a loan payment that would reduce your cash flow accordingly.

Other factors that impact cash flow are vacancy rates and operating expenses. Here’s how it all works:

*Gross rental income
*less Vacancy allowance
*Effective gross income
*plus other income
*Gross operating income
*less Operating expenses
*Net operating income
*less Debt service
*Cash flow

You can see from the schema above that net operating income (which pays the mortgage payment) can vary up or down depending on vacancy allowance and operating expenses. Therefore, both vacancy allowance and operating expenses must be considered seriously along with the debt service when computing the cash flow a rental income property generates.

Okay, but investors are not going to get excited about cash flow per se until they relate it to the amount of money invested. What they look for is the cash-on-cash return. Here’s the formula.

Cash flow / Cash investment = Cash-on-cash return

Tax Benefits

The other short-term benefit in real estate investing concerns taxes. The IRS permits income property owners to deduct from their annual earnings for (amongst other things) depreciation (also called cost recovery). Here’s the idea. The IRS theoretically assumes that structures (called “improvements”) of a rental income property wear out over time and therefore permits an annual tax deduction for that loss based on the property’s “useful life” as specified in the tax code.

This is a sweet deal for investors because deductions for depreciation are really a paper loss (i.e., not an out-of-pocket expense). Nonetheless, it reduces the earnings you will have to pay taxes on; so you can produce a positive cash flow and still have a loss as far as the IRS is concerned.

Here’s a simplified schema of how the concept works.

*Income
*less Operating expenses
*Net operating income
*less Mortgage interest
*less Depreciation
*Taxable income

You get the idea. Rather than having to pay taxes on the proceeds that actually might be collected; with real estate, investors are taxed on the income that remains after allowable deductions. So tax benefits are truly a short-term benefit in real estate investing that cannot be ignored.

James Kobzeff is a real estate professional and owner/developer of ProAPOD - quality real estate investing software solutions since 2000.