104: How Money Works in Real Estate Investing: 6 Important Terms Explained
Episode Transcript
Welcome to episode four of season one of the Growing Empires show. Today we're going to talk about how the money works in real estate investing.
00:11 Welcome to Growing Empires, hosted by real estate entrepreneur and trusted investment advisor Jennifer de Jesus. Growing Empires provides insight to building wealth through passive income-producing real estate investments for those who want to build and manage a more profitable real estate portfolio.
00:29 Very excited about today's show. This is one of my most favorite topics to get to talk about with investors. I've been fortunate enough to learn from some very wealthy people over the years exactly how to make money work. And today we're going to talk in great detail about how the money works in real estate investing. So let's break down some of the terms that we're going to talk about, today. We're going to talk about cash flow, depreciation, leverage, equity, appreciation and inflation. Those are my top six categories as they relate to money. And ultimately how you achieve great wealth is to master the money. So we're going to give you some insight today on exactly how to do that. Cash flow is your money leftover after all of your expenses are paid. It is simply the amount of money that you net on your investment month after month. And a quick analysis to figure out what your cash flow is, is you take all of your income for the month minus all of your expenses for the month and the leftover money is your cash flow.
So cash flow is the money that's leftover after all of your expenses are paid. Depreciation is a tax term, and it's a term that allows people to keep more of their cash flow because they're not paying it to the IRS. So depreciation works in a very specific way as it relates to investment properties. There are two types of depreciation factors residential investment properties can depreciate for 27 and a half years. Those are residential real estate properties that are one to four units. Anything five units or above or things that are considered commercial properties depreciate for 39 years. And that tax term refers to the ability to write off part of your asset against your personal income. You're going to want to ask your tax advisor how this is going to affect your assets. But essentially, depreciation is another way to earn money because as you're depreciating, and you're writing off part of the asset against your personal income, that means that you're able to keep some of that personal income in your pocket. And that income can be reinvested to help you generate better cash flow.
Cash flow
Depreciation
Leverage
Equity
Appreciation
Inflation
Leverage is using other people's money to acquire investment properties. It's typically funded by a bank. And the way that leverage works is it allows you to decrease the amount of personal cash that you invest into a property. So for example, let's say I'm going to buy $100,000 worth of a property. I can either take $100,000 of my cash, or I can take, let's say 20% of $100,000, and let the bank fund the rest of the deal. So instead of me putting $100,000 down, I put $20,000 down, and the rest of the money is borrowed money. That's your leverage. The reason that this is so important is because it allows you to have a much higher return on your investment than if you had just used all of your own money to begin with. And some people think that, well, cash is king, right? So if I make an all cash offer, I'm going to get a better deal. And that's not always the case in every market. As a matter of fact, that's not the case at all in our current market, because getting financing or getting leverage is just as easy as paying cash. And you could typically do it in roughly the same amount of time because by the time it takes you to get clear title on a property and get all the tax certifications, all those things that are required for closing, a good bank can actually fund that loan in that amount of time. So, the years of or the days of cash is king being a factor are really not anymore. As a matter of fact, leverage is king in my opinion, because if you're smart enough to not use your own money, you're gonna make a lot more money a lot quicker, and your returns are going to be much higher. So people that don't understand investments really well think that I'll put all my cash down, and I won't have any debt, and I'm gonna make more money, but that's not really the case because it can't spread their money as far.
If I have a total of $100,000 to spend, right? I can choose to buy one property that's $100,000. Or I can choose to leverage the property and put 20% down which is a typical amount for investment properties, which means that I could buy essentially five properties with that same $100,000. So you tell me what you'd prefer to have. Would you prefer to have one investment property or would you prefer to have five? Clearly, if I can find how to spread my money so that I could have five investment properties versus one investment per property, the return on my investment is going to be much higher because I have five buildings that are all contributing to my cash flow versus one property that's contributing to my cash flow.
This kind of leads me into the next topic, which is your mortgage pay down. So essentially, what you're trying to accumulate over time and why you would buy and hold the property is that you're trying to accumulate equity in a property. You accumulate cash flow, but you're also accumulating equity. And equity is the amount of money that is the difference between what the property value is and what you owe on the property. That's your equity. Right? So if you owe $50,000 on a property, and your property's worth $100,000, your equity is $50,000. As you start to build equity in properties, you're going to be able to pull out that money and what they call refinance, cash out refinance, the next property. So as my properties grow, remember, we talked about five properties so I just bought five properties with my hundred thousand dollars. And in over the course of the next year, I've paid down the equity using the rent that the tenants pay to pay down my mortgage, which has increased my equity on the property. And now I can pull out that equity by our cash out refinance and invest in multiple properties. So those five properties that I invested in, maybe just turned into eight properties or 10 properties because now I'm using equity, essentially money that is not your personal cash, you're using the equity to create more properties, you're building your portfolio.
06:34 The episode will continue in just a moment.
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So we're talking about equity and pulling out that equity to refinance. And equity is the difference between the value of the property and what you owe on the property. Essentially, every month that your mortgage is paid or that your tenants pay rent, you can pay down that mortgage. And you could choose to take some of your cash flow that we talked about before and actually pay down your mortgage at a more rapid pace as some investors choose to do, or you can just let your property naturally appreciate, and over the course of the next couple of years, take that that equity out and refinance. One key factor and being able to refinance, though, is watching what the mortgage rates are doing. Some people don't necessarily need to refinance, but should refinance simply because mortgage rates have dropped drastically. So you're gonna want to keep watch over what happens in the mortgage industry. Because typically, as the real estate cycle changes, the mortgage rates change. And as they're going up, you're going to want to hold on to your property. As the mortgage rates go down, you're going to want to reinvest that equity, doing a refinance.
A good example of inflation is when the value of money decreases, prices of goods and services increase. So I want you to think about when you were a kid, you know, do you remember a bottle of Coke being you know, 25 cents? Maybe I'm dating myself, perhaps I shouldn't do that. But we're gonna go with it anyway. Do you remember a hamburger being 50 cents to a dollar? Think about those expenses and now think about what they are today. That's inflation. Right? Right. And home values rise because of inflation. So inflation allows you to, in a sense, secretly increase your net worth, just because you can always assume that the value of your home is going to rise. Because when the value of money decreases the prices of goods and services increase. And last but not least, we have appreciation. There's two types of appreciation. In my mind, there's natural appreciation, which is something that's going to happen in every market. And it's either a good appreciation or bad appreciation depending on what's happening in that cycle. But typically, appreciation is how the market changes year over year based on sales in that local market. Everybody can remember the Great Recession. Most people remember specifically how home values decreased, right? But they also have since then increased. That's appreciation. And that's natural appreciation. Something that the market naturally does based on home values over the course of a couple of years. Then there's something called forced appreciation. And this is one of my most favorite terms as it relates to real estate investing. Forced appreciation is something that you get by hiring a rockstar property manager.
10:18 I laugh but it's not a joke. If you hire a rockstar property manager, I promise you, they will teach you how to force appreciation on your buildings. But essentially what force appreciation is, is if I am able to increase my rent and decrease my expenses, I am creating more value in my property. So for example, let's just say that this year, my income is $10,000. Next year, my income is $20,000. I have forced appreciation on my building. Therefore, I've made my building worth more money next year than it's worth this year. And you could do that a variety of different ways. Forced appreciation can be done by just getting rents to market rent with nothing else happening. Forced appreciation can happen by decreasing landlord paid expenses on the property. That could be done by separating utilities. And if there's landlord paid heat, insulating your windows, insulating your attics and your basements, making sure that your utilities are efficient. You can also decrease expenses by getting on budget plans. Or you can also decrease expenses by turning some of those costs over to the tenants.
But essentially, appreciation is forced when you are able to control it yourself. You don't have to wait for the market to react. And investment properties, what's neat about forced appreciation is that no matter what's happening with the market, you can make that appreciation happen. Because if you are increasing income and decreasing expenses, you're affecting the net income of the property. The value of an investment property is strictly based on the cash flow, not what I project the cash flow to be. That's called performa, but it's based on actuals. So even when we're thinking about selling investment properties, or what my investors are thinking about selling properties, we talk about how to force any additional appreciation out of the property, so that our net operating income is the highest that it possibly can be so that we can get the best valuation of our property essentially making it worth the most amount of money. We're forcing appreciation on the building to create additional cash flow. If you've ever heard the term value add, that's exactly what people are referring to. Value-add properties allow you to force appreciation. Value add means that there's some type of value that you can add by improving the property.
You can improve the property by bringing rents to market rent, you can improve the property by capital improvements. You can also improve the property by decreasing the landlord paid expenses. So as your annual your next investment purchase, I want you to look at the money as a whole, I want you to look at the opportunity for your building to increase your overall cash flow and your overall net worth based on being able to leverage other people's money versus yours. Being able to capitalize on depreciation to write off part of that asset against your own personal income. I want to make sure that the cash flow and the money leftover after all expenses, achieves the financial goals that you have set, I want you to think about how you're going to take out that equity and almost like the stock market, when to take it out at the right time, so that you can leverage that for future purchases. I want you to find properties that have a good sense of natural appreciation, but also those value-add properties that allow you to really force the appreciation and then something that's going to happen without you even have to really think about it or or focus on it is inflation. And all of those things built together allow you to create that passive income vehicle that will keep growing and growing and growing while you sleep. Now that's a great investment. I hope you enjoy today's show. In the next episode we're going to talk about passive income as it relates to property management services. Stay tuned, until then take care.
14:24 For more information about how Jennifer can help you plan, develop and manage a strong real estate investment portfolio, visit growingempires.com.
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