5 Ways a Rental Property Makes Money and Why You Need To Know All of Them

Dated: June 21 2022

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If you’re anything like me, you grew up believing rental properties were inherently profitable. Within that belief, you likely didn’t know how they made money, just that they did.

Well, in this article, you can learn precisely how rental properties make money. Overall, they make money in five different ways.

Cash Flow

Cash flow is what’s left over from the rental income after all expenses are paid. Cash flow may also be referred to as “net income” (as compared to “gross income” which is the income before expenses are taken out). 

Cash flow can be positive or negative. Positive cash flow means there’s excess income after the expenses are paid, and that income gets to go right into your pocket as profit. Negative cash flow means the costs have exceeded the income, and you now have to pay out of pocket to cover those.

You can calculate your cash flow on a monthly or yearly basis. Decide which you want to look at, total up your expenses for that period, and subtract that expense total from the rental income total. What’s left is your cash flow. 

A nice thing about positive cash flow is that it can act as a tremendous buffer against shifting real estate market dynamics. For example, suppose the real estate market crashes and the value of your property decreases. As long as you’re still collecting cash flow from the property, you can wait until the market corrects and the value of your property goes back to where it was. 

In that situation, you wouldn’t even know we were experiencing a recession since you’d still make the same amount of money from the property each month. 

Compare this to a negative cash flow situation and the market tanks. You may get stuck in a position that forces you to offload the property at a loss because you can’t afford to maintain it through the recession.

While not the highest profit center of all, cash flow can serve as a critical foundation for successful rental property investing.

Appreciation

Probably the most popular form of profit when people think of rental properties, appreciation has been a consistent performer over time and one of the biggest players in what makes people so wealthy from real estate.

Appreciation is when the value of a property increases due to various factors. 

The three main causes of appreciation are:

  1. Improving a property
  2. The location

Improving a property

Rehabbing a property will create appreciation because that rehab has now increased the property’s value. In most cases, the increase in the value of the property will be more than what the investor had to pay to complete the rehab. 

For example, let’s say you buy a $100,000 property and put $30,000 into a rehab. With all of the improvements, the property is worth $150,000. You only put in $130,000 ($100,000 plus the $30,000 rehab), but now the property is worth $150,000. There’s an extra $20,000 in free money thanks to the appreciation generated by the rehab. 

This kind of appreciation is called forced appreciation.

Location

The location you bought the property in will also be a primary driver of appreciation. If the demand for housing in the area—the broader market or the specific neighborhood—rises, so will property values. Demand may rise due to general market growth, or it may be because you bought in an area that got intentionally gentrified, which could force quicker and more dramatic appreciation. 

In addition to improvements and demand increasing the value of a property, an investor may likely also experience appreciation in the market value of rental income. Rents inevitably increase over time due to several factors, but what causes appreciation to the value of a property will usually trigger appreciation in rental values as well. When the rents increase, your cash flow will increase proportionately.

While appreciation is one of the highest profit centers of a rental property, it’s also speculative. It’s never a guarantee that the reason you believe a property will appreciate will pan out as you assume it will. You should always consider contingency plans on how you expect a property to profit should the appreciation strategy fold. 

The other consideration to remember is that rental properties are long-term investments, and often true appreciation potential is experienced over the long-term rather than the short-term.

Building Equity Through Mortgage Payoff

One of the coolest things about owning a rental property is that your tenants’ rent check is most likely covering your mortgage payment! Hopefully, it’s covering more than that, but if it’s at least covering your mortgage payment, it means that you aren’t the one paying down your mortgage—they are.

Here’s an example: You buy a $100,000 rental property with 20% down. That means you paid $20,000 upfront and the remaining $80,000 is the balance on the loan, in addition to interest payments. 

Over 30 years, the mortgage balance is paid down every month through the income you receive from your tenants. At the end of those 30 years, $80,000 has been paid off and you now own the property free and clear. The $80,000 isn’t immediately liquid because it’s in the form of equity, but it’s your money, and you can either keep it as equity or pull it out of the property and use it however you wish. 

The bottom line is that you turned $20,000 into $80,000, plus any appreciation that’s most likely occurred over 30 years.

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Tom Betsill

I have been working hand in hand with clients working in construction doing estimates, drafting, installations, sales and more for a granite countertop company since 2003. This experience gives me a g....

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