How to Make Money through Investments for the Real Estate License Exam - dummies

How to Make Money through Investments for the Real Estate License Exam

By John A. Yoegel

The Real Estate License Exam will expect you to know that you can make money in several different ways, such as capital appreciation, renting, and equity buildup, by investing in real estate. As an agent (and as a test taker), you need to be familiar with all the moneymaking methods and the appropriate terminology.

The most important thing to keep in mind when it comes to making money on investments is that an investor expects these two kinds of returns:

  • Return of the investment: You expect to get back your capital, the cash you invested in the first place.

  • Return on the investment: You expect to receive something more than what you invested. The expected return on the investment is related to the risk of the investment. The risk in any investment is the possibility of losing all or part of your original cash investment. The higher the risk, the greater the expected return on the investment.

Capital appreciation

One of the ways investors make money in real estate is by selling property at a higher price than that which they bought it for in the first place. In this case, the value of the real estate appreciates, or increases, creating capital appreciation, or growth. The profit made from selling property for a price higher than what you paid is called capital gain for tax purposes.

When you sell property for more than you paid for it, you get the return of your capital; that is you get your original down payment, back along with the profit or capital appreciation, which is the return on your capital.

So, if you buy a property that costs $500,000 with $100,000 cash and a few years later sell that property for $600,000, then you get your original cash investment of $100,000 back and an additional $100,000 in capital appreciation.

Rentals on property

Most investors get returns on their investments by means of rents paid on the property. All expenses, including the mortgage loan payment, are paid from the rent and whatever else (such as quarters from laundry machines) factors into the building income. Investors call the mortgage payment debt service.

The money left over after all expenses are paid, except debt service, is called the net operating income. After debt service is subtracted from net operating income, what’s left is called cash flow, or the money the investment has earned before taxes. Check out the following two-part equation:

Part 1: Building income – operating expenses = net operating income

Part 2: Net operating income – debt service = cash flow

Cash flow ideally is positive, meaning that you take money out of the investment each year. But cash flow also can be negative, meaning that the building’s expenses are greater than the building’s income. Three reasons why someone buys an investment with negative annual cash flow are

  • The investor may believe that the shortfall is only temporary. Maybe the building isn’t fully rented. Or the investor believes rents will go up faster than expenses or that expenses can be managed better and reduced.

  • The investor may believe that when selling the building it will make enough profit to make up for the negative cash flow each year.

  • The investor may be making a lot of money in another investment and wants to keep his income tax bracket lower by balancing a positive cash flow investment against a negative one.

Equity buildup

The mortgage payment, or debt service, always is included in the expenses of any investment property. If the borrower borrows money with an amortized mortgage, every payment made on that loan is part interest and part principal. (That’s what amortized means.) So every time the building’s income (in the form of rents and other income) is used to make a mortgage payment, usually monthly, the overall mortgage debt is reduced.

By paying off some or all of the mortgage loan, when the owner sells the property, he owes the bank less money on the balance of the mortgage loan than when he first bought the investment. The owner (investor) gets to keep more of what he sells the investment for. Equity is the difference between the value of the property and all debts attributable to the property.

Obviously any increase in the overall value of the property also increases the equity, but investors usually use the term equity buildup to specifically refer to the increase in equity that comes from the mortgage loan being paid off by the rents from an investment property.

Suppose you borrow $200,000 to buy an investment property that costs $250,000. You keep the property for 10 years, and through the monthly loan payments, which are coming out of rents, you pay off $50,000. Assuming the property doesn’t appreciate in value when you sell the property, you owe the bank only $150,000. That $50,000 you paid off of the mortgage is yours, courtesy of your tenants’ rent.