Getting Started in Real Estate: Part 5 – Income Producing Properties

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Income Producing Properties… what many consider the holy grail of real estate investing.  Buy a property, find a tenant, and enjoy the passive income.  Well, that is what most guru’s will tell you.

The fact of the matter is it can be just as easy as the guru’s make sound… but only when you buy right, choose quality tenants and know how to train/manage them effectively.

Owning income producing properties (residential rentals, apartment buildings, strip malls, self-storage units, mobile home parks and others) is the only true way to build wealth in real estate.  The possibilities are very real for positive cash flow, appreciation and several tax benefits which all play a strong role in increasing your net worth… and when done right your tenants, through the rents they pay, are making it all happen for you. 

Unlike the “one-and-done” scenario typical of wholesaling or rehabbing, owning income producing properties allows you to build a passive income stream where if done right your involvement can be less and less and the monthly income can be ever increasing.  I am sure you have heard this statement or something close to it…

More millionaires have been created by real estate investing then any other investment opportunity.

If you look at many wealthy individuals you will find that much of their wealth is as a result of their real estate holdings.  Also, consider this… what business do you think McDonalds is really in?  If you answered the fast food business you would be wrong.  It is the real estate business.  McDonalds owns some of the highest valued real estate in the world and this ownership, in its composite, makes the McDonalds balance sheet look like Fort Knox!

So… what makes owning income producing properties so attractive and what does it take to get into this very lucrative game? 

First the attractiveness…

The granddaddy of them all is… positive cash-flow.  This is what every investor seeks when they buy income producing properties.  Positive cash-flow is the amount of revenue that remains every month after operating expenses (management fee, maintenance, vacancies, taxes, insurance, etc.) plus the interest or mortgage payment are paid for that month.  For most investors, the target monthly cash-flow number is between $100 and $200 per month per unit.  In some areas of the country that is very easy to do, and in others it is almost impossible.

At this moment, our Federal tax system is set up to support investment in income producing properties.  One of the biggest benefits is the “phantom” income that is known as depreciation.  Depreciation is an expense deduction which doesn’t require an outlay of cash other then the amount invested for the purchase and/or renovation of the property.  And, if you can figure out how to accelerate that depreciation the benefit is even greater.

Other benefits include;

1.  Refinancing a property, pulling cash out and not triggering a taxable event.  While I realize that this approach is very difficult to accomplish in today’s credit markets it is still possible.

2.  Equity recapture through the pay down of the mortgage.  This benefit occurs when you have a loan on the property that is amortized (meaning that both interest and principle are paid down with each payment) and with each payment the principle balance is decreased.  And guess who pays the mortgage for you every month?  Your tenants!

3.  While I am not a fan of planning on appreciation to give you any part of your deal… the fact remains that on average, appreciation can increase the value of your property by 3% to 8% in any given year.  Unless you can “force” appreciation through up-side managing a rental property, don’t count on appreciation occurring in any meaningful way for the next 2 – 3 years.

4.  Again, based on current tax law it is possible to sell an income producing property and roll the capital gains from that property into another property without triggering a taxable event.  And this method of deferring taxes can continue for as long as you desire.   This type of transaction is called a 1031 Exchange… and while the concept is simple, the execution should be saved for the professionals.

As a new investor what does it take to become a successful income producing property owner?

Finding the deal… If you have been following this series you know that there are three basics that must be mastered. The first of course is finding the deal. Part 2 of this series spoke to this basic skill which must be mastered and Parts 3 and 4 reinforced the issue.

Getting it closed… As discussed in Parts 3 & 4 getting the deal to closing is critical. For income producing properties perhaps the biggest challenge is finding the right financing. The critical requirement here is being able to find financing that is ultimately long-term in nature and whose terms can be easily carried by the monthly rents, and still give you your minimum required cash-flow!

In today’s lending environment finding the right financing terms is critical and also very challenging. Many banks have been told by the regulators not to make loans on real estate and those that still can are so overwhelmed by investors that they soon reach their lending limits for real estate loans.

Even with the lending market like it is, the strategy that I prefer is to purchase and renovate with hard/private money and then refinance with lower priced longer-term bank or private loans.

Turn-key Vs. Rehabs… Everyone has their own opinion about whether to purchase income producing properties that are turn-key, in reasonably good condition with decent tenants or purchasing a property that needs work where you get the renovation completed and you select your own tenants. Either will work… but I believe your highest returns will be obtained through the purchase of properties that need work and where you find the tenants.

In my experience, buying “turn-key” properties requires more cash up front, leaves you with deferred maintenance anyway, and tenants that most likely don’t want to be trained as you would need them to be. The end result… a lower overall return on your investment.

Tenant management… When asked by new investors whether they should purchase residential income producing properties, I always ask them this question…

Can you evict a tenant in the month of December?

If they hesitate or their response is “NO” I advise that they either must find a good property manager or perhaps being a landlord would not be the best strategy for them.

It is one thing to be good at finding, financing and renovating a property… it is quite another thing to find the right tenant and effectively manage them so your cash-flow projections are a reliable reality every month. Finding the right tenant and keeping that tenant is absolutely critical!

As I have done in the previous articles discussing wholesaling and rehabbing below are some Pros and Cons to owning income producing properties.

Pros to owning income producing properties…

1. Positive monthly cash-flow.

2. Best opportunity for building true wealth.

3. Current Federal tax code supports property ownership.

4. The use of leverage when purchasing a property means that smaller investments can be made on your part increasing your return and decreasing your overall risk posture.

5. Executing this strategy is an easy transition from wholesaling or rehabbing and the skills learned in those two strategies make it much easier to transition into property ownership.

Cons to owning income producing properties…

1. Tenant management can be a challenge unless you learn to do it right or hire a property manager.

2. Finding quality property managers is always a challenge for the simple fact that no one will take care of your investment like you will.

3. Cash reserves are a must. It is very easy to purchase a property with none of your own funds, however if you are cash strapped and rely heavily on the monthly cash-flow… the first non-payment or major maintenance issue and you are out of business.

4. The burnout rate for most landlords is 3 – 4 years. To avoid getting caught in this certain trap you must manage your properties and tenants like a business… pure and simple!

I am sure there are others in each category… but I think you get the picture.

Owning income producing properties is a fantastic way to be in this business and I can tell you that while it is a constant challenge to manage tenants, it gets easier with each additional property. And, the financial rewards both in terms of monthly cash-flow and longer-term wealth accumulation are worth your time and effort.

I will close out this series next week by bringing all of these strategies into focus from the perspective of a new investor wondering where to start and what it takes to do so.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.