May 19, 2024


Mad about real estate

Owning Residential Rental Income Property Grows Your Wealth Faster and Better

If you want to grow your wealth fast and better, buy residential property to rent out. Your investment will grow faster because of the leverage that a mortgage gives you, and it grows better because rental income, tax laws, and responsible mortgage decisions keep your risk extremely low for such a high return. Here’s how.

Leverage gives you high investment returns:

Owning residential rental income can give you high returns at very low risk. The high returns come from the leverage of buying your property with a mortgage. Your investment is your equity – the value of the property less the mortgage amount you owe on it.

When you buy a house, you put a fraction of its price down. The bank pays the remainder through a loan (i.e. a mortgage) you now owe. Each monthly mortgage payment you make includes a portion for interest with the balance of the payment going toward paying off the principal of the loan. The principal payment portion eventually kills off (amortizes) the loan.

Early payments in a 25-year mortgage are mostly for interest; ending payments are mostly for principal. These two components are equal at about year 18. Very little principal (loan) is repaid during the first 10 years.

Here’s how your equity grows fast:

Suppose you put 20{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} down for a $200,000 house – which gives you $40,000 in house equity and a $160,000 mortgage. If house prices rise just 5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} over the next year, your $200,000 house will be worth $210,000. Since you still owe about $160,000 on the mortgage, your equity has grown to $50,000. That’s a 25{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} equity growth rate for your equity due to a 5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} growth rate in for the house.

The leverage factor, L, is 5 (= $200,000/$40,000) before the increase. So equity grows L times faster than house price growth. You get a high investment growth rates even for relatively low house price growth rates.

Because your equity grows faster than you house’s value, the leverage factor slowly reduces. But at a 5{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} annual growth rate for your house value, it takes about 10 years for your original 20{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} down to become half the value of the house. Neglecting a small mortgage change, your house would then be worth $320,000 with an almost $160,000 mortgage. Your leverage factor would only be ‘2’.

You can always ‘remortgage’ the house to pull money out and increase the leverage to keep your investment rate high.

Better by taxes, rental income and a responsible mortgage:

The high investment rate your property gives you doesn’t have to put you in a state of high risk. That’s because you can keep the cost of holding on to your property as low as you want by putting enough down so your rental income will always cover your holding costs. And tax breaks for rental income owners go a long way to help you out.

Rental income can cover your costs. Owners claim their rental income on a Schedule E (Rentals) form. But they also get to deduct not only their annual mortgage interest paid, but other annual costs of owning the rental property such as maintenance expenses and an annual depreciation amount.

Depreciation is a book-keeping deduction that presumably allows you to set aside money for replacement of your house. It represents no actual expense outlay; and the value of the house doesn’t go down – like a machine depreciates. It actually goes up! Here’s how it helps you.

Ideally, when you buy a rental property, in the early years, you want the rental income to just cover the costs of the mortgage payments and maintenance expenses that come out of your pocket. That way the ‘rental’ is costing you nothing because the rental income is paying all the out-of-pocket holding costs.

But the depreciation deduction -that pulls nothing out of your pocket – can create an ‘apparent’ yearly loss on the rental income/expense sheet. You can then deduct this ‘apparent’ loss against your regular job income on your 1040 to further reduce your tax on your own working income.

These depreciation deductions lower your house’s tax basis. So when you eventually sell, your capital gain – sales price less house basis – will be larger. But low capital gains taxes and other tax techniques can keep your profits high.

Conservative Investing:

But if you keep your mortgage costs low with smaller mortgages and a fixed rate, you can probably always keep renters paying your costs of ownership. That way you’ll weather any price or interest rate storm that threatens your investment.