Property Futures

Real Estate News, Reviews and Investment

How & Why Real Estate Investment Works – Generating Income

Generating income is the point of investment. Income may either be ongoing (such as rent from letting a house) or a single lump sum (such as the income from selling that house).  Both are necessary to for an investment to be considered worthwhile.

A real estate investment earns an income either from rentals or from the profit of sale (capital gains), and may be combined to form the total income scenario for the investment.

 

  • In order for the investment to be worthwhile, rental income and capital gains both need to have an acceptable return.

Investment-tax-strategies

Capital gains

A capital gain occurs when you sell an item, such as a house, for a higher price than you paid for it.

(sell price) – (buy price) = (capital gains)

For this to happen, the value of the item needs to increase. This could occur for many reasons including:

  • Growing market – more people want to live in your town, so house prices rise.
  • Change in circumstances – an excellent school opens nearby, making the area attractive to families.
  • Value added – adding an extra bedroom, for example, or repairing a broken-down home.

Changes in the market may take years to occur and may not be favorable. However, if you can anticipate a change in circumstances or add value to a property you may be able to realize higher capital gains.

  • Strategic lands are prime candidates for investment focusing on capital gains as they are an example of a change in circumstances affecting the price of a property:
    • A house in an up-and-coming area will probably be worth more tomorrow than today.
    • Buying land that a government may wish to purchase in the future for building new roads or other infrastructure is also a strategic investment that may result in a capital gain.

Will capital gains be worth the investment?

As capital gains are usually realized only on selling the property, a successful investor will need to ensure that they:

  • Buy at the right price
  • Sell at the right time

In order to do this, you need to calculate the probable return and assess the risks.  The expected capital gains should outweigh several other factors including:

  • Additional investment
    • Costs of obtaining planning permission, for example, or repairing a building.
  • Transaction costs
    • Any fees associated with buying or selling the property, including taxes on capital gains, can eat into profits
  • Risk
    • Any investment could result in a loss: is the risk worth the reward?
  • Tax
    • Most governments impose a capital gains tax, which will reduce the overall gain.
  • Opportunity cost
    • Do you have to give something up in order to make the investment? This may be another investment or it may be something entirely different.

Rental income

 

Capital gains do not show the full picture of real estate – the land or buildings may be rented out in order to generate an income.

Rental markets rise and fall and income may fluctuate over time.  Income can be difficult to accurately predict although an investment can still be assessed by considering:

  • Rental returns
  • Rental costs
  • Market stability

Calculating rental returns

The percentage of a property’s price that can be charged as rent is the rental return for the period:

(rent) / (buy price) x 100 = (rental return %)

For example, an apartment bought for US$120,000 and rented for US$600 per month will have a monthly rental return of 5% per month.

This number provides a quick way to compare two investments and may be helpful in assessing if a lender will finance the deal. It does not, however, provide a complete picture.

Rental costs

A number of factors can affect whether an investor gets the full rental return they expect on a property. Rental profits or income are usually lower than rental returns would suggest, as the simple calculation above does not include any of the following:

  • Taxes – property or income taxes
  • Property management
  • Repairs and maintenance
  • Insurance
  • Periods when the building is standing empty
  • Interest on any loans or mortgages

These are costs of investing in a rental property and need to be accounted for when calculating the profits. The rental returns should be high enough to cover these costs for the property to be worth the asking price.

Market stability

 

The rental market will affect future rental income and is hard to predict.  It is nevertheless always worth looking at the status quo to see if the market is favorable. A market will generally be:

  • Growing
    • people and businesses are moving to the area,
    • few houses or buildings are being built ,
    • people are renting instead of buying (higher rental demand).
  • Shrinking
    • people are leaving the area,
    • lots of new homes are being built
    • people are buying instead of renting (lower rental demand)
  • Stable
    • the market is neither growing nor shrinking

 

The big picture of generating income from a real estate investment means running a lot of numbers and researching markets.  It’s not always easy, and there’s always a risk.  But for a smart investor, the returns may be worth the effort.

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This entry was posted on April 28, 2013 by in Future, Property and tagged , , , , , .

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