Real estate purchased solely for renting or leasing to others.
Income property is real estate that is purchased and held onto solely for generating income by renting or leasing to others.
A key aim of making such an investment is to create a source of consistent income using the property.
This type of income has gained popularity today and is commonly referred to as passive income as it amounts to earnings that are not received from an employer or legal contractor.
It can comprise a variety of properties as they include any estate that can generate income. Therefore, the different ways in which land is used can indicate the type of income property. A few examples include:
1. Commercial Property
Renting/leasing real estate to firms that use the land for the sale of goods and services to create financial profit. A few examples of commercial property use include shopping malls, restaurants, and business workplaces.
2. Residential Property
Residential property can be leased out to individuals demanding housing to create an income-generating property. For example, this may include single-family homes, condominiums, apartments, and townhouses.
3. Industrial Property
Land used for manufacturing, packaging, processing, storing, and similar purposes are classified as industrial property.
Firms in many sectors require such spaces and are thus willing to pay adequate rent rates to lease out these spaces for operations. Some examples include factories, warehouses, manufacturing plants, etc.
4. Agricultural Property
Growing crops and raising animals requires space. Therefore, land used for agricultural purposes also serves as an income property. Therefore, farms can be leased out for these reasons.
Commercial and Residential properties are usually the most common avenues through which investors generate income.
However, as described above, there are also other areas in which income property can be created. Although, they may be less accessible in many areas and require more capital and experience to manage.
A fundamental parameter that is used to judge an investment that seeks to create such income is understanding if the cash flows from the estate can cover the costs of owning the property, such as mortgage payments, property taxes, and other expenses.
Therefore, investors conduct rigorous analysis to determine if the said income generates adequate cash flows.
Nowadays, there are many opportunities where investors can invest in it with little capital. This is possible through companies like addy that allow a group of many investors to own shares in income properties. Therefore, individuals can get a small share of real estate property.
This type of innovation has made purchases to income property accessible. As we will discuss further, real estate is hard to access for most individuals, therefore, removing barriers
Understanding Income property
Many factors need to be considered before purchasing income property. Investors should also first judge their risk tolerance and investment thesis and conduct market research to make an informed decision.
The factors to consider before acquisition of an income-producing property include
1. Cost of financing
Investors needs to judge the financing they are eligible for. Further, there need to be questions on how leveraged they are planning to be-for example, understanding the amount of down payment they can afford.
Moreover, the rate of interest will determine the cost of the mortgage payments made on the property, which ultimately needs to be used to understand if these payments can be afforded. Additionally, the terms of the loan agreement.
2. Acquisition costs
Costs to acquire a property include loan approval costs, registration fees, legal fees, and similar costs.
3. Renovation costs
An income property just after an acquisition is usually not completely ready to be listed on the market as basic requirements and specifications that make the property attractive and more appealing for lease uses need to be considered and addressed. Therefore, there may be changes to the property after acquisition to increase market rents and add value to the estate.
4. Rent Roll Summary
A rent roll summary is a snapshot of expected rental incomes and other aspects of the property, such as the number and type of units. Preparing such a summary will let the investor judge if the property's expected future cash flows are positive.
5. Costs of ownership
Costs associated with owning the property, such as property taxes, maintenance, and other costs, need to be considered and included as cash outflows in an analysis.
All the above factors play a role in evaluating if an income property is worth its valuation and making a judgment on the future cash flows.
How to purchase Income producing property?
Perhaps one of the most important things when analyzing an income property is financing. It is uncommon for the majority of investors to have enough cash on hand to purchase a property outright, which is further relevant to purchasing commercial property.
Therefore, cost and source of financing are vital components that determine an individual's ability to acquire an asset.
There are several factors relevant to financing an income property these include:
1. Interest Rate
The interest rate of a loan agreement with a traditional bank would be determined based on the credit history of the borrower. Thisincludes the evaluation of judging the credit worthiness of the respective person.
The interest rate would have large implications in influencing the borrower's purchasing power as it has direct relevance to the size of the interest payments on the debt. Interest rates can be fixed or variable.
2. Loan Period
Based on the buyer's preference, the loan period can be a five-year or thirty-year loan.
Thus, this determines how spread out the debt payments would be, and it also has an impact on the amount of interest paid on the debt as more extended loan periods generally cost higher interest.
3. Down Payment
A down payment is the sum of money the buyer puts up front on the acquisition of the asset. Down payments may range from 5% to even 50% of the property's price. The size of the down payment would determine the loan amount.
Advantages & Disadvantages
There are some key benefits and issues with owning income-producing property, they are highlighted in the table below:
|Access to consistent income from the property.||Returns are spread over a long horizon, contrary to investment property flipping where payouts are in the short term or immediate.|
|Some level of capital appreciation on the value of property over the long horizon.||The asset may not experience as much capital appreciation as an investment property.|
|Tax write-offs through consideration of depreciation on the property.||Issues with handling difficult tenants that create hassles for the management of property and may make late rental payments. Although this can be tackled by well-written lease agreements and uptight enforcement.|
|Investment is usually leveraged and so can create sizable returns if successfully executed.||Lack of diversification as real estate is local and thus a decline in the local neighborhood/area causes a substantial impact on the value and cash flow potential of the property.|
|Benefits of owning an asset that can be used as collateral and acts as an inflation hedge in a high inflation environment.||Income property cash flows are not guaranteed. Property may be vacant for an indefinite period.|
Let's suppose that you purchased a residential property in 2022 for $750,000, intending to rent it out for twenty years and then sell it. In this hypothetical example, we can highlight a few factors/assumptions.
1. Purchase Assumptions
- You put a down payment of 20% on the property, thus amounting to $150,000, and hence your loan on the property is $600,000.
- The market mortgage rate is currently sitting at 5% for a 30-year fixed loan period.
- The cost of acquisition (closing costs) amounts to $3000, this includes the legal registration fees, financing fees, and other fees
- The property needs repairs worth $10,000 so that it is in the required condition to be rented. The estimated value of the property after these repairs is about $765,000
2. Recurring Operating Expenses
- Annual property tax is $2500 and increases by 3% annually
- Total insurance on the property is $1000 per year and increases by 3% annually
- Annual maintenance costs are $2000 and increase by 3% annually
- Other miscellaneous costs are $200 per year and increase by 3% annually
- The property provides a rental yield of about 5%, which grows about 3% compounded annually. Therefore, this puts the annual rent at about $38,250 ((765,000*0.05)) for the first year.
- There is also other income from the property amounting to $200 annually. For example, when the tenant pays rent late and incurs late fees. This income grows by 2% compounded annually
- The property has a vacancy rate of 5%, meaning that the property is vacant for 5% of the time.
- The property value appreciates about 3% per year
- As mentioned before, the holding length of the property is 20 years
- The cost to sell the property is 8% of its value. This includes legal advertising, registration, and other costs.
Therefore, we find that for the first year the property would have the following income and expenses:
|Net Operating Income (NOI)||$2,629.00||$31,548.00|
Now that we have established certain parameters and expectations, we can conduct a thorough analysis. Consider the cash flow breakdown of the property over the twenty years:
|If Sold at Year End|
|Year||Annual Income||Mortgage||Expenses||Cash Flow||Cash on Cash Return||Equity Accumulated||Cash to Receive||Return (IRR)|
Notice that the property is cash flow positive from year nine onwards, this means that income generated from the property is greater than expenses being incurred. Over the twenty years, equity is continually being accumulated on the estate.
Here is a deeper analysis of the cash flow breakdown for the twenty years
|Return (IRR)||9.34% per year|
|Total Profit when Sold||$873,160.96|
|Cash on Cash Return||535.68%|
|Purchase Capitalization Rate||4.21%|
|Total Rental Income||$994,877.75|
|Total Mortgage Payments||$773,023.14|
|Total Net Operating Income (NOI)||$841,716.62|
The Internal Rate of Return (IRR) is phenomenal on this property, a little greater than the S&P 500's average annual total return of 9.3% from 1994 to 2019.
The cash on cash return is also significant as it represents the return on the cash invested in the property. Overall, this hypothetical investment should be taken up and can provide consistent income for twenty years and then a large cash flow at the end when the property is sold.
Yes, income earned from real estate is liable to tax. In the U.S, an individual'sdetermine the rate at which such income is taxed on. Investors can reduce their tax liability by accounting for depreciation expenses on their real estate.
A residential property such as a townhouse or condominium is perhaps the most common example of an income-producing property as it can be rented out to people demanding to the house.
No, they are slightly different.Property are both real estate, but the investor's goals are distinct with each investment.
Income property is purchased for the sole reason of receiving positive cash flows every month after expenses. In contrast, investment property can be purchased solely for the benefit of receiving capital appreciation on the property.
Therefore, investment property can be bought and sold in the short term for a higher price. This is an example of flipping.