How To Make Money from Rental Properties in 2022 (Cash Flow vs Appreciation)

How To Make Money from Rental Properties in 2022 (Cash Flow vs Appreciation)

Agnes A. Gaddis

The way to make money from rental properties has changed in the past five years. According to Joe Torre, a veteran real estate investor, “cash flow has diminished in most markets because home prices have increased and rents haven’t picked up as fast”.

He adds that “during the financial crisis of 2008, foreclosures were flooding the market and properties could be bought cheaply. An investor seeking appreciation would be investing at the wrong time.

Today, while there are pockets of cash flow here-and-there, it’s generally an appreciation market.”

This article will compare cash flow real estate investing in 2022 with the rental property appreciation strategy. You’ll also learn how to make money from rental properties through forced appreciation.

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What are the 5 Ways to Make Money in Real Estate?

Cash Flow

Many real estate investors aim to make money in real estate by owning rental properties with positive cash flow, because more cash flow means more income and a better return on investment. Cash flowing properties take care of their own expenses, even in economically challenging times.

Positive cash flow means that income exceeds expenditures (expenses and financing costs). Negative cash flow is the opposite. A property could also be cash flow neutral, in which case, all income goes towards outlay costs.

Property improvement costs are a major factor affecting your cash flow and projected returns at the early stages of your investment. If an asset has a steady tenant base, only minor improvements may be needed upon acquisition to preserve its cash flow. On the other hand, if the property needs significant renovations, it may take a while to generate positive cash flow.

According to Joe Torre, who is an investment counselor with RealWealth, today, “high cash flow can be found in “C” neighborhoods, with Section 8 tenants in markets like Baltimore or with multi-family properties like duplexes and fourplexes.”

Natural Appreciation

With appreciation properties you make most of your return when you sell since you wouldn’t sell the property at the same rate you bought it.

Based on this chart from the Federal Reserve Bank of St. Louis, average home prices in the U.S. have grown since 1963. So if you bought a piece of real estate in 2009, it would probably have tripled in price by now. Why does this happen?

Mark Twain’s famous quote “buy land, they don’t make more of it” explains why real estate has proved to be one of the most stable investments for the past 100 years. Because land is an irreplaceable asset, its supply is limited, so its value is determined by demand.

Natural appreciation results from population growth since a rise in the population increases the demand for a particular piece of real estate, in turn increasing its value.

As an investor, provided you do your due diligence, appreciation can be a relatively secure way to make money. And if you don’t plan to sell, you can tap into the home’s equity through a cash out refinance or home equity line of credit (HELOC). Equity may be used to improve your existing home, pay the down payment on a new property or settle debts.

Forced Appreciation

Another way to make money in real estate is with forced appreciation. The investor is most in control when it comes to this strategy, as he can (mostly) control how fast and by how much his property rises in value. This is the idea behind fix and flips where an investor purchases a distressed property, fixes it up and sells it for profit. By fixing it up, the investor has added value to the property and forced its appreciation.

You can add value through renovations, upgrades, and amenities to improve desirability. This will lead to an increase in rental income and overall property value.

For Example:

Let’s say you purchased a property in Cupertino, CA where houses are selling for $1,000 per square foot.

If you can take a 3 bedroom/ 1 bathroom home and convert it into a 4 bedroom/ 2 bathroom home, adding add 1,000 square feet, you would be building at $300 per square foot and selling at $1,000 per square foot.

In other words, by spending $300,000 you will add $1,000,000 to the sales price of the property. That’s $700,000 in forced appreciation!

Of course, not all markets sell for $1,000 per square foot, but if you can find a market with a big difference between the selling price per square foot versus the building cost per square foot, you can do very well in terms of forced appreciation.

Equity Capture

In the absence of equity, you are vulnerable to market volatility. Expert investors prefer discounted properties like short sales, foreclosures, and REOs for this reason. Buying a property at below market value means that you immediately capture equity when you buy the property. In a nutshell, this is equity capture. The average investor aims to capture 15 – 35 percent equity in each property.

REITs and MBSs

MBSs and REITs are both passive investment vehicles that are other options for making money in real estate. Investors in REITs receive distributions from rental income after expenses associated with operating buildings and the REIT have been deducted. In addition to multifamily housing, commercial offices, warehouses, and even health facilities can be leased by REITs.

MBSs are used to diversify risk in real estate investing. And they seem to be a lucrative opportunity now for smart investors since mortgage rates are currently rising while housing demand has not slowed down. Mortgage backed securities (MBSs) allow investors to own a piece of mortgage debt.

What Is a Good ROI for Rental Property?

Joe says “anything above the rate of inflation (7.5%) would be good, but in places like Baltimore, double-digit cash-on-cash returns are possible with 20% down.”

It’s hard to overstate how pivotal location is to a property’s ability to generate profits. If you’re planning to buy a rental property, you should do a thorough assessment of the property’s location since this is the only thing you can’t change.

To assess the property’s ability to generate revenue, you should use these measures.

  1. Cap rate (without financing). The cap rate is the annual return after expenses divided by acquisition cost (the full price of property plus closing costs)
  2. Cash-on-Cash Return (with financing). This is the annual return after expenses divided by the acquisition cost (the down payment plus closing costs)
  3. The 1% Rule. The 1% rule states that your monthly rent should make up at least 1% of the final purchase price.
    This is hard to achieve in today’s market since prices have gone up faster than rents, but with low interest rates, it’s still
    possible to get positive cash flow with a rent ratio of 0.8% in some markets. In other words, “0.8 is the new 1.0%.”

Cash Flow vs Appreciation: How Does Appreciation Affect Cash Flow?

Torre says “With 20% down, even 5% appreciation represents a 25% return on your invested capital. But in markets with job, population and wage growth like Florida, double-digit appreciation greater than 10% is possible.”

Having said that, a market can’t appreciate 10% per year indefinitely, otherwise no one will be able to afford housing. “There might be a short-term spike of 10% in one year, but even 6% means your property doubles in value in 12 years (rule of 72s).”

As appreciation rates increase, rents rise, leading to increased cash flow. So a cash flow negative property can turn positive over time and still offer significant returns through appreciation.

Dustin Olson, Principal Broker and Owner at Venture Do LLC says, “if a property appreciates in value, the rents typically move up, and if your property’s value increases, you may be able to borrow against that equity without even selling, and stack leveraged equity to invest in more investment properties.”

How Making Money from Rentals Has Changed In Recent Years

History shows that home prices and rent prices tend to move in unison. As home prices rise, so does rent in any given area.

Based on NAR stats, national median prices continued to rise 14.6% in the fourth quarter of 2021. And 67% of metro areas showed double digit appreciation rates.

Buyers who cannot afford their dream homes are transferring demand pressure to the multifamily housing market, leading to real estate rent increases.

Cities like Austin, Boise, Denver and Phoenix with high price growth during the Covid-19 pandemic are now seeing steep rent jumps.

But while that should be good news for rental property owners in these cities, it isn’t. Dave Meyer, VP of analytics at Biggerpockets simulated cash flow for the largest 588 cities in the U.S. He found the average (unweighted) cash on cash return to be -6.5.

He concluded that since “the home price is the foundation of many of the largest expenses an investor faces (principal, interest, taxes, insurance), when home prices move up, so do expenses. Therefore, if rent does not keep pace with the rate of home price appreciation in a given market, the cash flow potential of that market (or the market as a whole) will decrease”.

Why Appreciation Is the Ideal Real Estate Investing Strategy for 2022

In 2022, rather than looking for short term returns, you should invest for appreciation or total return to maximize your investment over the long run.

According to Torre, “one option is to buy in an appreciating market today for around $250,000, sell in 7-10 years for $350,000 and 1031 exchange into two or three houses in whatever the next up-and-coming market is at that time.”

You could also do “a cash out refi to liberate some capital to buy more, but make sure that after the refi, you can still gain positive cash flow (potentially in new high demand markets).”

How to Make Money in Real Estate Through Forced Appreciation

Increase Square Footage

Depending on the floor plan, you may be able to finish out an attic, create a sunroom on the back patio, or transform the underused garage into living space. Some landlords in high demand areas divide larger bedrooms into two separate bedrooms. More bedrooms means higher rent.

When increasing square footage, pay special attention to ROI. You should be prepared to spend up to $300 per square foot on remodeling costs. Since adding space is costly, make sure to focus on high value improvements. According to Remodeling Magazine, deck additions and bathroom additions generate the highest returns on investment.

Add Valuable Low-Cost Improvements to the Property

While home additions are costly, there are minor improvements that generate big returns in value. For example, according to Remodeling magazine’s report, a kitchen remodel adds $18,206 in resale value and has a 77.6% ROI. Replacing garage doors and beautifying the exterior walls with manufactured stone veneer each generate a 95% ROI.

You could also use neutral paint on interior walls. Painting is a relatively low cost way to improve your property and it generates a high return on investment. Updating kitchen countertops, cabinets, installing new light fixtures, changing door knobs and replacing blinds would improve how people perceive your rental.

Raise the Rent

For multi-family real estate, rent is used to assess property value. In general, the higher the baseline rent for your property, the more it will be worth on the open market when you sell it to another investor.

Landlords typically increase rent at lease renewal to offset rising home maintenance costs. If you’ve made improvements to your property, you want to recoup some of your investment through increased rent. Also, when the market rate of rent increases in your neighborhood, you might be able to raise your rent.

Minimize Vacancies

When calculating rental property expenses, it’s easy to forget that vacancies are one of the biggest expenses that affect your bottom line. While you can’t totally eliminate them, there are some things you can do:

  1. Proactively reach out to tenants whose leases are about to expire (30-60 days before lease expiry) about their plans. Do they plan to stay or leave? By knowing this ahead of time, you will stay proactive with your marketing efforts.
  2. Renters must be notified in advance of changes in terms or rent increases.
  3. Get your listing out there. You can use free websites like Craigslist. You can also get more eyeballs on your listing by advertising on social media.

Decrease Energy Usage

An easy way to boost the value of your rental to make money from rental property is to increase its energy efficiency. Traditional ways to improve your rental’s energy efficiency include adding energy efficient windows, insulating the attic, and weather-stripping doors. You could also use modern techniques such as installing a tankless water heater and using a programmable thermostat.

Learn How to Make Money from Rental Properties

In today’s hot market, the most reliable way to make money from rental properties is through appreciation. But you need to do your due diligence as investing in the wrong location can hurt your finances. With RealWealth’s network of professionals, you will find a team of trusted experts dedicated to helping you achieve your real estate investing goals. To start investing, become a member today for free.

How To Make Money from Rental Properties in 2022 (Cash Flow vs Appreciation)