This is the second part of a series on the three types of income one can get through real estate investing. If you missed the first part, please read it before reading this. You can find part one here – How to get portfolio income through real estate investing
Earned income is the type of income that only comes in if you work for it. Sometimes it is also referred to as active income. In real estate, we can get earned income by investing for capital gains, and also through commissions or professional fees by acting as a real estate broker or agent. For beginning real estate investors, earned income is arguably the easiest to earn.
Earned income through capital gains
A common way to get earned income through real estate is by investing for capital gains. We can get capital gains through buying and selling properties quickly for a profit, which is more commonly referred to as flipping. Flipping can be further divided into wholesaling or retailing.
From what I understand, wholesaling is when one ties-up a property under contract, turns around, and sells it to a buyer who is usually another real estate investor for a small but quick profit. The wholesaler basically buys a property below market value and sells it at a higher price but still below market value, leaving enough room for profit for the next buyer. Sometimes it is also possible to just assign the contract.
Retailing on the other hand is when you buy a property, renovate or rehabilitate it (hence the term rehabbing), and then sell it for a bigger profit as compared to wholesaling. Although flipping is usually associated with quick deals, retailing is also often described as flipping, even if it obviously takes longer to complete.
Wholesaling and retailing examples
In our previous example on portfolio income, I bought a foreclosed property for Php1Million, renovated it, and sold it for Php1.5 Million. That’s a perfect example of a retail deal.
What if I just tied-up the property by putting an earnest money deposit, and then sold it to another real estate investor by assigning the contract to him for a total contract price of Php1.2Million, leaving him with still enough room for a significant profit if he himself would renovate and sell the property for Php1.5Million afterwards? That’s wholesaling! Your profit of Php200,000 is your earned income.
By the way, if one is investing for capital gains through flipping, one can be greatly affected when market conditions deteriorate and property values go down. One may not be able to sell the property at the desired selling price.
Earned income through commissions
Another way to get earned income through real estate would be through commissions, either as a real estate broker or agent. Take note that I said through real estate, not through real estate investing. In my opinion, when one is after commissions, it is not really investing in real estate but is rather selling time and effort, more on this later.
In the Philippines, the common commission rates for brokers are 3% to 6% while agents usually get 2% to 3%, at least that’s what I often see from other real estate brokers and agents. Remember, I am also a licensed real estate broker.
Advantages of earned income
1. You get quick cash – There is a potential for quick cash because of the quick turnaround time for selling the properties when filliping or acting as a broker. Obviously, there is still a need to actually sell the property and close the deals
2. Requires little capital – When you structure a wholesale deal, one might be able to tie-up or get the property under contract with just a little earnest money which means there is little capital needed. If you act as a broker, there is really no capital needed as you are just selling someone else’s property.
Disadvantages of earned income
1. No sales, no income. Effort driven – If you are unable to consistently (1) find a property to flip or to broker and (2) complete the deal by actually selling it and closing the deal, no income comes in.
2. Need buyers or investors lined up – For flipping to work, you obviously have to have a lot of ready buyers or investors lined up to buy the properties from you.
3. Highest tax rates – If you consistently buy and sell properties and the BIR sees that you are already habitually engaged in the real estate business, your earnings will get taxed at earned income levels, and you pay this through income tax. If you end up at the highest tax bracket, your income will get taxed at a rate of 32%, if I’m not mistaken. Take note however that one can still lower the taxable income through allowable deductions, thereby lessening the payable income tax.
In our example above where the wholesale deal netted a gross profit of Php200,000, one would have to pay income tax amounting to 32% of Php200,000 or Php64,000. If one is also habitually engaged in real estate (you already have at least 6 real estate transactions in the current year), you also have to consider Creditable Withholding Tax (CWT) and VAT if applicable. Yes, you read that right, CWT should be considered instead of Capital Gains Tax (CGT).
If you earn commissions by being a broker or an agent, you also have to pay income tax.
4. Earnings might be inconsistent – Earnings become inconsistent because there will surely be months with no sales or when there are no ideal properties to flip. In case market conditions go bad, one who is investing for capital gains through flipping, one can be greatly affected as market conditions deteriorate and property values go down. One may not be able to sell the property at all.
5. You are actually selling your time, instead of investing in real estate – One drawback is you really have to put in a lot of time and effort into this type of income. I can’t help but say that this sounds like you are back in the rat race.
6. You let go of a property and its fruits – When you flip properties, you let go of the potential cashflow it can generate, along with any appreciation that the property may have as the years go by. How many times have you heard other seasoned investors say that they regret selling a property because of the excellent rental income they could have had up to now, along with the appreciation of the property ? In a way, all the effort in finding a good deal goes to waste.
Is earned income through real estate for you?
I guess it depends on one’s answer to the question “Why are you getting into real estate investing?”
Is it for quick cash? Do you want to get rich quick? Or is it for financial freedom?
Either way, I suppose this is meant to replace the income you would get from a regular 9 to 5 job and right?!
To illustrate, let’s just say your target income is Php100,000 per month. Lets run the numbers and see how we can achieve this through flipping or through commissions.
How many deals would it take to make Php100K per month through flipping?
In my opinion, a wholesale deal worth pursuing should at least make a net profit of 100K so this means you need to complete a deal at least once a month. Again taxes must be considered, the Php100,000 should already be net of all applicable taxes.
If your profit will be taxed at a rate of 32%, then your gross profit should be at least Php100,000/(1-0.32) = Php147,058.82
For retailing, which usually takes 3 months to complete on the average, a decent target would be to earn at least Php300,000 of net profit. This means your gross profit should be equal to Php300,000/ (1-0.32)= Php441,176.47
Do take note that the above should apply when you are already categorized as someone who is habitually engaged in real estate by the BIR.
Again this is on target for the goal of making at least Php100,000 of net income per month.
But there’s a catch. If we apply the 100-10-3-1 rule where for every 100 deals we analyze, we can expect to have 10 worth inspecting, and 3 are worth making offers, to end up buying one, this means we need to have more than enough leads that would lead to 100 deals worthy of being analyzed and we have to do this each and every month, 12 months a year, or else your income won’t come in. And we haven’t even considered marketing which is needed to sell the properties, which is also very labor intensive.
How many deals would it take to make Php100K per month through commissions?
Let’s say you are a licensed broker and are entitled to a 5% commission for each sale of a property worth less than Php10Million. How much worth of properties do you need to sell just to make Php100,000 per month.
Assuming that you will have to pay income tax at the rate of 32%, then the actual commission one needs to earn would be Php100,000/(1-0.32) = Php147,058.82, similar to the example above for flipping. If this amount represents the 5% commission, then the property should be worth Php147,058.82/0.05 = 2,941,176.47. This means I need to sell about Php2,941,176.47 worth of properties per month just to take home Php100,000 of earned income.
Why does it feel like I’m back in the rat race if I focus on earned income generating activities? Is it just me or are you also beginning to feel that getting earned income through real estate is no different from having a job?!
So much work and taxes to pay and income stops when you stop working
If your goal is financial freedom, then earned income in itself might not be able to provide this mainly because of the amount of work to be done, the huge amount of taxes to pay, and the income stops once you stop working actively, unless you find a better way…
My thoughts on earned income
Earned income is okay if it will eventually be used to buy passive income generating assets. Earned income through flipping properties is great for the short term. The long term goal is to use these earnings to eventually buy properties that generate passive income.
I also believe it would be a good source of supplemental income as opportunities arise, where significant and quick profits are hard to ignore. Supplemental in the sense that it can supplement our income while we ultimately build our passive income streams.
Earned income generating activities as explained above like flipping through wholesaling/retailing and earning through commissions are okay if they can be turned into a business where you are the business owner. When I say business owner, I mean the business can thrive even without you. If a business can’t survive without you, then you own a job, not a business, as paraphrased from Michael Gerber’s book “The E-Myth Revisited”.
Let me try to explain these further in the next part of this series.
Coming up next: Passive income – the path to financial freedom
Coming up in the third part of this series, I’m going to tackle how one can build passive income streams through real estate investing, which I believe is the path to financial freedom.
To our success and financial freedom!
Real Estate Investor
Real Estate Broker License #: 3194
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Text by Jay Castillo and Cherry Castillo. Copyright © 2010 All rights reserved.
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