This is part one of a 3-part series on the types of income one can get through real estate investing. Rather than write another 3000+ word nosebleed article, I’ll break it down into three parts which should be more manageable and easier to digest.
Through this series, I hope to help beginning real estate investors by sharing my thoughts and ideas for each type of income, based mostly on actual experiences as a real estate investor. Part one tackles portfolio income through real estate investing. Here goes…
Obviously, real estate investors get into real estate investing because of the income that real estate investing can generate. But what types of income can one get from real estate investing? What are the advantages/disadvantages for each type of income?
There are basically three types of income that one can get from real estate. These are:
- Portfolio income
- Earned income
- Passive income
Let me first try to explain portfolio income.
What is Portfolio Income
Portfolio income in a nutshell is the income or the gain you get in the form of an increase in equity.
What is equity?
Equity is basically the difference between a property’s current appraised value/market value and the loan principal balance as of a particular point in time.
For example, I bought a foreclosed property for Php1Million by putting down 20% downpayment or Php200,000, with a remaining loan principal balance of 80% or Php800,000. Assuming the property’s current market value at this point in time is really Php1 Million, then my equity can be calculated as follows:
Equity=Php1 Million – Php800,000 = Php200,000
In this example, my equity is equal to my downpayment because I bought the property at market value.
For the example above, there really is still no portfolio income as I still have no gain in equity.
Portfolio Income from properties bought below market value
What if for the same foreclosed property above, which I bought for Php1Million pesos by putting 20% downpayment or Php200,000, with a remaining loan principal balance of 80% or Php800,000, I had it repainted and got it ready for occupancy. I then had it appraised afterwards and the new appraisal is Php1.5 Million. My new equity can be computed as follows:
Equity = Php1.5 Million – Php800,000 = Php700,000
From an original equity of Php200,000, it increased to Php700,000. In effect, I now have a portfolio income of Php500,000 in the form of equity that I have gained.
By the way, sometimes the equity can increase even without the introduction of improvements like painting or fixing up the property. This happens when the property was simply sold below market value because the appraised value or market value used by the seller was outdated.
The problem with portfolio income
There is only one problem with portfolio income. The income is just on paper! One still needs to do something to get the income out. In other words, I still need to turn my portfolio income into cash or realized income. Otherwise, it is just on paper and I cannot make use of it.
I also believe that portfolio income is still just an assumption and can be looked at as a form of speculation until the portfolio income is actually turned into cash.
How to turn portfolio income into cash
In order for one to turn the portfolio income into real cash, one would have to either sell the property at a price equal to the appraised value/market value or have the property refinanced at the new appraised value/market value.
1. Sell the property to get cash
For example, I decided to sell the sample property above and it got sold for Php1.5 Million cash. I would then have to pay off the loan principal balance of Php800,000 with the bank. That would leave me with Php700,000 cash on hand. I have already recouped my downpayment of Php200,000 and made an additional Php500,000 in the process, which was the equity I gained or portfolio income.
Of course one should also consider the taxes(Capital gains tax, etc.) and other closing costs when a property is sold.
By the way, if one just keeps on selling properties, one is really just investing for capital gains. He/she would lose the cashflow the properties would generate, if any.
2. Refinance the property to get some cash out
On the other hand, if I had the property refinanced at the new appraised value/market value, I would be able to get a big chunk of my portfolio income if the new loan is approved.
Let’s say I went to a second bank, applied for a new loan to refinance my existing loan, and they had the property appraised. The new appraised value turned out to be Php1.5 Million as expected and the bank granted me a new loan based on this new appraised value, and they are willing to loan me 80% of the appraised value which is Php1.2 Million. The second bank would then pay off my loan with the first bank, which is Php800,000 and that would leave me with Php400K. This means I pocketed Php400,000 in cash by refinancing the loan.
Sure it was smaller than what I would have gotten if I had just sold the property, but that’s okay for 2 simple reasons:
(1) I didn’t have to sell the property which means I don’t have to pay taxes related to properties getting sold like capital gains tax, documentary stamps tax, etc., and
(2) The property remains to be mine and I get to continue enjoying the cashflow it generates(if any if it is tenanted) and any appreciation in its value, just in case I do decide to sell it down the road.
Of course, with refinancing, the new loan amount will translate to an increase in monthly amortization payments, etc. which should always be considered to determine the cashflow a property generates. At least I have taken out some of the cash which used to be portfolio income and I can use this to buy another income generating property, etc.
My thoughts on portfolio income
From my examples above, you will see that one cannot make use of portfolio income unless one takes steps to get the cash out. It looks good but the income is still just on paper.
However, portfolio income gives a good indication as to the potential of a property in terms of capital gains. It can help one see if you are really following the well known advice from Robert Kiyosaki and his Rich Dad which is
“You should make money when you buy, not when you sell…”
because the portfolio income is basically the money you can potentially make the moment you bought a property at a price below market value.
As stated earlier in this article, until you can turn portfolio income into cash by actually selling the property at a price equal to the market value or refinancing it at an appraised value higher than your purchase price, you are just speculating. Remember, we are supposed to be real estate investors, not speculators.
Since portfolio income is only on paper, having a large portfolio of properties that look good on paper is useless if you can’t get any cash out. Instead of being real assets, they are just liabilities that take money out of your pocket, unless these properties are generating passive income through rental or rent-to-own income.
In hindsight, I also believe that by selling a property, one is converting portfolio income into earned income. Earned income will be tackled in the next part of this series on the types of income one can get through real estate investing.
What do you think?
Coming Up Next: Earned income through real estate investing
Coming up in the next part of this series, I’m going to tackle how one gets earned income through real estate investing, how it can make you feel like you are back in the rat race (this should be interesting), and what can be done about it.
If you want to know more about earned income, head on over to part two of this series – Earned income through real estate investing
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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