Investment Property

The question for many investors is “when is the right time to buy? While not directly addressing investment property, see “Never a Better Time to Buy” on the “tip sheet” section of this web site. The message is that waiting to buy real estate is almost always a mistake and purchasing when you have found the appropriate property and financing usually makes sense.

There are certain facts that make purchasing real estate an excellent investment. The following discusses these facts as they are contained in the “language of investments”.

1. LEVERAGE: is the ability to control property with the investment of minimum cash accompanied by maximum loans. This is known as using OPM . . . Other People’s Money. It refers to the general rule that the least money invested into the property, the greater the profit potential. But, it is also critical to avoid too much negative cash flow. So, while leverage is good, the investment can be jeopardized by attempting to leverage too much. Careful analysis is required, taking into consideration the investor’s goals, comfort zone (how much negative cash flow can be accommodated), ability to find appropriate financing, etc. With today’s property values, the “break even” point for many properties requires 20-30% down payment. This amount of down payment is also required if the borrower is to acquire the best rate and terms in the investment property arena.
2. APPRECIATION: is identified as the growth value due to inflation or the “paper” increase in value. Property appreciation has in the past typically run ahead of the inflation factor. During the run-up in home values, many borrowers purchased with the anticipation that they would realize significant quick appreciation. The past recession has slightly changed the philosophy and while appreciation may still be obtained, other factors may now be as important in determining the advisability of the investment. In any case, an owner must sell or refinance in order to realize any appreciation increase.
3. DEPRECIATION: represents a “paper” loss for tax benefit purposes. Investors are able to shelter income without affecting cash flow in their investment. There are several things to remember regarding depreciation rules:
   1. land value is not depreciable, only the improved portion of the property.
   2. a new owner begins a new depreciation schedule
   3. upon liquidation of the property, the amount of depreciation taken for tax purposes may have to be recaptured (unless a 1031 tax deferred exchange is used). A popular idea is to retain a present home as a rental property when purchasing another home. While this can be a good strategy for obtaining rental property, whether to do so depends upon several considerations:
      1. current tax rules favor selling a home if it has been owned 2 of the last 5 years. (see “Capital Gains Tax Clarified” on the Tip Sheet section of this web site)
      2. clearly determine one’s goals . . . would it be better to sell and buy two properties, one of which is a rental property?
      3. determine the “basis” of the property to be retained as the amount available for depreciation purposes might be limited. It may be better to sell?
      4. new regulations require 30% equity in the “retained” property in order to count rental income for qualifying purposes. (See your mortgage consultant for clarification and pre-approval). “Basis” is a calculation for tax purposes that is calculated as follows . . . Purchase Price (acquisition price) + costs of sale + costs of improvements less depreciation.

4. LIQUIDATING INVESTMENT PROPERTY: One can develop a portfolio or an estate using the investment property rules. While it is not easy for an owner to liquidate investment property without incurring what can sometimes be significant tax consequences, allowing property to pass to heirs via inheritance can be a way to avoid taxes. Of course, it does require the owner to die which is a drastic way to avoid taxes. Through a process called “stepped up basis” heirs can acquire property without paying taxes. In its simplest form, a property’s value “steps up” in value to its new reassessed value. If the heirs then sell the property for its reassessed value, there will be no capital gain consequence. On the other hand, inheritance tax consequences need to be investigated.
5. EXCHANGING: The provisions contained in section 1031 of the tax code allows for property held for investment to be transferred on a tax deferred basis. It provides a way for an owner to retain equity rather than paying taxes to the government. There are numerous details to consider in any 1031 tax deferred exchange transaction. Information, including the terms used in exchanges, is contained in “Understanding the IRS Code” in the tip sheet section of this web site.
6. PYRAMIDING: is the term applied to the art of increasing an investor’s equity at the fastest rate possible via the use of leverage, depreciation, appreciation, inflation and income tax regulations to maximize the investment.

Here are several other considerations when preparing to invest in real estate.

FIGURING THE RETURN

A distinction must be made between various “returns” on investment property. Most people first think of “before tax cash flow” which is determined by first deducting the overall cash outlays (e.g.: mortgage expense, taxes, insurance and operating expenses) from the gross income. The percent of return is then determined by dividing the resulting cash flow by the amount of cash invested . . . resulting in a before tax consequence return.

More important to most investors is the “after tax return” taking into consideration the tax shelter benefits of depreciation. Calculate depreciation (27.5 years) by multiplying the “improved” portion of the property value by the factor of .0363. There are various analysis worksheets available that will identify the return following all the allowable deductions in calculating the after tax return on actual cash invested.

DETERMINING VALUE

A common phrase heard in the investment arena is “the project is made at the time of purchase”. Translated, this means that if one pays too much (over market value) for the investment, it will impact the return on yield on the investment over time. At the same time, it is important to remember that good investments are lost because someone wanted to make a “killer deal”. Another adage to remember is “buy at market and sell at market and one will generally make money”.

These are some rules of thumb that have been used to provide a guide to value (e.g.: gross rent multipliers, cap rate calculations, etc.). Each method has its deficiencies and must not be relied upon totally in the decision making process. There are also very sophisticated methods of evaluating an investment, most of which provide so many numbers and statistics that most investors can not make sense of them or become so confused that they end up making no decision.

TRUST YOUR INSTINCTS (AND YOUR TEAM OF ADVISORS)

There comes a time in the investment process that, after evaluating all of the information, you end up relying upon your gut instinct . . . does the venture feel right or not? Seek some consensus from your team of advisors . . . your real estate representative, mortgage lender, attorney and/or accountant. Then make a decision and move forward. After all, remember the phrase “he who hesitates is __________________”.

INCOME PROPERTY EVALUATION

Finally, here are the ways that investment property is evaluated by most savvy investors. Financing will depend upon the strength of the borrower and the debt service ratio. Any quotes for financing without a loan file submission are unreliable.

Lenders are likely to expect at least a 1.2 to 1.3 debt service ratio for the property. Anything less will have to have compensating factors  . . .  high credit scores, additional reserves at COE, larger than minimal required down payment (likely to require 25-30 percent down payment)

Calculating debt service ratio:

Gross Rent

– Less vacancy (most lenders will likely use 10%)

= Gross Operating Income

– Less Operating Expenses (taxes, insurance, management fee, repair contingency)

= Net Operating Income (NOI)

Annual Debt Service is the monthly Principal and Interest payments (including first and secondary loans)

NOI divided by Annual Debt Service = Debt Service Coverage

NOI

Annual Debt Service        =    Debt Service Coverage

Rent Multiplier Method of Determining Value

This income approach to determining value is based on the assumption that there is a relationship between the income the property can earn and the property’s value.  A Gross Rent Multiplier is a ratio that states the relationship between gross rental income and the sales rice. Note that GRM represents an estimate of value and is not a precise figure. Many consider this a “rule of thumb”  method of evaluating a property’s value.

Sales Price

Gross Annual Rent           = Gross Rent Multiplier on Annual Basis

Appraiser may provide an estimate of local rent multiplier factors. Then, using this information, one can estimate the price an investor is likely to pay for the property.

Annual Rent  X  Market GRM  =   Indicated Value (investor is likely to pay)

Information to Acquire:

• Rental Agreements: determine total rental income by reviewing the contracts
• verify via estopple agreements:  these are verifications in writing from every tenant as to the contractual agreement under which they occupy the premises. It should verify not only the rental amount but whether the tenant is occupying under a month to month or a longer term lease agreement.
• Expenses: verify the taxes and insurance costs. Other expenses could include yard maintenance, laundry facilities, utilities, etc.
• Estimate likely financing before finalizing your purchase contract. Required down payment amount, interest rate and/or term of the loan could modify your offer.