You'll find in both Parts I and II a number of useful forms, as well as spreadsheet templates that you can download from my company's Web site at www.realdata.com/book. These will simplify many of the calculations in this book.
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You'll also find "Rules of Thumb" throughout the book. I have taken the liberty of using these sections to offer my personal insights and opinions—and to separate clearly my opinions from facts. It may be a fact when I tell you how to calculate a gross rent multiplier, but it's an opinion when I tell you what values would seem unreasonable to me. Some of these "rules" may not fit a particular place and time so I encourage you to test them against the realities of your market. I offer them as a guide, not as laws of nature.
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the true investor treats the physical property as a secondary issue. He or she is not so much interested in buying the property but in buying the property's anticipated economic benefits—what is called the income stream. Rule of Thumb: Don't make a decision to buy, hold, or sell based on emotional factors. In particular, don't buy a building because you've fallen in love with it; and don't hold because of a sentimental attachment when you really ought to sell. If you need that warm and fuzzy feeling, get a puppy. To the extent that some
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the ways you make money with income property. You can call these elements the four basic returns: 1. Cash Flow 2. Appreciation 3. Loan Amortization 4. Tax Shelter
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Not all properties generate a meaningful cash flow, however, and for those that don't, the next most important of the four basic returns is appreciation.
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Changing market conditions may make the property more attractive. An area that was once marginal may become fashionable, and consequently, the balance of supply and demand shifts.
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You may not enjoy the benefit of appreciation until you sell, but when you do sell, the value of this benefit can be substantial.
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It's really nice when someone else pays your bills. In effect, that's what happens when you use a mortgage loan to help you purchase an income property. Consider a $1 million office building. You could write a check for the full amount but, sadly, that would almost clean out your bank account. On the other hand, you could write a check for just $300,000 and get a loan for $700,000. That would leave you with enough money to buy two more similar buildings and still have change leftover.
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The last of the four basic returns is tax shelter. An income-property investment can shelter some of its own income from taxation and occasionally shelter income received from other investment sources as well.
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As owner of an investment property, you take in taxable rental income and pay out tax-deductible operating expenses like insurance and repairs (see Part I, Chapter 2 and Part II,
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leaving you with a "net operating income" (NOI) on which you would expect to pay taxes. However, to promote the general economic benefits that tend to flow from real estate development (e.g., the creation of office and retail space, multi-family housing, etc.), the tax code permits further deductions. The first of these deductions is for mortgage interest. Interest
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The second source of tax shelter is through the depreciation deduction, which is now called cost recovery in the tax code, but is still usually called depreciation by real flesh-and-blood investors.
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taxation. If the depreciation deduction is large enough, it can even exceed the amount needed to shelter the property's own income and provide shelter for other investment income as well. In that case, the deduction creates what is effectively a cash yield of its own by reducing your other tax liabilities. To anyone who has ever attempted to fill out a tax form, it should come as no surprise that you cannot find a nice simple formula for the tax shelter component of a real estate investment. Nonetheless, you can at least get a feel for the concept by following this path: Income less Operating Expenses = Net Operating Income Then, Net Operating Income less Mortgage Interest less Depreciation (Cost Recovery) = Taxable Income
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If you're considering the purchase of an income property, the information you receive will probably come either directly from the seller or indirectly, through the seller's agent.
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Ask to See the Leases There are a lot of good reasons to do this. For one, if you buy the property, you are going to be subject to the terms of those leases, so it's a very good idea to know what they say. More to the immediate point, however, is the question of the rental rates. Do the leases agree with the seller's representations? How long does each lease run? Do tenants have options to renew, and at what rates? The
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Look at the Property Tax Bill That's one way to confirm the accuracy of this expense; but also look to see if the current owner has received some sort of tax abatement (perhaps a development incentive) that may expire or may not apply at all to a new owner.
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Spot-check Utility Bills Most gas, electric, and water companies will give you usage information if you call.
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Ask to See the Appropriate Sections of the Seller's Tax Return You'll have to cover your ears when you try this, because the screaming can be painful. When the din subsides, point out that you don't need to see anything unrelated to the property.
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the income and expense information probably appears on Schedule E, and he or she can show you just that form.
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The owner may own the property as a limited liability company (LLC) or some other form of partnership, in which case the property has its own tax return.
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Recite the Representations about the Leases and the Schedule of Rent Income in the Offer to Purchase Check with an attorney about the proper language, but put into the offer to purchase something along the lines of, "The Seller warrants and represents that as of the date of this agreement, the leases are for such and such amounts and the expiration dates and renewal options are whatever." Then ask the lawyer about adding, "...and that these warranties will survive the delivery of the deed."
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Market-Related Data Investigate Comparable Sales If you were contemplating the purchase of a home, you would want to know how much other homes in the neighborhood had sold for.
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Your search might be a bit more productive if you look at some additional factors in regard to these comparables. Total square footage is one.
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examine the selling prices per square foot to see if you can discern a trend. You could also consider each property's gross rent. Dividing the selling price by the gross rent gives you something called the gross rent multiplier
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Look for Lease Rates and Operating Expense Data
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Find Out about Local Capitalization Rates
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www.realtyrates.com as a current source of such data.
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Gross scheduled income is the total annual rent value of all units in the property. This amount includes the actual rent generated by occupied units, as well as the potential rent from vacant units.
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Vacancy allowance is usually expressed as a percentage of the gross scheduled income. As its name suggests, it is an estimate of the amount of potential income that will be lost due to vacancy. Some investors prefer to call this category "vacancy and credit loss" so that it also accounts for uncollectable rent.
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Gross operating income (GOI) is the gross scheduled income, less the vacancy allowance. It is also known as effective gross income. In short, it is the amount you actually collect.
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Operating expenses are items such as property insurance and taxes, repairs, utilities, and management fees. Operating expenses include any costs that are necessary to keep the revenue stream flowing. Mortgage payments and depreciation are not considered operating expenses, nor are capital improvements.
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Net operating income (NOI) is the gross operating income, less the operating expenses. In other words, it is what is left of your total potential income after all vacancy and expense items have been subtracted. Again, mortgage payments and capital expenditures have no impact on the NOI.
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Annual property operating data (APOD) is the real estate equivalent of an income-and-expense statement. You'll use the terms APOD and income-and-expense interchangeably.
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Your vacancy allowance is an estimate, as it almost always will be. Ideally, you should base this estimate on your knowledge of market conditions and of comparable properties in the area.
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Rule of Thumb: In the absence of usable market data, many investors like to use a vacancy allowance in the range of 3% to 6%. An exception to this rule of thumb usually occurs in the case of a newly built project that is being leased for the first time. Vacancy during the initial lease-up period can be much higher. Conventional wisdom also has it that a property whose actual vacancy history is close to zero has probably been rented at less than market rates. In other words, if you don't experience some vacancy, you're just not charging enough.
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What you really want here is the ability to compare your data to some kind of norms. Your expense percentages may not tell you very much in an isolated example, but they might shed a good deal of light if you could compare them to some reasonable expectations.
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it is quite typical for a commercial tenant to be responsible for its own utilities and interior repairs, and often for any increase in property taxes.
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you might be wise to allow yourself a bit larger vacancy allowance than you do with your residential properties, since an empty store can often take a lot longer to rent than an empty apartment.
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It's always a good practice for you to get a quote on insurance from your own agent rather than relying on the current cost. After all, it's your own agent's bill that you'll have to pay. In
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you should always verify heating and other utility costs by contacting the utility suppliers directly. If the costs are higher than you might expect, as they are here, you want to know why. Is the condition of the heating system suspect? Where are the thermostats? Who controls their setting? Can you correct certain deficiencies and cut your costs? You can answer many of these questions with a careful inspection.
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Investors call this phenomenon "deferred maintenance," a polite term that means the owner is letting the property go to the dogs and someone is going to have to pay for the repairs sooner or later. Unfortunately, the longer those repairs are postponed, the higher the cost and the greater the likelihood of management problems and lost income. A building that has uncommonly low repair costs must be scrutinized
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You may focus so intently on the information that is provided that you may easily forget to notice the information that is missing. It's not enough just to evaluate the expense figures, as you did in analyzing Property B. You must always remember to ask yourself, "When you own this property, what else are you going to have to spend money on?" If
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The Annual Property Operating Data Form Let's get used to working with an APOD form similar to what an experienced investor might use.
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If you prefer, you can also go to www.realdata.com/book and download a spreadsheet of this form. The spreadsheet will calculate totals and percentages for you.
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you might even be bold enough to ask to see a copy of Schedule E of his previous year's income tax return, which will show you how much he claimed as taxable income and deductible expenses on this property.
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The owner may have enjoyed low repair costs last year, but he paid for that privilege with his remodeling expenses. You should count on something more realistic for repairs and maintenance for next year, perhaps 6%, which would be the low end of your typical range.
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FV is not the only one of the four variables you can calculate. If you know any three of the variables, you can calculate the fourth. Why do you care? Because sometimes you may want to estimate how long it will take a piece of property to grow from its original purchase price to a targeted resale price at a given rate of growth. In that case, you'll start off knowing the PV, FV, and periodic rate, and will want to figure out the number of periods. Or maybe you're looking at a piece of property that was bought some years ago and sold recently for a higher price. You'll want to know what the annual growth rate was for that property.
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To pose the same question mathematically, you know the PV ($100,000), the FV ($200,000), and the periodic rate (3%). You need to calculate the number of periods, given the other three variables.
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FIGURE 3.1 Excel functions. 3. In the left-hand pane, you'll see function categories. Choose "Financial." Excel has a financial function called NPER for calculating the number of periods in a lot of different investment scenarios. Select that function in the right-hand pane and click "OK." 4. You will next see a window where you can enter amounts for each
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www.realdata.com/book. These Excel sheets make it easy not only to perform the calculations, but also to visualize the examples.
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The time value of money plays a critical role when you consider just how valuable your property's cash flows really are. Timing is everything. Cash you receive sooner is more valuable than cash you receive later because the sooner you have it, the sooner you can put it to work earning more cash.
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The dollar will typically lose buying power each year, so you can't expect in five years to purchase goods and services with a current value of $100,000. Perhaps more importantly, if you don't have the cash in hand today, you can't put it to work for you.
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Discounting is a way of measuring the loss of value caused by the deferral of a return. In the typical real estate venture, you expect some kind of return each year that you operate the property, and an additional benefit from the eventual sale. Each of these returns will have its own timing, and therefore, will require its own discounting.
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If you sum the PVs of each of these cash flows, you get $105,856.47. Assuming your discount rate of 10% is reasonable, you can think of this sum as the value today of this property's expected future benefits.
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Keep in mind that the PV represents the present worth of all future benefits. If that's so, then you should compare the PV to what it cost you, namely the cash required to purchase the property. You find that the value of what you expect to receive ($105,856.47) is greater than that of what you had to invest ($90,000) to get it. As a successful developer once said to this writer, you can't lose money making a profit.
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The difference between these two is called the net present value (NPV). In this case, the NPV is $15,856.47. Rule of Thumb: Whenever the NPV is greater than zero, it means that the discounted value of the future cash flows is greater than your original cash investment. Translation: Your real rate of return is actually higher than the discount rate you used.
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The easy way is to use a spreadsheet like the one called "NPV," available for download. The model uses a built-in Excel function called @NPV. This function allows you to specify a periodic discount rate and a range of spreadsheet locations for the cash flows.
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Keep in mind the theme of this chapter: the time value of money. As the owner of a property, you may be able to seal the deal with a tenant by agreeing to a lease that provides for a small rent increase each year rather than just one, much larger increase that kicks in at a later time. A quick discounted cash flow analysis of the lease payments may be able to show you that the concession that convinces the tenant to sign on the dotted line really costs you little or nothing in discounted dollars.
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impractical. One decision you may face with a small commercial property concerns terms for a tenant who has just started in business. Do you begin at a low rent to give the tenant a chance to get established and then escalate quickly to make up for lost time? Or do you start off high, assuming that you'd better collect as much as you can while the tenant is still solvent, and not worry about a long term that may never occur? You can use a basic Excel model (See www.realdata.com/book for "Present Value of a Lease") to analyze such a situation. The model treats each monthly payment as a periodic cash flow. Since lease payments are made at the beginning rather than at the end of each period, it leaves the first payment undiscounted and applies Excel's NPV function to the remaining payments. It also divides the discount rate by 12, so that it's applying a monthly rate to the monthly payments.
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First, turn to the Appendix in the back of the book where you will find the first page of a table called, "Monthly Mortgage Payment per $1." The rest of the table can be found at www.realdata.com/book. The chart runs from 1% to 14.375%, and from 1 to 30 years in one-year increments.
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if you know three of the mortgage variables, you can calculate the fourth. Let's use
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As you can see, you have the four variables: N, the number of payment periods; %i, the interest rate per period; Pmt, the payment per period; and PV, the present value.
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Now suppose you want to know how your situation might improve if you succeeded in negotiating this loan at 8% instead of 9%. You can simply change the %i figure to .0067 (8% annually divided by 12 months) and view the results immediately. The change in the interest rate lowers the monthly payment from $839.20 to $771.82. As a final consideration, let's say that you want to consider a 30-year term. Change N to 360 (the number of months in 30 years) and note that your payment now drops to $733.76.
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a house is worth what someone is willing to pay for it. Income-producing property, however, is different. Value is determined by the numbers. The owner of the Yankees may admire a batter's graceful swing, but he pays for that player's batting average. Let's begin this discussion
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(NOI) represents a minor variation on this theme and has a very specific meaning. You might think of NOI as the number of dollars a property returns in a given year if the property is purchased for all cash and if there is no consideration of income taxes or depreciation. By more formal definition, it is a property's gross operating income less the sum of all operating expenses.
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Gross Scheduled Income less Vacancy and Credit Loss = Gross Operating Income
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To be considered a real estate operating expense, an item must be necessary to maintain a piece of a property and to ensure its ability to continue to produce income. Loan payments, depreciation, and capital expenditures are not considered operating expenses.
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Repairs and maintenance are operating expenses, but improvements and additions are not—they are capital expenditures. Property tax is an operating expense, but your personal income tax liability generated by owning the property is not. Your mortgage interest may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it.
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Gross Operating Income less Operating Expenses = Net Operating Income
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Investors don't decide to buy properties; they decide to buy the income streams of the properties.
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The NOI represents a return on the purchase price of the property, and the cap rate is the rate of that return. Hence, a property with a $1,000,000 purchase price and a $100,000 NOI has a 10% capitalization rate. However, the investor will purchase that property for $1,000,000 only if he or she judges 10% to be a satisfactory rate of return.
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Apply the 12% cap rate (PV = NOI / Cap Rate), and now the investor is willing to pay about $833,000.
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you can depreciate a residential income property over 27.5 years, and a nonresidential property over 39 years.
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taxable income is not quite so real. It's whatever the tax code du jour says it is. If tomorrow the House of Representatives should decide that the useful life of commercial real estate ought to be 100 years instead of 39, then your property's taxable income will rise without your experiencing a single additional dollar in rental income. Why?
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Up until now, we have been discussing cash flow before taxes (CFBT), but a more meaningful bottom line to you as an investor may be cash flow after taxes (CFAT).
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From your NOI, you subtract anything that is tax-deductible. Mortgage interest falls into that category, so you subtract the interest from each of the three mortgages. Depreciation, even though it is not cash out of pocket, is also deductible. Similarly, you can deduct a portion of the points you paid to obtain each mortgage. If you had income that was not from rent—typically interest earned on the property's bank or escrow accounts—that interest needs to be added in as additional income.
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NET OPERATING INCOME – Debt Service, 1st Mortgage – Debt Service, 2nd Mortgage – Debt Service, 3rd Mortgage – Capital Additions + Interest Earned CASH FLOW BEFORE TAXES
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In subsequent years, the debt service remains constant, but your NOI increases, so you forecast that your cash flow will increase every year.
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In short, if you achieve your projected year 2006 CFBT of $71,037, you'll have a tax liability of $19,890, leaving a CFAT of $52,501.
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Note that you expect to pay more tax each year because the property earns more taxable income each year. However, your CFBT is growing faster than your tax liability, so your bottom line—the CFAT—becomes greater each year.
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Rule of Thumb: Recite this mantra whenever you consider purchasing an income property: If it's not worth selling, then it's not worth buying.
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It pays, therefore, to run tomorrow's numbers today and to see just what this investment will look like to a future buyer.
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It is common for a buyer to estimate value by capitalizing the current year's NOI, and for a seller to capitalize next year's expected NOI. The buyer often takes the position, "I am buying the income stream that just happened, and the property's value is based on that income stream. If the income goes up next year when I own the property, that's my business." The seller, as a rule, will assert, "You didn't own the building last year. You're buying next year's higher income stream. The value of what you're buying should be based on that."
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PROJECTED SELLING PRICE – Costs of Sale – 1st Mortgage Payoff – 2nd Mortgage Payoff – 3rd Mortgage Payoff BEFORE-TAX SALE PROCEEDS
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Rule of Thumb: 7% of the selling price is an estimate of cost of sale that has traditionally been popular among income-property investors. This amount would presumably be sufficient to cover the legal and brokerage costs of a typical transaction. Before you assume that such a percentage is always sufficient, keep in mind that not all transactions are typical. Stir in a little contaminated ground water and add a dash of environmental liability insurance and you may be serving up an altogether different deal.
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That's what you pay your accountant to do. To figure the tax on the sale of income property, you must first figure the gain. The gain is the difference between the selling price the property's "adjusted basis."
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Adjusted basis is the property's original cost, plus capital improvements, plus closing costs and other costs of sale, less accumulated depreciation. Essentially, the adjusted basis is what you spent to purchase, improve, and sell the property, less the amount you have already written off. If you sell the property for more than this amount, you have a taxable gain.
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If you have an unamortized balance on any of these items, you can deduct it when you sell.
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One of the oldest and simplest measures is the payback period. You can define this as the length of time required to recover your initial cash investment. Let's say you invest $100,000 in cash to purchase a $500,000 property. The balance, of course, is financed. The property generates a positive cash flow of $20,000 per year. Hence, the payback period is five years.
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To achieve a quick payback, your property must have a strong positive cash flow. The sooner you get your investment back, the sooner you can begin to "make" money.
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The payback period has been known colloquially as the "bingo year," presumably because that is what the savvy and sophisticated investor would exclaim upon seeing the return of the Prodigal Down Payment.
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One weakness of this method is that it does not take into account the time value of money. It treats a dollar received at some future date as being just as valuable as a dollar received—or invested—today. Looking again at the preceding example, if the property had no cash flow at all for 4 years and then $100,000 in year 5, it would still represent a five-year payback. However, you would have missed the chance to collect and reinvest $20,000 per year for the first four years. Even if you had reinvested the early cash flows at money market rates, you would certainly have accumulated some interest by the end of year 5. One five-year payback of $100,000 is not necessarily as good as another.
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"cash-on-cash return." With this approach, you look at the cash flow (usually before taxes) from a particular year of a property's operation and compare it to the cash you invested to purchase that property. You express the result as a percentage, so if you have a $10,000 cash flow this year from a property in which you initially invested $100,000 of your own cash, you would have a 10% cash-on-cash return.
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Cash-on-Cash Return = Cash Flow before Taxes / Cash Investment Cash-on-Cash Return = 10,000 / 100,000 Cash-on-Cash Return = 10%
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The cash-on-cash return is perhaps even less illuminating than the payback period because it considers a property's performance over just a single year. Nonetheless, it has typically been a very popular measure, probably because it expresses its result as a simple rate of return. It is easy to look at such a number and say, "10% is better than the rate I can get on a T-Bill. I like that."
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Deferring maintenance or improvements can prop up a sagging cash flow, at least for the short-term, and give the appearance of a higher cash-on-cash return. The very actions that might increase the apparent return would, at the same time, make the property less attractive and ultimately less valuable.
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A cousin to the cash flow measures is the gross rent multiplier (GRM). GRM is a method of estimating or expressing a property's value as a multiple of its gross rental income. Gross Rent Multiplier = Market Value / Gross Scheduled Income (annual)
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By using comparable sales and establishing a rent multiplier based on a number of other properties, GRM essentially establishes by default a typical level of annual expenses and improvements for this group of properties.
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An investment measure that remains widely used is the debt coverage ratio. This is the ratio between the annual net operating income and the annual debt service. Debt Coverage Ratio = Net Operating Income / Annual Debt Service
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A property with a 1.20 debt coverage ratio has income before debt service that is 1.20 times as much as the debt service—in other words, the property generates 20% more net income than it needs to make its mortgage payments. Rule of Thumb: Most lenders require a debt coverage ratio of at least 1.20 in order to finance an income property. This ratio is not going to tell you if you'll meet your own investment goals with this property, but it will tell the lender if you are likely to be able to meet the mortgage payments. A presentation that's designed to seek financing for an income property should always include the anticipated debt coverage ratio, preferably over a period of several years.
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Capitalization Rate = NOI / Value You recall that a property's NOI is its gross scheduled income, less vacancy and credit loss, and less operating expenses. Gross Scheduled Rent Income less Vacancy and Credit Loss less Operating Expenses = Net Operating Income
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Operating expenses include insurance, utilities, maintenance, and similar items, but do not include mortgage payments, depreciation, or income taxes. Hence, the NOI is the net income before debt service and before income taxes. Like GRM, cap rate
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It is perhaps the easiest to calculate of the useful measures, and is a good tool to compare a property's current performance to that of similar properties. Other
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The downside to the capitalization rate, however, is the same as with most of the others we've considered so far. It looks at the property at a point in time (usually the current year), without regard to the property's expected performance over your entire holding period.
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Perhaps the simplest and most elegant definition of an investment is that it is the present worth of an anticipated future income stream. If you parse this definition, you reveal both the strengths and weaknesses of yet another measure, called discounted cash flow analysis (DCF): Present worth implies that there is a time value to money that you must take into account. Anticipated hints at an element of uncertainty. You are going to have to make projections regarding events (i.e., cash flows, resale) that have not yet occurred. Future income stream suggests that you will be looking at more than just a single point in time. You expect to experience not just one, but a series of cash flows whose timing and magnitude will affect the success of your investment.
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According to the venerable "Show Me the Money" principle, you would prefer to have a dollar in the hand today, rather than the same dollar tomorrow or next year. The reason for your impatience is that the passage of time imposes what is called an "opportunity cost." If you receive the dollar today, you can invest it and earn some return during the next year. If you receive the dollar a year from now instead, that delay has cost you the opportunity to invest, and hence, has cost you the return that that opportunity represents.
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Internal rate of return (IRR) holds a dubious distinction in the panoply of investment measures. It is the most widely used and oft-quoted rate of return for real estate, and at the same time, the least understood.
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We defined an investment as an expected stream of income, and we defined the PV of that investment as the sum of the discounted values of each of the future cash flows.
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To put it less technically: Each year, the investment throws off some sort of cash flow—positive, you hope, but negative perhaps. In the year that you dispose of your investment property, you realize one extra cash flow—the proceeds of sale. The longer you have to wait to collect your money, the less "PV" it has today. As you've seen repeatedly throughout this book, there is a time value to money.
LOCATION: 1656
You also believe you should discount future cash flows by 11%. What that really means is that you think if you had this $25,000 in hand today, you could invest it for an average return of 11% per year over the next five years. You think this is true because you discover that other property investments of similar kind and risk are currently returning about 11% to their owners. You assume that for every year you don't have one of those cash flows in hand, you're going to lose a potential return of 11%, so that's how much of a discount you should apply to each.
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Add these all up and you get not the $25,000 face value, but $15,564.92. That is the sum of the present worth of each of the expected future cash flows, including the resale. If you have made accurate projections of these cash flows and have selected an appropriate discount rate, then it is reasonable to say that the future economic benefit that you will derive from the property is worth about $15,565 today.
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Given these cash flows occurring at these points in time, $15,565 is how much cash you, as an investor seeking an 11% return, would be willing to invest.
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if you buy a property for all cash, then the sum of the discounted cash flows equals the value of the property, because that is how much cash you invest. If you finance the purchase, then the sum of the discounted cash flows represents the value of just your cash outlay.
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If I know or can project the future cash flows and the proper discount rate, I can calculate the PV of my cash investment. If I know or can project the future cash flows and the PV (i.e., the amount) of my cash investment, I can calculate the discount rate, which I will then call the IRR.
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Financial calculators can do this and so can Microsoft Excel. We provide a basic Excel model that you can download at www.realdata.com/book. You can also avail yourself of easy-to-use income-property analysis software, such as that provided by RealData.)
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IRR is superior to most other measures of investment quality because it takes into account both the magnitude and the timing of every cash flow. A difficult concept to grasp at first, it is elegantly direct. Discount all future cash flows from the point in time when they occur back to the present using a single discount rate. When you find the unique rate that makes the sum of these discounted cash flows equal to the initial cash investment, you have found the IRR.
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