In this section we will discuss the fundamentals of real estate investing as well as some ways people invest in real estate. This will not turn you into Donald Trump, but hopefully will spur some additional thought and discussion.
Real Estate Investing takes many forms and most people that own their own home are at least marginally involved in it. Congratulations! This type of real estate investing is called “Amenity real estate investing”. Basically it means that it provides you shelter as well as potential for tax savings and capital growth. It differs from investment real estate in the decision on where to buy, how to own and what financing to obtain. It may also impact how long you hold it for and the objectives for purchasing it in the first place. But, make no mistake – it is an investment.
If you are an investor (Real Estate or otherwise), you are generally concerned with some basic principles namely: Risk, Cash Outlay, Cash Flow, Yield (reward), Management and Liquidity. Depending on your personal preferences and views, you will place more attention on one or more aspects of these principles. Let’s talk about these as they relate to real estate.
Risk: Risk is defined as “The possibility of suffering harm or loss. A factor, thing, element, or course involving uncertain danger.” A major risk to Real Estate investment is that it is “immobile” that is you can’t move it (easily). This means that your investment can be impacted by external forces (i.e. a nuclear power plant going up next door) which you have no control over and you can’t always predict or prevent. Additionally, there are many laws, regulations, codes that you must be aware of that are imposed by Government agencies, banks and the market space.
Cash Outlay: Regardless of what you see on late-night investment seminars, buying or selling real estate requires cash. There may be some programs that allow you to limit the amount of cash you need to outlay, but there will always be some form of outlay. Typical requirements include: Appraisal fees, load application fees, closing cost and down-payment. For investment real estate, most financial institutions ask for 10% down payment plus closing costs to be paid by purchaser.
Cash Flow: This is the amount of money the investment produces (see calculations below). There are several different variations of cash flow including: cash before taxes, after taxes, net, gross etc… Different investors have different needs. You should determine your needs before you buy a property and select properties that give you as close as possible to your requirements.
Yield (Reward): Yield is defined as: “the income produced by a financial investment, usually shown as a percentage of cost.” Yield is generated in real estate by cash flow, upon the sale or both. Investors should receive a return on the money invested as well as the return of the money invested. Yield should be proportionate to the risk. The higher the risk, the higher the yield and vice versa.
Management: Real Estate requires management and that comes with an expense. Management can be done by a professional company (i.e. 85 & Sunny Property Management) or the investor. Regardless, who does it, it costs money.
Liquidity: This is the ease and relative speed at which you can turn your investment into cash. Obviously a savings account is very liquid (it is already cash) whereas a real estate investment is more “illiquid” it takes longer to sell and turn into cash. This prevents the investor from being able to use the funds quickly.
Here's a good formula to determine whether a potential real estate purchase is a deal. It's a simple acronym called C.L.E.A.R.
C.L.E.A.R stands for: Cash Flow, Leverage, Equity, Appreciation and Risk.
These five areas are critical for investors to understand and assess their investment strategies. We addressed some of these above, but a refresher is always good.
Cash Flow – Determine if you need it or not and what is acceptable for your investment.
Leverage – Understand that the least amount of money you put down and the higher your cash flow the better your rate of return. Leverage can be positive or negative.
Equity – buying into equity is always preferred, however, it is possible to create equity in your property if you take the time to do your homework.
Appreciation – timing of markets is very risky. Go for the longer term (7 – 10yrs) and shoot for an average for 7-10% and you will be very happy with your return.
Risk – Risk is the least understood of all. What if your assumptions are wrong? What can you handle and for how long? What’s Plan B. Answer those and you’ve started to think about risk.
Some Math that you need to be aware and know how to calculate it when evaluating an investment. This math relates to two main items, Cash Flow Before Taxes (CFBT) and Capitalization Rate. You must learn how to use the Capitalization rate to determine the potential purchase price for an income producing investment, and how to calculate CFBT which is the basis for reviewing all real estate investments.
Capitalization Rates: Capitalization is a procedure in the appraisal process by which the value of a property can be estimated from the quantity, quality and durability of the property’s net expectancy. The basic formula can be used to calculate various rates to evaluate a property, depending on what information you have available.
Income = Rate / Value
Overall Capitalization Rate (OAR) = Income / Sales Price.
This includes three things:
1) Return on the dollars invested in the land
2) Return on the dollars invested in the building
3) Return of any loss in value due to future building depreciation (also called recapture).
Real Estate Investing Example (OAR)
(Net Operating Income) 12,000 / 187,000 (Sales Price) = 6.4%
You can use this to understand your rate of return (OAR) or you can use it to determine the purchase price to pay for a property. If all similar properties have a OAR of 8% and you expect to be able to get 15,000 in net income then the purchase price should not exceed: 15,000/.08 = 187,500. If you pay more than 187,500 for the property then your rate of return will be less than 8% or if you get less than 15K in net income your rate of return will be less as well. Leverage may increase a yield on the investment. When the percentage of return exceeds interest rates you have positive leverage.
Cash Flow Before Taxes Calculation
Potential Gross Operating Income (PGI): ____________
Less (-) Vacancy Losses (VL): ____________
Equals (=) Effective Gross Income (EGI): ____________
Less (-) Operating Expenses (OE): ____________(fixed, Variable and reserve)
Equals (=) Net Operating Income (NOI): ____________
Less (-) Annual Debt Service (ADS): ____________
Equals (=) Cash Flow Before Taxes (CFBT):____________
So, now you’ve analyzed your risk profile, studied the market and run your Rate of Return calculations and you’ve chosen the right investment for you. You have purchased it and it has been performing just as you’ve expected it to. In fact, it has grown substantially over the past several years that you’ve owned it skyrocketing from an investment of $100,000 with an $80K initial loan to an estimated $1M with an outstanding loan of $50K. If you sold it now, you would owe taxes on the gain as well as the recaptured depreciation. If your tax bracket is 30%, your tax liability could be north of 250K! But, you don’t want to stop investing…you are just ready to take this gain and invest in other real property. If you are thinking, Tax Deferred Like- Kind Exchange, 1031(a)(d), or what is more commonly referred to as a 1031 Exchange, you’re thinking correctly. Let’s call subject property the one that we are exchanging and target property, the one that we are exchanging for. To do a successful, qualified exchange the subject property must be exchanged for a like-kind target property, the proceeds can not enter your hands or control, and certain timeframes must be met. First, let’s talk about like-kind exchange. All real property can be exchanged with any real property as a like-kind exchange. You can exchange a single family investment (or many single family investment homes) for a commercial office building. Second, you must maintain the same ratio (or higher) of debt to equity in the target property as you have in the subject property. This means that if you have a mortgage of 50K, you must maintain at least a mortgage of 50K in the target property for it to be fully qualified. If you take any money out of the transaction it is call “the Boot” and will be subject to taxes. You must have a qualified intermediary handle the transaction. They will “dispose” of the subject property and procure the target property and transfer title into your name. You may not use your regular accountant, attorney or anyone that you have a relationship with that owes you a fiduciary responsibility to act as an intermediary. The intermediary must be independent for the transaction to be qualified. Additionally, within 45 days of disposing of the subject property you must identify up to 3 target properties, and with 180 days you must complete the exchange with one of the target properties you had identified. A question that comes up often is “how do I get access to the money that I made?” One strategy is to take a loan on the target property once the exchange is completed. Remember, loan proceeds are not taxed. If you have any questions about 1031 Exchanges, contact Patricia Lorenzo (321-254-1353), your attorney or CPA.