Real estate investing is an important aspect of a balanced portfolio and can be a lucrative investment but should be entered into by first conducting due dillegence and assessing the risks involved. The following information will give you a general understanding of what is involved in buying and selling investment property.
Standard Cash Flow Model
Before Tax
Cash flow analysis begins with the income received. Operating expenses are then subtracted to arrive at net operating income (NOI). Then the annual mortgage payments are subtracted to arrive at before tax cash flow.
After Tax
To arrive at after-tax cash flow, annual interest and depreciation are subtracted from the net operating income to arrive at real estate taxable income. Real estate taxable income is multiplied by an investor's marginal tax rate to determine the amount of tax that is owed or saved. The amount that is owed or saved is then subtracted from before-tax cash flow to arrive at the bottom line of the cash flow model, after-tax cash flow. (Confused? We will take you through this step by step.)
Steps to Calculate Before-Tax Cash Flow
Before-Tax Cash Flow
GROSS SCHEDULED INCOME - Vacancy & Uncollected Rents = EFFECTIVE RENTAL INCOME (ERI)
ERI + Other Income = GROSS OPERATING INCOME (GOI)
GOI - Annual Operating Expenses = NET OPERATING INCOME (NOI)
NOI - Annual Debt Service = BEFORE-TAX CASH FLOW
Step Two: Break it down.
Cash Flow Definitions
1. Gross Scheduled Income (GSI) is the maximum amount of annual rent you would receive if the property were 100 percent occupied all year.
2. Vacancy & Credit Losses represent an estimate of rental income that will be lost because portions of the property are not rented, or because existing tenants fail to pay rent. When expressed as a percentage, it is called the vacancy factor. When expressed as a dollar amount, it is referred to as the vacancy loss. Each market and sub market has its own vacancy factor, which can frequently be obtained by asking appraisers, property managers, and loan officers.
3. Effective Rental Income is obtained by subtracting Vacancies & Credit Losses from Gross Scheduled Income. It represents the actual amount of money collected in rents for the year.
Gross Scheduled Income
– Vacancy and Credit Losses
= Effective Rental Income
4. Other Income refers to income from sources other than rents. Other income can have a significant effect on cash-flow analysis. Typical sources of other income include:
Laundry machines
Rental application fees
Storage fees
Parking fees
Vending machines
Late fees paid by tenants
5. Gross Operating Income (GOI) is obtained by adding Other Income to Effective Rental Income. Gross operating income is the total pre-expense income investors are able to deposit in their properties checking account.
Effective Rental Income
+ Other Income
= Gross Operating Income
6. Annual Operating Expenses are the actual costs involved in running the property. An annual expense budget should include sufficient funds to ensure that the property continues to produce market rents. If maintenance is deferred for a prolonged period, the property's ability to compete for the best renters will be diminished. Operating expenses include:
Property tax
Insurance
Maintenance and repairs
Management fees
Services (garbage, janitorial, pool, elevator, lawn, etc.)
Utilities
Supplies
Loan payments are not considered an annual operating expense. Loan payments are a financial cost to an owner who chooses to borrow rather than pay cash. Also, operating expenses do not include cash outlays for major improvements. These outlays, called capital additions, must be placed on a cost-recovery or depreciation schedule and deducted over time.
7. Net Operating Income (NOI) is obtained by subtracting Annual Operating Expenses from Gross Operating Income. NOI is a key component in cash-flow analysis. First, it is the estimated amount of money the property will produce to cover the annual debt service (twelve months' mortgage payments). Second, it is used by investors and appraisers, in conjunction with a cap rate (see Chapter 5), to determine a property's value. NOI is a common factor that can be used to evaluate an investment regardless of whether an investor is paying cash or using financing to purchase a property.
Gross Operating Income
– Annual Operating Expenses
= Net Operating Income
8. Annual Debt Service is the total of all monthly loan payments (principal and interest) paid throughout the year on all mortgages.
9. Before-Tax Cash Flow is obtained by subtracting Annual Debt Service from Net Operating Income. Before-tax cash flow is what the investor has left of the property's income after all expenses are paid except taxes. If annual debt service exceeds net operating income, this number will be negative. (Cash is flowing from the investor to the investment.)
Net Operating Income
– Annual Debt Service
= Before-Tax Cash Flow
Step Three: Case Study 1
Four-Plex Rental Property
A four-plex rental property is listed for $200,000. Two units are rented at $550 per month and two units are rented at $640 for a total of $2,380 per month. The average vacancy in the area is reported to be 5%. The current owner receives an additional $418 per year from laundry machines. 80% financing is available at 7.5% on a 30-year fixed-rate loan with monthly payments of $1,118.74. Annual operating expenses are as follows:
Taxes $2,200
Insurance $1,000
Property Management $2,204
Repairs & Maintenance $1,400
Utilities:
Electricity $600
Sewer & Water $800
Total Utilities: $1,400
Services:
Garbage $550
Landscaping $800
Total Services: $1,350
Annual Operating Expenses $9,554
What is the first year's before-tax cash flow?
1. Gross Scheduled Income . . . $ 28,560 ($2,380 x 12 months)
2. – Vacancy & Uncollected Rents . . – $ 1,428 (5% of $28,560)
3. = Effective Rental Income. . . . . . . . = $ 27,132
4. + Other Income . . . . . . . . . . . . . . . . + $ 418 (laundry machines)
5. = Gross Operating Income. . . . . . . = $ 27,550
6. – Annual Operating Expenses . . . – $ 9,554
7. = Net Operating Income . . . . . . . . = $ 17,996
8. – Annual Debt Service. . . . . . . . . . – $13,424.88 (Mtg. $1118.74 x 12)
9. = Before-Tax Cash Flow . . . . . . . . = $ 4,571.12
Interest Deduction Rules
· Interest paid on rental property loans is deducted from rental income, whereas homeowners' mortgage interest is deducted from personal income. Only the interest portion of a mortgage loan is deductible.
· There is no limit to the amount of interest a rental property owner may deduct against rental income, whereas homeowners can only deduct interest on the first $1.1 million borrowed.
· Finally, there are limitations regarding interest deductions for refinancing. If a rental property owner refinances and pulls out cash, that cash must be spent for a business purpose in order for the interest on it to be deductible. This situation is covered by a complex section of the tax code called the Tracer Rule (T.D.8145). While these regulations generally do not concern an agent making a sale, a buyer should be aware of them and consult a tax professional if he or she is considering refinancing.
Cost Recovery (Depreciation)
The deductions discussed so far–for operating expenses and interest–require the property owner to pay first, then deduct. But with cost recovery (formerly called depreciation), you can deduct a non-cash expenditure. Remember, always recommend that your client consult his or her own tax professional to determine their specific tax issues.
Only buildings and improvements can be depreciated, not land.
The cost recovery period is 27.5 years for residential investment properties and 39 years for nonresidential investment properties. Mid-month convention applies. *
Movable business property (also known as personal property), such as appliances and carpets, has a cost recovery period of five or seven years.
To estimate annual cost recovery (depreciation) for a residential rental, you must first determine the property's cost basis.
Sales price plus capitalized closing costs equals cost basis. (Loan points are not included in capitalized closing costs.)
Once you arrive at the cost basis for a property, the next step is to allocate the cost basis between land and improvements. Typically, an investor will use either the assessor's records or the allocations on their appraisal to determine the percentage allocation between land and improvements.
Once you have determined the improvement allocation of the cost basis, divide this number by 27 ½ years to estimate 12 months depreciation. *
* Mid-month convention allows only 11 ½ months of cost recovery in the year of acquisition and disposition.
Amortization of Loan Points
If points are paid when obtaining financing for the purchase of an investment property, they are amortized over the term of the loan. The term of a loan can differ from the amortization period. For instance, if a purchase loan is amortized over 30 years but has a due date or term of 5 years; the points paid on this loan would be amortized over 5 years.
GROSS SCHEDULED INCOME
– Vacancy & Uncollected Rents = EFFECTIVE RENTAL INCOME (EFI)
EFI + Other Income = GROSS OPERATING INCOME (GOI)
GOI – Annual Operating Expenses = NET OPERATING INCOME (NOI)
NOI – Annual Debt Service = BEFORE-TAX CASH FLOW
Determining the Value of Investment Property
Two commonly used methods of determining the value of an investment property are the Gross Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.
Gross Rent Multiplier (GRM)
The investment value of a property can be calculated using the estimated Gross Scheduled Income (GSI) for year one, multiplied by a factor known as the Gross Rent Multiplier (GRM). ("Gross Rents" is just another way of saying Gross Scheduled Income.)
First-year GSI x GRM = Investment value of property
The gross rent multiplier used in evaluating investment property is typically derived from comparable properties in the marketplace and may be adjusted by the investor to reflect his or her specific requirements.
To determine the Gross Rent Multiplier:
Monthly Income x 12 (mos.) ÷ Selling Price = Gross Rent Multiplier (GRM)
Using the Gross Rent Multiplier to Determine Investment Value
Example:
Suppose a potential buyer's gross rent multiplier (GRM) requirement is 8. (This means the investor will pay no more than 8 times the gross scheduled rent to purchase an investment property.) The property the buyer is considering has an estimated first-year gross scheduled income of $24,000. The investment value, or the amount this investor would be willing to pay for this property, is:
$24,000 x 8 = $192,000
Pros and Cons in Using a Gross Rent Multiplier:
Pros: The gross rent multiplier is a convenient tool because of its simplicity.
Cons: The usefulness of the gross rent multiplier is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income past the first year.
Capitalization Rate (Cap Rate)
The value of an investment property can be determined by its ability to produce cash returns. After paying all expenses, except principal and interest payments, the remaining cash flow is called the Net Operating Income (NOI). NOI is most commonly used in conjunction with a cap rate to determine property value.
Cap Rate
The cap rate is the ratio (expressed as a percentage) between purchase price and the first-year net operating income (NOI) of the property.
Determining the Cap Rate of an Investment
Investors use cap rates to measure investment performance:
Cap Rate = Net Operating Income (NOI) ÷ Purchase Price
Example: An investment property selling for $200,000 with an estimated first-year NOI of $20,000 would have a capitalization rate of 10%.
$20,000 = .10 or 10%
$200,000
Using a Cap Rate to Determine Investment Value
A variation of the cap rate formula can be used to solve for investment value (price) when the cap rate and the net operating income are known.
Example
Suppose a potential buyer is looking at a property listed for $200,000 with an estimated first-year NOI of $18,400. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 9.5%. We can use the formula below to determine the purchase price he would be willing to pay.
Income (NOI) = Investment Value $18,400 (NOI) = $ 193,684
Cap Rate 9.5% Cap Rate
Pros and Cons in Using a Capitalization Rate (Cap Rate):
Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and operating expenses.
Cons: The reliability of using a cap rate is limited because it only looks at a one-year forecast and does not take into consideration any financing or tax implications.
Cash on Cash
Another measurement of investment performance is called Cash on Cash (C/C). This involves comparing an investor's initial investment to the potential before-tax cash flow an investment property is likely to produce. Let's assume the investor's initial investment is $45,000 ($40,000 down plus $3,400 in closing costs plus $1,600 for points). We will also assume the property produces a before-tax positive cash flow of $4,972 per year.
Before-tax cash flow = % Return
Initial investment
$4,972 (cash) = .11 or 11%
$45,000 (on cash)
Pros and Cons in Using Cash on Cash:
Pros: Cash on cash takes into consideration vacancy and uncollected rent, operating expenses, and debt service.
Cons: Cash on Cash does not take into consideration anything past a first-year forecast. It does not take into account tax considerations or any increase or decrease in equity.
OBTAINING ACCURATE DATA
Obviously, your cash-flow analysis will only be as accurate as the information you plug into the cash flow model. Current information on a property's income and expenses may be available from the following sources:
The property manager's records
Copies of the current lease and rental agreements
A copy of the owner's Schedule E (rental property income tax schedule)
The owner's personal records
Important Questions to Ask
Gross Scheduled Income
What are the current rents, according to the lease and rental agreements?
Are these market rents?
How long do these agreements run?
Are the tenants prompt payers?
When were rents last increased?
What did the owner report as rental income on his Schedule E?
If there is a property manager, what do his records show as collected rents?
Vacancy & Uncollected Rents
What is the current vacancy factor for the property?
What is the current market or sub market vacancy factor?
What is a reasonable forecast for future vacancies?
Is the property competitive, or does it need to be upgraded?
Other Income
Are the laundry and vending machines owned by (a) the property owner or (b) an outside vendor?
If (a), how long will the machines last, and how much will it cost to replace them?
If (b), what are the contract terms?
Are parking fees charged for extra or large vehicles?
Annual Operating Expenses
Annual expenses should be broken down into categories. This will assist a buyer and his or her tax professional to properly analyze the property. In addition it makes it easy to enter the expenses on a Schedule E at tax time. The following is a typical breakdown of annual expenses:
· Advertising
· Cleaning and maintenance
· Leasing commissions
· Property insurance
· Legal and other professional fees
· Management fees
· Repairs
· Services (garbage, gardening,
pest, pool, landscaping, etc.)
· Supplies
· Taxes
· Utilities
· Other
Annual Debt Service
Remember to include only principal and interest payments; taxes and insurance have already been accounted for under operating expenses.
