# The Magic of Income Property Math

duplex

#### How Income Math Is Magic

Owning income property is the key to magic money. Don’t believe me?

Think of it this way. Let’s take a small income property, say a fourplex. A quick way to figure the value of a fourplex or a duplex or triplex is to take the NOI [net operating income] and multiply by 10 or 12, the going rate here in Southern California.

So for example, a fourplex has four equal units and each is rented for \$1000. Monthly income is \$4000 and yearly income is therefore \$48,000. The owner pays water and garbage collection for a total of \$300 per month or \$3600 per year. The taxes and insurance amount to \$5000 per year and repairs about \$2000. Subtracting these expenses from the income of \$48,000 gives us the net operating income of \$37,400. Multiply that by 10 and the value of the property is \$370,400.

Rents have been going up all over the country and especially here in Los Angeles, so it’s time to raise the rent to current market rates.  Each unit will now rent for \$1100. Yearly income becomes \$52,800 and, assuming expenses stay the same, the NOI  \$42,200. Multiply that by 10 and the value of the property is now \$420,200. Magic. Pure magic.

For every extra dollar in increased rent, the value of the property goes up \$10. This is truly magic math. Almost all the gains are passive. This kind of math is much more favorable than paycheck math, small business math or stock investing math.

#### More Magic

In the above example, the owners have not only increased the value of their property, but are also receiving a monthly income of \$3500. If the property also has a mortgage, not included in the NOI, the tenants are paying that mortgage, not the owner.

Many owners of income property fail to keep their rents at market rates. Now you can see why this is potentially catastrophic in the event that they wish to sell the property, take cash out of the property or refinance. Unless the rents are kept at market, the value of the property does not increase.

# Real Estate Tax Provisos for 2013

Finally, “fiscal cliff” debate is over! For months now, it’s been impossible to turn on the TV or radio without getting an earful of breathless and mostly unwanted information.  Even though most of us now regard Congress as on a par with cockroaches, what happens there does have an impact on our lives. All the more reason for members of Congress to act like grownups, but that’s another topic…

## Real Estate Tax Deductions

Rushed through at the last minute, the “fiscal cliff” legislation contains a number of important provisions and none more important than those that relate to real estate.  Here are a few of the most salient.

• Short sale taxation relief extended for another year until January 1, 2014
• Deduction of mortgage insurance premium is retroactive to 2012 and extended to 2013 for incomes under \$110,000
• 10% tax credit [up to \$500] for energy-saving home improvements retroactive to 2012 and through 2013.
• Capital gains tax stays at 15% except for those earning over \$400,000 [single filer] or \$450,000 [joint] and then it’s 20%.
• \$250,000/\$500,000 [single/married] exclusion on capital gain from sale of principal residence remains unchanged.
• Estate taxes on first \$5 million for individual and \$10 million for family estates are ZERO.  Above those amounts, the rates are 35% and 40% respectively.

## Effect of Real Estate Provisos of 2013

Given these provisos, it’s clear that real estate remains in a privileged position as far as federal taxes go. Not only do homeowners get a tax deduction  for the interest in their mortgage payments, which is unheard of in other developed countries, such as Australia and Canada, but we can deduct mortgage insurance premiums which are only applied if the equity in the home is less than 20%. By extending this tax deduction, Congress is implicitly encouraging home ownership among those who do not have the traditional 20% down payment. Is this a good thing? Considering the recent mortgage meltdown, maybe not.  It does help lenders and real estate professionals, though.

Homeowners also get to purchase equipment for their homes and then deduct some of the cost–just so long as it saves energy and fits the criteria.  Naturally, no one can argue that energy-saving is bad, but here the government supports homeowners and no one else.

Additionally, estate taxes on the first \$5 or \$10 million, depending, amount to nothing. This also supports homeowners since a large proportion of most estates of this size is made up of real estate holdings, both principal residence and investment properties. Again, the tax code is supporting home ownership and investment in property.

Last, but not least, the tax code encourages home ownership by not taxing any capital gain up to \$250,000 or \$500,000 respectively. This means that home owners can sell their homes frequently, pocket the gain or purchase a more expensive home, without worrying at all about taxes. This has been part of the tax code several decades, though the amounts have increased, and does encourage home ownership. In fact, it encourages or at least does not discourage serial home ownership.  Of course, this benefits those who change jobs and must change jobs, but it also benefits lenders and real estate professionals.

Extending the tax relief to those who short sale their homes is in a different category. So long as underwater homeowners face no tax penalties for short selling their homes,  they will usually prefer it to the foreclosure alternative. At the same time, short sales are a much faster way of  dealing with an inability or unwillingness to pay the mortgage in underwater homes.  Short sales help to clear the vast inventory of underwater property which has been clogging the system for the past few years making it difficult for the real estate industry to recover.

# What Is The Best Investment Property? Part 2

Besides the considerations of Part 1 in  the previous post, price ,  tenants and condition, the investor has to investigate thoroughly before purchasing anything. In fact, the main job of the investor is not getting the money together, which, admittedly, can be  very tough, or running around looking at various deals, which does takes time and shoe leather.  No, the most important job for the investor is doing the due diligence.

We often hear that expression, “You’ve got to do your homework” or do the due diligence. For real estate, what does due diligence entail exactly? As might be expected with such a vague term, it’s complicated. To me, though, it can be simplified by dividing your due diligence into pre-purchase and during-purchase due diligence. Whatever happens, you don’t want your due diligence to happen post-purchase.

Location, Location, Location

Of course, that’s the most basic mantra of real estate and it certainly should be part of any investor’s pre-purchase due diligence. The location of the property will determine the rents and the quality of the tenants, so it is of utmost importance.

What is a desirable rental location?

Many would-be investors think that a newer building in their own suburb is an ideal investment. This may or may not be true. If the suburb is filled with homeowners, it’s likely that it’s not an ideal place for renters. Here are few questions to ask when considering location?

• where do most residents work?
• is public transportation handy?
• what is the area vacancy rate?

If most locals commute to the city, then renters will, too. That means most renters will seek housing closer to their work. Many renters do not have cars, so proximity to public transportation is a must. Whether tenants have cars or not, for most areas the building must have adequate parking. This means at least one space and preferably two per unit plus one or two extra for guests. Failing that, overnight street parking must be available. Make sure the vacancy rate is not above 5% as nothing costs a landlord more than vacancies, especially multiple vacancies.

Sometimes areas near a military base or adjacent to colleges and universities offer wonderful rental opportunities which are, nevertheless, different from “normal” rentals. Frequently, in such areas rentals are for six months or two semesters or a summer and then over and out. This might entail more work prepping the units more often,  but  the rents are actually higher. Usually, too, students and soldiers are not particularly fussy about their short-term digs.

Often, would-be investors start out looking for the “best” properties. That is usually a mistake. The best rental properties are usually in moderate to low-moderate areas which are not only more likely to attract renters, but which also offer what every investor should be seeking-immediate cash flow. Cash flow is the name of the game and more expensive properties in the best areas rarely offer it. Also, those moderate renters are more likely to stay put than the higher-paying renters with plenty of options. Remember: vacancies are a landlord’s bane.

# How To Assume A Non-Assumable Loan

## Half the Country Has Bad Credit

It’s no secret that half the county’s credit has been trashed during the Great Recession. Due to short sales, foreclosures, bankruptcies, job loss and assorted maladies, a significant chunk of the population can no longer qualify for a mortgage loan. Add, too, the new, much more stringent, underwriting guidelines adopted by lenders in the wake of their irresponsible behavior during the “bubble” years and that creates a huge problem for many, many would-be home buyers and investors.

## What to Do?

What to do? One thing buyers can do is search out seller-financed properties, though often such sellers, too, will check out the credit report and be unhappy with the result. Another, lesser-known, option is to assume an existing loan, saving thousands of dollars in closing costs to boot.  Now, this, too, has its own problems since most fixed-rate loans of the past 10 or so years have a “non-assumable” clause. This means that if the property title is transferred, the  new owner cannot take over the old mortgage. Most loans have a “due-on-sale clause”, meaning the lender can call in the entire amount of the loan in the event of a title transfer. Even the “assumable” loans usually require that the buyer qualify.

## Some Ways To Assume a Non-Assumable Loan

Is there a work-around? Thankfully, in some cases, but certainly not all,  it may be possible to assume a non-assumable loan. Here are some of the scenarios where that may just work.

1. Make Sure There Is A Due-On-Sale Clause. Even if the lender insists that the mortgage is not assumable, here’s a tip: read the mortgage and promissory note to make sure that it has a due-on-sale clause.  With all the confusion in the past few years, the lender may not even be able to produce the required documentation.  Without it, no due-on-sale clause is legally enforceable.  This is a check-with-a-real-estate attorney option.
2. Death of a Joint Tenant. When the surviving joint tenant receives title after a death, federal law, the Garn-St. Germain Depository Institutions Act of 1982, prohibits the mortgage lender from enforcing a due-on-sale clause.
3. A Related Owner-Occupant Inherits. When a related owner, such as a spouse, either occupies or continues to occupy the property, the lender cannot enforce a due-on-sale clause.
4. A Junior Lien Is Placed On The Property. Here, too, the primary lender is enjoined from enforcing the due-on-sale clause.  In reality, the primary is in a better position if the homeowner has a second mortgage or an equity line since now two parties are  vitally interested in seeing that payments continue to flow in.
5. An Owner-Beneficiary Trust Takes Title. These days, trusts and, especially inter vivos trusts, are used to avoid probate costs. Although the lender cannot enforce a due-on-sale clause under this scenario, the mortgage-holder does have a right to a copy of the trust.
6. Transfer After Divorce. After a divorce the lender cannot enforce a due-on-sale clause if either children or a former spouse occupy or continue to occupy the property. They must occupy though.
7. Ask About an Assumption Fee. Even if the situation is not one of the above, it always pays to ask the lender if an assumption is possible despite the presence of a due-on-sale clause. Especially if the loan is in default, the lender may be exceedingly happy to have the loan brought up to date often with no fee whatsoever. Lenders today have plenty of foreclosures and short sales already and so may be quite willing to make a mutually-beneficial deal.

# Is Your Real Estate Investment A Good Deal?

Mortgage rates are the lowest since World War II.  Property values have hit bottom in most locales. Many now see the stock market as corrupt and manipulated.  Besides gold, silver and precious metals, all already hitting record values, real estate has emerged as the best place for an investor to place money.  Investors in mutual funds are passive participants in the process. Real estate investment is usually active. How does the novice investor recognize a good deal?

# How To Value Real Estate

Traditionally, real estate investments generate value in two ways-through cash-flow and appreciation.  Simply put, cash flow is the amount flowing to the owner on a monthly basis after payment of the mortgage and all expenses. This calculation can and should be made before purchase. The second way to generate value, appreciation, is more tenuous as it refers to the future value of the property. No matter how good the deal, how wonderful the neighborhood or how solid the local economy, the future is always unknown, so appreciation cannot really be calculated, only assumed.  Never rely on appreciation alone in making a real estate investment.

# Calculating The Cash

## Cash Flow Calculation

That leaves cash flow. The serious buyer must always calculate the cash flow before jumping into any investment.  From my observation, though, it seems this crucial step is often skipped.  For simple cash flow, here’s what you need to consider.   The owner will also have to pay whatever is stipulated in the leases, such as water, trash, electricity, gas,  gardening, pool maintenance, snow removal, pest control and, possibly, property management and whatever other monthly expenses might accrue.  Subtract this from the rental income and that is Net Operating Income [NOI].

The purchase price minus the down payment equals the amount financed which, in turn, tells us the monthly mortgage payment.  For instance, on a \$200,000 investment, the down payment might be 25% or \$50,000, leaving a mortgage of \$150,000 and a payment of  \$1000, including taxes and insurance.   The NOI minus the mortgage payment is the monthly cash flow.

## Cash On Cash Calculation

Another way to calculate a real estate investment is called the cash on cash return method. This time, the investor considers all the money invested in the property, including the down payment, to figure out exactly what is the return for every dollar invested.  the purchase price is still important, but more vital is the amount generated from the cash put out.

On a \$200,000 investment, the down payments is typically 25% to 30% or \$50,000 plus an additional  5% in closing costs, loan fees and rehab costs, another \$10,000.  The total cash outlay is now \$60,000 with a mortgage of \$150,000.  Now, estimate that the rents generate \$2000 monthly and the ongoing costs amount to about \$500 [utilities, maintenance] leaving \$1500 a month. This is the Net Operating Income. From that subtract the monthly mortgage cost of \$1000 and that leave \$500 a month, producing a cash flow of \$6000 per year.

Divide that \$6000 by \$60,000 to get the cash on cash return. In this case, it is 10%. Considering that leaving money in a CD will generate less than 1% these days and even the stock market less than 5%, that’s an excellent return on money invested. But, real estate investment is an inherently risky investment, so the returns should be decent.

# Rental Property: Amazing Tax Benefits

These days we hear a lot about the tax havens and tax loopholes available to high-income taxpayers and corporations, but  most ordinary people do not understand the amazing tax benefits offered by owning rental property. In most cases, a “taxable loss” accrues from the rental which can offset ordinary income and thus the federal income tax bite. Of course, most people’s eyes glaze over at this point, so I’m going to make this as painless as possible!

## Tax Savings For Middle-Income Earners

Not everyone is going to save tax money on real estate investments. Most middle-income wage-earners, though, will.  First, let’s be clear.  It takes a certain type of person to be a landlord as indicated in a previous post.  So, looking at owning property to save money on taxes is, how do you say, bass-ackwards.

First and foremost, purchase a rental property with the idea of making money. Look for a property which will give you income after all the expenses are eliminated. This is cash-flow. Assuming you have such a property, how does it happen that even cash-flow properties can save you money on your taxes?

Rental properties generally show a “taxable loss” for many years after the purchase. This is true because, as in any business, you have the income from the rents, but then you can deduct all your expenses  to come up with your net operating income. Your expenses include repairs, utilities paid, labor costs, property management or any of a vast variety of other expenses. Once you have your net operating income, then you can deduct any mortgage interest paid to arrive at the net income.

## Rental Tax Saver: Depreciation

Now, here comes the good part for rental property--depreciation. You also get to deduct 1/27.5 of the building’s cost from your net income.  This figure becomes your taxable income or, in many cases, loss. This is how even a good, cash flowing property can manage to be a loss for tax purposes. It is also how an investment property can help reduce ordinary income because this “loss” is deducted from the owner’s wage income and can often substantially reduce income tax owed.

There is a hitch, naturally. If losses are over \$25,000 and ordinary income is over \$100,000, then the taxpayer may not be able to deduct the whole amount due to Passive Activity Loss Limitations. Still, the taxpayer does get all other ordinary deductions and may well substantially reduce the amount of tax owed. Owning real estate is one of the best tax strategies allowed by the current tax code. Anyone earning any kind of money really should consider investing in rental property, whether residential, multi-family or commercial.

Today’s real estate market offers amazing opportunities for anyone thinking about investing in real estate. Mortgage rates are incredibly low, values are lower than they have been in many years and rents have not dipped. Want to discuss rental property? Call me anytime.

# After December, The Avalanche?

Louis XIV of France, styled the Sun King, famously opined, “Apres moi, le deluge.”  After me, the flood. He was right, of course, for his excesses so infuriated the people that his successor was guillotined and his monarchy overthrown in the French Revolution.

### SoCal Plunge In Foreclosure Filings

Something similar seems to be brewing in Southern California and maybe even nationwide as lenders ratchet up their foreclosure filings after the “robo-signing” lull. Though foreclosures dropped dramatically in SoCal this fall, so, too, did all home sales. The reasons seem to be many: the end of the home buyer tax credit, stubbornly high unemployment and the generally still-moribund economy. In fact, sales are down a full 16% from November of 2009. This at the same time foreclosure filings fell 14% from the previous November after a 22% decline in October for a two-month total 36% decline. Nationwide, the filings fell 21%.

December is traditionally a slow month in real estate as consumers focus on retail buying, parties and holiday travel plans. Typically, though, also in December  smart investors are out there snapping up last-minute bargains of the now-extremely motivated sellers still on the market. Competition is almost always much less, to put it mildly, and sellers are determined to close out their books for year’s end.  This year seems to be different as even investors are holding back.

That may be because the huge drop in  foreclosure filings this fall has ominous repercussions for home prices in the new year. With the foreclosure freeze over, informed observers now expect to see the banks ratchet up their foreclosures with a vengeance, restarting filings begun in October and November and barreling ahead with new ones in January. Executives from RealtyTrac, a real estate data collection firm, speculate that the housing recovery could be set back three months, if not more, as the foreclosures pile up. In fact, we can expect ” an avalanche” of foreclosures shortly.

### SoCal Home Prices

The most immediate effect of an avalanche of foreclosed properties on the market will be to further depress prices in Southern California which had started a slight upward movement. Los Angeles County home prices had dropped 1.2% over November 2009 to a median of \$325,000. Riverside and San Bernardino Counties, the hardest hit by the bursting of the real estate bubble, lost 2.5% and 5.0% respectively to medians of \$195,000 and \$152,000. But, that is a huge improvement over the 30% and 40% drops of previous years. Other SoCal counties actually gained in value. Orange County eked out a .6% improvement for a \$435,000 median home price. San Diego topped the charts with a 3.1% improvement over last year to a median of  \$335,000 with Ventura County just behind at 2.7% uptick to a median of \$375,000.

### Future: More Underwater Homes

These hard-earned gains will soon be lost as the promised avalanche of foreclosures hits the market. Perhaps sales will pick up as buyers and investors are lured back into the game. But, bargain-hunting fun aside,  another price drop for already distressed homeowners will plunge yet more homeowners underwater.  That, in turn, spirals down into more foreclosures and more equity loss in future.

Like Louis XIV, banks see this as well as anyone, yet still refuse to modify loans in any serious way. Like Louis, they see, but, obviously, don’t give a damn as long as they get their bonuses. Short-term is the only term.

# Loan Mods: What’s the Situation Now?

It’s been about a year now since the Obama administration introduced its loan mod program, HAMP, so what’s happened?
What have American homeowners been getting for our government’s \$7 billion?

### Loan Mods One Year Later

Aw, come on, you know the answer–not much. As usual, the big banks don’t want to play. Always ready for a handout, they pretend to go along, but never really deliver. At this point, one year later, we now have about 299,000 permanent loan mods as of April 2010, according to the US Treasury. That’s about 25 percent of the 1.2 million who started the program since its March 2009 launch. They are paying, on average, \$516 less each month.

### Terrible Loan Mod Results Compared to the Problem

Placed in its proper context and you will see how measly that is. We’ve already had more than 3 million foreclosures. Estimates are that about 7.5 million mortgages are in the 90-day-late situation, meaning they are most likely heading into foreclosure. So, that 299,000 doesn’t seem like much, does it, for a whole year?
But wait, it gets worse. The number of people who failed to get loan mods rose dramatically in April, up 79%, in fact. About 270,000 or 23% dropped out at some phase of the process.

### Why would this be happening?

I’m sure that banks would like to point the finger at deadbeat homeowners, but that would be a lie, a big, fat lie. Having been involved in a few of these mods and receiving many calls from anxious homeowners, I can say categorically it is not the fault of homeowners. It is the fault of the big banks who make the task so tedious and so long and drawn out that anybody would get frustrated and quit.
Here are just a few of the comments I’ve heard lately..One that particularly galls me is Maria who cannot get CitiBank to give her the time of day. Why would that be? Why, she’s current in her payments, so unless there’s already a fire, this company has no interest in preventative maintenance. Then, there’s Monica who owns several investment single-family homes she was hoping would help provide her retirement. They’re all upside down now and the bank will not even talk to her because she’s also current.

### Only Solution Now: Short Sale

Talk to Mike. AMHSI told him point-blank it had no interest in doing loan mods. So, he stopped making his payments and put it on the market as a short sale. Is that a better solution? Folks, that’s about the only solution left. We can all stop dreaming now that the banks will actually do these “workouts” whether they have support from the government or not. They will pretend to do them, but make the process as onerous as possible. Then, too, many who actually produce all the paperwork and wait the 3 to 6 months of processing time are refused a loan mod anyway. Why? Well, if you’re unemployed and really need one, you can’t get one because there’s no income to pay it. If you’re employed, you, like Goldilocks, need to make just the right amount of money or you’ll make either too much or too little and you won’t qualify…

I don’t think I want to write about loan mods anymore. They are a complete crock.

# Short Sale Update: LA County’s Pricier Areas

Short Sales, strategic and otherwise, would seem to be the name of the game this year in L.A. County as in much of the rest of the country. With some 25% of the population now “debt-impaired” and 3 million foreclosures already accomplished, short sales are beginning to seem like business as usual.

Just wondering how the more pricey areas of L.A. County were handling the situation, I took a little tour on the MLS. Here’s what I found:

• Malibu has one active listing of \$4.5 million and 12 active  short sales priced from 389000 to \$3.8 mill; 6 pending short sales, but no other pending sales. One short sale closed in the last 3 months, but no standard sales.
• Pacific Palisades has  one active listing and 8 active short sale listings ranging up to \$2.5 mill; one pending short sale , but no standard pending sales.Four short sales closed in the past 3 months and one standard sale at \$3.75 mill.
• Santa Monica has 19 active short sale listings and 14 standard, but 16 pending short sales and only 8 standards with 8 short sales closed in the past 3 months as opposed to 2 standard sales.
• Beverly Hills shows 7 active short sale listings maxing out at \$3.5 mill with 10 pending short sales up to \$2.7 mill and no standard sales. In the past three months one short sale has closed, no standard sales.
• Bel-Air has 2 active short sale listings, 7 pending short sales [up to \$4.1 mill] and no sales in the past 3 months.
• Brentwood, a larger city, has 217 active listings, 9 short sale listings, with 7 pending short sales,  but in the past three  months only one sale–a short sale, of course, for \$2.9 mill.
• Arcadia in the San Gabriel Valley shows 148 standard listings with 5 active short sales, 12 pending short sales out of 39 pending sales and in the past three months 68 closed sales with 7 short sales.

What are we to make of this? I see a number of different strands.

One, standard sellers who do  not lower their prices to short sale levels don’t sell their houses, so if you have to sell your home, it’s better to bite the bullet and price it right. If you don’t have to sell, take it off the market.

Two, in areas like Arcadia where many homeowners purchased their homes all cash or have paid off their mortgages, the crisis is less severe. If you want to live there, you will most likely do a standard sale.

Two, the short sale, strategic or otherwise, has certainly hit affluent areas.Any notion we may have had that expensive homes are somehow  immune to our ongoing financial crisis must surely be seen as wrongheaded. Owners of expensive homes, mansions, are also sacrificing. Short of calling up all these sellers or their agents, I can’t know if the sales are strategic or the result of genuine hardship. What I do know is that the rich are now as “debt-impaired” as the rest of us.

# Paperwork and the Short Sale

It’s pretty clear that banks are much better off financially with short sales as opposed to foreclosures. Then, why on earth are these crazy banks making them so complicated?

Typically, banks require reams of paperwork for homeowners who wish to do a short sale on their properties instead of heading directly into foreclosure. Primary among the tax returns, financial statements, bank statements, pay stubs, W2s,   and such is the hardship letter, delineating reasons why the homeowner can no longer make the payments and so is requesting that the mortgage holder accept less than what is owed on the property and call it good.

Some banks have already recognized the futility, stupidity, hypocrisy, call it what you will, of this method and are no longer requiring mountains of paperwork and are, in effect, streamlining the whole process. Wachovia, now defunct,  but operated by Wells Fargo Bank,  announced quite some time ago that it would no longer require any paperwork other than the listing from the homeowner  wishing to do a short sale  along with a  buyer’s offer.  Most marvelous of all, Wachovia actually makes a decision and accepts or rejects the offer within 5 business days or tries to. Contrast this with Bank of America’s [aka Countrywide] 3 to 4 months.

Wachovia’s way makes sense, doesn’t it? It recognized that homeowners who are underwater to the tune of 50% or hundreds of thousands of dollars are not going to make the payments whether they are able to or not. They would need to be financial morons to stay in that situation. So, why force  or punish the poor homeowner who is nevertheless giving up his home or his investment and require all this useless paperwork?

Let’s just face it. With about 24% of loans nationwide underwater, millions of homeowners, clogging up the system with all this useless and unnecessary pasperwork looks more like punishment for the homeowner than anything really needed to make the transaction happen. Listen up, big banks, let’s hear it for Wachovia!