The Magic of Income Property Math

duplex

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.

Fiscal Cliff Approval and Real Estate

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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…

home money

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.

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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?
  • is there adequate parking?
  • 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.

cash-flow

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.

What Is The Best Investment Property? Part 1

With the low mortgage rates and super-low housing prices, many investors who have fled the crazy stock market would like to invest in real estate. Most of us think we know something about real estate and, really, we do. After all, everyone lives in real estate of one kind or another. Owning your own home and owning a rental-producing asset are two different things, however. Let’s assume you are looking to purchase rental property for the first time. Let’s also assume that you will have the 30% or 20% down to invest and want to leverage your money to best possible advantage. What would be the best use of your money?

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Single-Family or Multi-Family?

Many first-time investors automatically gravitate towards single-family homes.  That’s what most people know best, so it makes sense. But, is that the best use of the available money? I would say no. On the same amount of land and  often for the same price, it’s possible to purchase a duplex, a triplex or a quadruplex. That means for the same money, you will get double, triple or quadruple the rent. It also means that if one renter does not pay, you still are receiving half the rent, two-thirds or three-quarters. This will make quite a difference because you have to pay the mortgage and the expenses of the property every month whether you have tenants or not.

Therefore,  all things being equal, which they never are exactly, my preference is to purchase a multi-family dwelling instead of a single family one.  A fourplex is probably the most units a first-timer can handle.  Beyond the fourplex also more complicated loans apply. An investor can even purchase up to a four-unit building with an FHA loan which requires only about 3.5% down plus another 3 to 4% in closing costs. Using such a loan puts the investor at a significant advantage due to the gain in leverage from the smaller down payment. fixer Fixer or Repaired?

Many first-time investors naturally tend to look at fixer properties because they are cheaper than properties in good condition.  If the investor is an experienced rehabber or in the construction business, then it might make sense to buy a fixer. As long as the buyer has experience, knows the cost of the needed materials, and can either do the work himself or can get it done at a reasonable price, integrated into the purchase price, then a fixer can be an ideal asset.

For everyone else, though, it’s really not a good idea. During the rehab, the investor is paying the mortgage but receiving no rent. Sometimes repairs take longer than anticipated. As a rule of thumb, rehabbing a property always costs more than anticipated. Besides the loss of rent, the investor should take into consideration the wear and tear on his personal psyche. Searching out reliable contractors and overseeing their work can be exhausting. For someone with a full-time job, the time lost to the new property can never be recovered.

Fully-Occupied or Vacant?

Another issue that investors have to consider is whether they want a fully-occupied or a fully- or partially-vacant building. Often, sellers are trying to get rid of properties which they have saddled with bad tenants or tenants not paying market rents.  Asking for the rent roll and checking it carefully will show if the existing tenants are paying or not. A smart investor also has a good idea what the rents for the proposed purchase property ought to be. The purchase price should usually be a multiple of the yearly rents. Thus, if the yearly gross rents amount to $26,000, then the purchase price should be about 10-12 times the rent, or $260,000- $312000, depending on the market.  In some markets investors will find properties for significantly less.

In the MLS listings, frequently the would-be investor will encounter “pro-forma” rents alongside the actual rents of the property. This means the seller has failed to keep his rents at market, so the potential  or “pro-forma” market rents are included.  That’s fine as long as the price of the property is calibrated on the actual, not the pro-forma, rents. Of course, usually sellers want to base their price on the pro-forma rents.

But, think about it. The new investor will have to approach the existing tenants with a hefty rent increase as a first introduction, not a good start. Some of the tenants will leave rather than pay more. Others will have to be evicted. Whatever happens, it will cost time and money for the new investor. Reasonably, then, the investor should not pay pro-forma prices.

If the investor feels confident that the current renters are paying close to market rents and have a good history of on-time payment, that is the ideal situation. On the other hand, there are good reasons  to purchase a vacant property as well. The new owner will be able to thoroughly investigate each and every unit, which is usually not possible with tenant-occupied, making any repairs or cosmetic updates required. Plus, the new owner will set the deposit amount, the rent amount and the qualifications for the renter. Don’t want dogs? Want to check credit and do a background check? Want to limit smokers? Any of these are possible with a vacant building.