Demystifying Investing

Demystifying The Four Ways Multifamily Investors Benefit From Ownership

When investors buy any commercial real estate they are acquiring a revenue stream.  Admittedly there are a few signature buildings that are so iconic that they are a “pride of ownership” acquisition, but most properties are valued solely for their future economic potential.  There are four primary ways in which investors benefit from their acquisitions:

1. Cash Flow

is the sum of:  Cash In – Cash Out.  The primary source of inflow cash is rent.  Pet rent, late fees, laundry and owner contributions are also part of the cash in stream.  Cash Outflows include taxes, expenses and distributions to owners.

Owner types vary widely on the importance they place on distributions:

  • Residential Multifamily properties (2 to 4 units) and smaller Commercial Multifamily properties cast off little cash.  Their owners tend to focus more on equity gained at the time of disposition.
  • Investors of larger properties often use cash flows (distributions) as a primary source of spendable income.  They certainly expect gains at sale, but they often will use that gain to step up in basis to acquire a larger asset in the hope of increasing the monthly cash-flow.
  • The bane of all investors is the much dreaded Cash Call.  When cash out ‹ cash in to the extent that operations are impacted, the property owner(s) are forced to add cash to keep expenses current.  Because of their focus on maintaining regular, dependable distributions, the owners of larger properties tend to have lower LTV loans.  This doesn’t eliminate cash calls, but it does make operations inherently more stable, reducing the likelihood of requiring additional cash.

2. Appreciation

is Future Disposition Price – Original Acquisition Price.   A 53 unit complex that is purchased for $3.2 million is 2007 appreciates $700,000 if it is sold for $3.9 million several years down the road.

  • Appreciation gains can occur from (external) market forces such as a downward trend in Cap rates, or from increases in rent relative to expenses due to high demand.
  • Gains can also be “forced” by internal forces.  This occurs when we reposition a property.  Renters will pay more for upscale amenities and newer looking accommodations.  Success requires having the amortized costs of improvements be exceeded by the increased rents.  In some cases we merely seek to raise the rents on the existing renters; other times we are using the upgrades to attract a new tenant profile.

3. Loan Paydown

is determined by subtracting the initial loan amount from the remaining loan balance at any given time.  Suppose a $3,200,000 property is acquired with a roughly 65% LTV loan at 6% with a 30-year amortization.  Day one the beginning loan balance would be $2,000,000.  42 months later (3-1/2 years) the loan balance would be $1,909,649.  The loan paydown amounts to $90,351 for that period.

4. Tax Shelters and Tax Avoidance Benefits

The final benfit to investors is the tax sheltering of income.  Cost Recovery (Depreciation) is the primary example.  Industrial and retail properties are depreciated on a 40-year basis; housing is depreciated using 27.5-years.   Note: Land is not depreciable.  Using our previous example of a $3,200,000 community, let’s assume that land was 25% of the value, leaving a deprecable amount of $2,400,000 to be depreciated over 27.5 years, or $87,27.73 per year.  That will act as a tax deduction to reduce profits by that amount for tax basis purposes.

A more rapid depreciation methodology is provided by Cost Segmentation, or familiarly, Cost Seg.  This is performed based on findings of a cost engineer during their on-site inspection and review of the property. There is great acceptance of this approach by the IRS, but it is not fully understood by investors and many Tax Accountants.  Cost Seg. on Assets under $1 Million is not always cost effective due to the fixed costs of the on-site inspection.  Savings on multimillion dollar properties are substantial, and can change a 1.1 DSCR property into a 1.25. That means that Cost Seg utilization can be the difference in some loans being approved!

Duties of Professional Investment Brokers

It is incumbent on the Real Estate Professional assisting a client with a multifamilty acquisition to have an understanding of that client’s risk profile, investment horizon plus target cash flow and appreciation rates.  It is also beneficial to have an awarenes of how important their client deems tax shelter options.

--- END POST ---

Demystifying Investing /

Demystifying Why Investors Switch From Residential To Commercial Properties (Part 1)

  1. Single Family Residences (SFRs), duplexes, triplexes and quads are maintenance, management and hassle intensive per unit of profit.
  2. SFRs and residential multifamily (less than 5 units) rarely “pencil out.”  They sometimes make fine “buy and hold” properties, but rarely cash flow well. Today’s sophisticated investors know that if they combine a number of small investment properties they can afford a commercial multifamily asset.  (They may even be able to take advantage of Cost Segmentation for accelerated depreciation…impossible for smaller investments.)
  3. Of course, as we trade up to more and more units at a property, we get to the point where we can pay someone else to manage the property.  Then our role transitions to “managing the manager.”
  4. Explanatory note: While by definition we typically say 5 units and up are Commercial Multifamily, in practice 8 to 10 units is when the first tier of economies of scale appears.
  5. In the past, up to 10 properties could be owned by an investor, including their primary residence…but about 10 months ago Freddie Mac stopped loaning to borrowers with more than 4 residential loans.  Fannie Mae has followed suit.  There is no legal prohibition against owning more properties…but borrowers no longer qualify for many loans if they exceed the new number.  (I do work with one lender who will still loan on up to 10 properties…call me at 503.577.1034 for information.)
  6. In order to move up to larger opportunities, some investors will refinance multiple houses and residential multifamily assets.  Lenders may approve 3% down loans on owner/occupied homes, and be comfortable writing 20% down for investments, but on “cash out” loans many require at least 30% down (70% LTV).

--- END POST ---

Demystifying Investing /

Intro to Demystifying Residential Multifamily Investing:

Residential Multifamily (RM) definition:  Typically regarded as 2 to 4 units, or “doors”, with 5 units and up being considered Commercial Multifamily (CM).  Many multifamily investors start by purchasing a duplex, triplex or quad; living in one unit and renting out the balance.

Residential Multifamily Pluses and Minuses: One advantage of a plex investment strategy is that lower downpayments are permitted by banks…sometimes as low as 5-10%.  RM loans close much more quickly with fewer requirements than CM loans.  It’s easier to keep a watch on your renters when they’re next door, too.  Prices per door are lower than single family homes…an area where starter homes are $225,000 is likely to have duplexes and even triplexes for not much more.

The inherent nature of plexes is that their pluses are also a source of their weakness:  living next to your renters means they always know when you’re home.  From the renter’s perspective you are always available to discuss their maintenance problems and “wish list” of improvements they would like you to make (without compensation.) You are more likely to become “friends” rather than business associates.  It’s harder for most to enforce rent timeliness on friends.

Plexes tend to produce low Cash Flow, a reason they are eschewed by some investors.  Cash Flow is simply the monthly amount remaining from:  (All Income) – (All Expenses, including taxes, insurance and debt service).  With fewer units to amortize expenses over, plexes can’t compete with the functional efficiency of commercial complexes.  As a result, the plex investor focuses primarily on returns gained over time from appreciation.  Those gains are that are reaped at resale or refinancing of the property.  Contrast this with the investor of larger investments that expects to make a higher downpayment (20 to 40%) and recieve monthly distributions from profitable operations.  (In addition to appreciation.)

Valuing Residential Multifamily Assets: The local submarket  for single family residences (SFR) is the strongest fundamental in determining values of plexes.  Without adding in other factors, most potential renters will not pay more for the inconvenience of living close to neighbors than they would pay for of a SFR which would likely have more privacy. RM purchasers use the Gross Rent Multiplier (GRM) to compare properties.    GRM = Purchase Price ÷ Annualized Gross Rent. GIM, or Gross Income Multiplier is also used interchangeably.  It’s intended to reflect that rent is not the sole source of income; late payment fees, NSF charges, garage rent and other revenue sources need to be considered.  A triplex that rents for $600 per door and produces $400/year in other income that is for sale for $279,000 is available at a 12.7 GRM.  Proof:  $279,000 ÷ $22,000 = 12.7.

GRM Limitations: As it is based solely on the Gross Income, there is no accounting for vacancies, concessions or expenses.  What if ther property has occupancy problems due to poor maintenance?  What if the landlord is giving a lease concession of two months free rent, thereby reducing revenues by 10/12’s or 16.7%?  What if expenses are managed poorly?  In each of these examples the value of the asset is lessened, yet the GRM would remain the same.  Use GRM only as a rule of thumb when investing in plexes to see if a more thorough investigation is warranted.  All competent investment advisors will offer a proforma including expected profits based on actual income and expense.

1% Rule: This archaic valuation factor was derrived from the notion a property’s value would  equal 100 times a month’s rent.  Rent rates have not increased at the same rate as home values.  A $250,000 house would rent for $2,500/month under this scenario.  If someone cites the 1% rule they are telling you: “I don’t know what in the heck I’m talking about.”

--- END POST ---

Demystifying Investing /

Intro to Demystifying Cost Seg. (Cost Segregation)

One of the ways we deliver value to investors is to inform them of the benefits of Cost Segregation and to offer a free Cost Seg Feasibility Study. CS doesn’t apply in every situation, but the possibility of saving clients tens or hundreds of thousands of dollars is too much to pass up.

In essence, CS employs greatly accelerated depreciation on commercial real property assets. The improvements (not raw land) of a commercial real property are broken down into their components and then rated for their cost and remaining life. The building improvements are classified as either Section 1245 or Section 1250. S-1245 (basically tangible personal property) is the primary source of Investment Tax Credit savings. I will differentiate property types and the process of Cost Seg in a series of future posts.

This process is typically performed by Cost Engineers, not Cost or Tax Accountants.

Properties are normally depreciated at 27.5 years (multifamily) or 39 years (commercial and industrial improvements.) Clearly a washer and dryer have a shorter useful life and…cost seg permits depreciating that at a pace that reflects its actual remaining useful life.

Disspelling Cost Seg myths:

MYTH 1: “Cost Seg will increase my Alternative Minimum Tax payments.” Wrong! AMT will reduce the positive impact of Cost Seg slightly..but only slightly. It certainly does not increase AMT. My opinion: If I can save a lot on taxes, I’m in!

MYTH 2: “CS is not fullytested.” Wrong! There is significant case law on this item; the IRS is well aware of the provisions.

MYTH 3: “It will increase my odds of being audited.” Wrong!

MYTH 4: “CS only applies to new buildings.” Wrong! As an example, Cost Seg can be used on a recently acquired 1906 era hotel.

MYTH 5: “This is only applicable to certain types of commercial/industrial property.” Wrong!

MYTH 6: “I have to pay for the program before I know if I will enjoy savings.” Wrong! Reputable firms will provide a feasibilty study at no cost, including a conservative savings estimate.

MYTH 7: “It takes forever!” Wrong! To properly study the property for all savings available, a site visit will need to be scheduled…but this process takes days not months.

MYTH 8: Cost Seg is for Casinos and huge assets only. WRONG: In many cases Cost Seg Treatment produces savings on smaller commercial assets in the $1M range

QUALITY: Use a respected Cost Seg Specialist…just like you would use only a top tier 1031 Exchange Accomodater.

To request more information, or a no cost/no obligation Cost Seg Feasibility Study please contact:

Rick M. Bean

503.577.1034

--- END POST ---

Demystifying Investing /

Demystifying Tenants In Common

One strategy of acquiring investment properties is to pool individual owner’s equity stakes and take title as Tenants In Common or a TIC.  TICs feature an undivided unity of possession, but they may, or may not have unities of percentage of ownership, title, or time of acquisition and disposition.  Upon the demise of a co-tenant their interest passes to their devisees/heirs, not the co-tenants.

It is critical that an executed Operating Agreement be in place to define critical items including:

*Ownership percentage
*Conditions underwhich the property will be sold
*How distributions from operations will be made
*Rights and responsibilities of each investor

STRENGTHS INCLUDE:

  1. Pooling resources may permit the ownership of far larger assets than could be acquired individually, resulting in economies of scale for  management and maintenance.
  2. Overall flexibility. TICs permit owners to sell,  encumber, or convey their interest without permission of their co-tennants.
  3. Depending on the structure of the Operating Agreement, TICs may permit General Partners to run the asset, allowing investors to have the benefits of owning an asset without having to be involved in routine operations.

WEAKNESSES INCLUDE:

  1. Litigation is more likely.
  2. Closings are more cumbersome.
  3. Coordinating items that require input from the co-tenants is more involved.

Note:  The information contained herein is deemed accurate and reliable, but is not guaranteed.  To assess applicabilty to individual situations please consult your legal proffesional.

--- END POST ---

Demystifying Investing /
Scroll to Top