The Basics
Why invest in real estate? The word “real” is the first clue. You could
invest in shares of a company that could go bankrupt tomorrow or you can
invest in something that is tangible. The stock market has performed well
historically, but so has real estate. They can both be good investments.
There are lots of arguments, by lots of people, of which you should pursue.
That’s more than I care to go into in this article.
Two terms are worth noting here, “return of” and “return on.” There is a distinction between the two when investing. The first, “return of investment” refers to getting your initial investment back. Say you buy an apartment building for $300,000 and sell it for $500,000. You have received both a return “of” the initial $300,000 and you have a return “on” investment of 60%. You would have made 60% on your initial investment.
Income is the second part of the basic equation. If you purchase an income-producing real estate investment, then not only do you stand to have returns of and on your investment, but you receive income while you hold the property (assuming you have positive cash flow).
Tax benefits are the third part of the equation. Investors can depreciate the property over a given period of time. That depreciation becomes a tax credit on the investor’s tax return. (You may have to recapture the depreciation when you sell, but you still come out ahead if you don’t sell until you are in a lower tax bracket and you took the tax write-offs when you were in a higher tax bracket.)
Positive Cash Flow
Some investors have the means to not worry about positive cash flow because
they are investing for the long-term and/or need the tax benefits. Investors
with resources who are in high tax brackets can afford to be in a negative
cash flow situation and use the loss as a tax write-off while holding the
property for long-term price appreciation.
However, many small investors are looking to supplement or replace income from their “day job” by investing in real estate. Positive cash flow then becomes very important.
There are three factors involved in determining whether an investor will have positive cash flow:
Knowing how these three relate to each other will let you know whether the
asking price for a property is worth considering.
Let’s say a strip mall generates $5,000 per month in gross rents. Your
monthly operating expenses are $1,000. That provides a net operating income
of $4,000. However, what is your debt service? If it is more than $4,000
per month, you will be in a negative position.
Let’s say that strip mall cost you $500,000 to purchase. If you financed 100% (not likely in the commercial world, but we will consider this later) at 8% (remember commercial interest rates are higher than residential owner-occupant rates), amortized over 30 years, your payment would be $3,669. That would leave you with $331 per month positive cash flow or $3,972 per year. Not much help considering the work and risks involved.
So, you can see if you change any of the parameters above in your favor, your cash flow will increase.
Let’s say the strip mall purchase price was negotiated down to $480,000 and you put 20% down (typical minimum down-payment required) and your interest rate was 7.5% amortized over 30 years. Your monthly loan payment would be $2,685 per month which leaves you a monthly positive cash flow of $1,315 or $15,780.
The point is that each of the variables is very important. Just a half-point increase in the interest rate would make the payment $2,818, reducing your monthly net income to $1,182.
Net Operating Income (NOI)
Interest expense and depreciation can vary from investor-to-investor, so
the industry does not include them in NOI calculations. NOI is derived by
taking the annual gross income less an industry-standard 5% vacancy rate
less the actual operating expenses for the property. It is imperative when
shopping for an investment property that you obtain actual operating expenses
and scheduled gross rents from the current owner.
Capitalization Rates
Why does everyone talk about cap rates? It is criteria used by investors
and their financiers to determine if the property is valued correctly. Cap
rate just means capitalization rate, in other words, the rate at which a
property will be fully capitalized. It is calculated by dividing the net
operating income by the purchase price.
So, if you have $48,000 per year in net operating income (NOI), a purchase price of $500,000, your cap rate is 9.6%. It will take 10.42 years to pay back your original investment of $500,000. If the purchase price was $450,000 instead then: $48,000/$450,000 = 10.67% cap rate. It would take 9.37 years to pay back your original investment of $450,000.
Summary
A thorough analysis of an investment property would include a before-tax
cash flow and an after-tax cash flow which takes into consideration tax credits
for depreciation. The analysis also would show the recapture of depreciation
when selling, projected costs of selling, and capital gains tax. I am happy
to provide this type of analysis on potential investment properties. You
can reach me at 801.554.9988.