Real estate has always been considered a good investment (provided you don’t overpay for a property). For some people that investment might also be their home. For others the sole purpose of the purchase is to make an investment they’ll see a return from later. If you’re considering real estate as investment, you might want to learn more about what is involved.
One of the first things you’ll do when sitting down with a real estate agent
to talk about investment properties is to decide what your objective is. Some investors want immediate return and some are willing to settle for long term return; i.e. an investor who is investing to pay for his kids (or grandkids) college education as opposed to an investor who makes his/her living by operating investment properties.
Terms Associated With Investment Properties
When meeting with a real estate agent, it might first be handy to understand some of the terms you’ll hear.
CAPITALIZATION RATE OR –CAP RATE
You will see/hear this term used when analyzing a real estate investment. CAP RATE is nothing more than the relationship of the net operating income a property is capable of producing to the value of the property. Value is usually considered to be what a willing buyer, in the current market, is willing to pay for a particular property.
IRV FORMULA (HOW TO CALCULATE CAP RATE)
I = R X V or Income (net operating income) = Rate (cap rate) X Value (value of property). This is typically the formula used to calculate cap rate. Cap rates will differ by market location. For instance, the cap rate for a 4-plex in New York may differ from the cap rate for a 4-plex in Dubuque, Iowa.
If you would like an explanation on how to calculate a cap rate for your area please ask. So, if an acceptable cap rate for your market for a particular type of investment property is say 10% and you find a property that has a calculated cap rate is 8% you (and your agent) may want to address that issue. REMEMBER, cap rate is only one indicator of value. A decision to buy or not buy should not be made on cape rate alone.
What we are discussing here is a method to help you determine if a particular real estate investment might be suitable for you. It in no way is an in-depth look at how a particular investment might perform over the life of the investment. They can never give you a specific rate, however. They’ll present the numbers (facts) and discuss with as to whether or not it is prudent for you to purchase a particular property. They may in fact tell you that a decision to buy a specific piece of property is not well founded.
There are basically 4 ways you can profit from, or experience a loss from, a real estate investment. They are:
- Cash flow – calculated based on operating data
- Equity build up – Paying down your loan. This is called leverage, or OPM (using other people’s money)
- Tax savings/obligation – If when an investor files their income tax for the year the property shows a taxable loss the investor will pay less taxes on his ordinary income than if he did not own the property – but the reverse holds true also.
- Appreciation – If the property increases in value due to market conditions this will have a positive effect on the investment return but not until the property sells. Remember, what goes up today may come down tomorrow.
OWNER’S STATEMENT- Usually when analyzing an investment property, you will look to the seller for numbers – i.e. income, operating expenses, etc. You will find that many sellers do not keep good or accurate records – the numbers you get from them may not be reliable. An example might be “upkeep”. When you ask the seller for those numbers they might respond they do all their own maintenance and therefore there are no upkeep expenses. Really?? What about an investor who can’t do or elects not to do his own maintenance and has to pay others for that service. The amount paid for that service becomes an operating expense
BROKERS RECONSTRUCT- Because the owner’s statement on operating data may not be reliable you may have to do what we call a “Brokers Reconstruct”. You will need to verify the sellers numbers and if they fail to provide reliable numbers you will have to verify those numbers and maybe even estimate some of the numbers. When you have all the numbers you are ready to complete your analyses.
CASH FLOW – As a potential investor you will want to know if the property produces a “positive” or “negative:” cash flow. Here is how you calculate cash flow.
SCHEDULED RENTAL INCOME- $ 12,000.00 (annual rents as if rented 100% of the time)
VACANCY RATE – $ – 600.00 (5%)
GROSS OPERATING INCOME – $ 11,400.00 (the actual dollars you have to operate the property)
OPERATING EXPENSES – $ – 2,500.00 (taxes, insurance, upkeep, etc.)
NET OPERATING INCOME – $ 8,900.00
DEBT REDUCTION (P&I) – S -6,300.00 (annual principal & interest payments)
CASH FLOW – $ 2,600.00 (this is before paying any taxes which may be due as a result of operating this investment)
So- if all of the above numbers are accurate you can expect to put $2,600.00 into your pocket the first year of operating this investment — IF you do not have a tax obligation as a result of owning this property. If a property does not have a positive cash flow (as above – $2,600.00) then it either has no cash flow or a negative cash flow. If the cash flow is negative then you’re going to have to inject that amount of your money into the investment just to make the mortgage payments and operate the property – something you may not want to do.
NET OPERATING INCOME (N0I) – Net operating income (see above) is what an investor is taxed on by Uncle Sam. But as an incentive for investing in Real Estate the IRS says that an investor can offset his NOI (for tax purposes) by the amount of interest he pays on his loan (if he has a loan on the property) and depreciation.
So, let’s say in the above example you have made interest payments on your loan of $7,100.00 and that depreciation for the year is $3,500.00. This means you can offset the NOI of $8,900.00 by those two amounts ($10,600.00) giving you a taxable loss on this investment of $1,700.00. For talking purposes let’s say your taxable income from all other sources for this year just happens to be $1,700.00 (ordinary income). Since you can apply the tax loss from your income property against your ordinary income from other sources you will not have to pay any taxes this year. So, in our example here you get to keep the entire $2,600.00 cash flow produced by your real estate investment.
But what if the interest you’ve paid on the loan this year is only $3,000.00 (instead of $7,100.00) and the depreciation remains at $3,500.00 and your ordinary income is the same ($1,700.00)? In this case NOI of $8,900.00 could only be reduced by $3,500.00 and $3,000.00 ( $6,500.00) so you would have taxable income of ($2,400.00) as a result of operating this investment property. This taxable income from this investment will be taxed as ordinary income. So you add the $2,400.00 to your other ordinary income of $1,700.00 and your taxable income on your tax return will now be $4,100.00 and you will have to pay tax on that amount at whatever tax bracket (rate) you are in.
Here is another way of looking at it strictly from the investment standpoint. . If your taxable income from operating this investment property is $2,400.00 (see above) and you’re in the, let’s say 30% tax bracket, then you will owe Uncle Sam $720.00 in taxes as a result of operating this investment ($2,400.00 x 30%). So from an investment analysis standpoint you really aren’t going to pocket the $2,600.00 CASH FLOW on this investment because you will have to take $720.00 from that cash flow to pay his Uncle Sam. You can only pocket $2,528.00 of the $2,600.00 CASH FLOW. Thank you Uncle!!!
So NOI( NET OPERATING INCOME) and CASH FLOW are two pretty important numbers to consider when analyzing a real estate investment. So what affects those numbers? What might make them higher or lower? It is really pretty simple. If your (revenues) typically rent, increase or decrease, or your vacancy rate increases or decreases, or your operating expenses increase or decrease your NOI (and your CASH FLOW) will change accordingly. Remember, NOI is the number you are taxed on; so higher- more potential tax, and lower- less potential tax. BUT it also affects cash flow; so the higher the NOI the more cash flow the investor will realize (everything else being equal) and the lower the NOI the less cash flow the investor will realize (everything else being equal)
This can be a little overwhelming and if you’re like many people; confused with just reading this, no worries. Your agent is there to give you advice and guide you through the process. Doing some homework on your own is good, but don’t be afraid to ask questions. Real estate investments of any type are a big deal and you want to know you’re making the right decision.
Is there any way to eliminate the risk of making a real estate investment? Not really!! Being informed and relying on the advice of professionals in the area of investing such as your accountant, your lawyer and your realtor will help you manage that risk.
If you live in Eastern Iowa and looking to make a real estate investment in Dubuque or the surrounding communities, then give American Realty a call. We have agents experienced in real estate investments who will be glad to talk to you about your needs and help you find an investment that works for you.