Tom’s Investment Analysis Course

San Diego Real Estate Investment Analysis Course
If you currently own, want to own, or have ever thought about owning investment real estate in San Diego, I have an important tool for you! In fact, if you happen to be curious whether an investment in real estate might be a possibility for you but are hesitant because you know too little about the "nuts and bolts" of how it all works, then listen up! There are lots of books and literature which you can pick up at your local bookstore about investment real estate and they´ll cost you $20+. And, to justify the cost, they will provide you with a lot of gibberish which is not only out-of-date due to tax rule changes, etc., but they also take forever to instruct you on the most important real estate investment concepts so that you really understand the basics when you finish. Thus, when I have been asked to recommend a source where folks can use to learn more about such an investment, I have been at a loss. So, recognizing a need, I have written this short course which I hope fills the void and it´s FREE! If you are interested in learning about the topics noted below, then "Tom's San Diego Real Estate Investment Analysis Course" will be an important source for you.
  • Basic characteristics when considering a real estate investment: liquidity, marketability, leverage, diversification, management, taxation, tax advantages, rate of return, risk, etc.
  • Advantages of both small and large investment properties, considering: income from cash flow, equity from loan pay-down, equity from appreciation and tax savings
  • How to calculate income from rents, miscellaneous income (e.g., laundry, parking, etc.), vacancies, expenses, debt service, cost recovery (depreciation), etc.
  • How to determine and calculate before and after tax cash flow
  • How to take advantage of "passive loss" rules
  • Vacation/second homes
  • Methods used to determine market value when considering a purchase: Gross Rent Multiplier, Cap Rates, Cash-On-Cash, Debt Coverage Ratios, etc.
  • Questions you should ask when considering a real estate investment purchase
  • Ownership of U.S. property by non-U.S. citizens
  • Case studies provide examples for understanding
Enjoy the course and of course, I would love your feedback. This course is for educational purposes only and is intended to provide a broad overview of basic investment property analysis. Participants are urged to seek independent legal/tax guidance on each transaction as circumstances often change and can affect the validity of the investment analysis. Nothing contained in this course shall be construed as providing legal, tax or other professional services. Every investor should always seek the advice of his or her tax and/or legal advisors regarding his or her specific situation. In this course, I often mention "San Diego real estate." However, please be assured that all of the principles of real estate investing which I address herein apply throughout the U.S. and some no doubt will apply to investment in foreign lands as well.  
   
About Investing
Investing Defined Whenever an individual places surplus funds in the bank or stock market, or purchases real estate for speculation, he or she has made an investment decision. There are a wide variety of investment vehicles available. Each type of investment has unique characteristics that may be desirable to one investor yet undesirable to another. In addition, investors may evaluate each investment differently. Each investment may also exhibit different risk levels, and the return or yield on an investment should be commensurate with the amount of risk associated with that investment.  
Why People Invest
People invest to obtain the financial independence necessary to achieve their goals. Achieving financial success usually takes time, careful planning, and the assistance of other professionals. Most people invest for the following reasons:
  • To generate additional income
  • To acquire wealth for their retirement
  • To accumulate for their children's education
  • To create an estate for their heirs
  • To acquire prestige in the community
  • To obtain financial independence
Common Investment Vehicles
An investor has an almost unlimited number of investment vehicles to choose from. The most common are:
  • Savings accounts and certificates of deposit*
  • Stocks and mutual funds
  • Real estate
  • Partnership interests
  • Bonds and bond funds
  • Mortgages/trust deeds
  • Collectibles/art
* Many times, people think that saving is different from investing. In reality, a savings account is just another type of investment vehicle.  
Investment Characteristics
An investment may seem more or less desirable depending on the objectives of a specific investor. The objectives of one investor can be completely different from those of another. To understand investor objectives, we must first understand the basic characteristics of investments. As we review each of these, we will make comparisons between savings, stocks & bonds, and investment real estate, especially San Diego real estate.  
Basic Investment Characteristics
Liquidity:Liquidity refers to the ability to convert an asset quickly into cash, without a significant loss of principal. Investments vary substantially in how quickly they can be converted to cash at their full value. Money in your possession is purely liquid because it is already cash.Savings:
      Money in savings accounts can be withdrawn quickly and is therefore highly liquid.
Stocks & Bonds:
      Stocks and bonds can be sold quickly, any day the financial markets are open. Brokerage fees vary, but are usually nominal. For these reasons stocks and bonds are highly liquid.
Real Estate:
    In contrast, real estate is much less liquid. A sale or refinance can take weeks or months. Fix-up expenses, commissions, and closing costs reduce the cash actually received. Also, to facilitate a quick sale, a property owner may be required to discount the price substantially.
Marketability:Marketability refers to the ability to convert an asset to cash quickly regardless of price.Savings:
      Money in a savings account can be withdrawn quickly. It does not require marketing.
Stocks & Bonds:
      Stocks and bonds can be sold quickly, any day the financial markets are open. However, on a given day, the sale price of an asset may be less than the purchase price.
Real Estate:
    The marketability of real estate is directly tied to the principles of supply and demand. Marketability can change dramatically as the market fluctuates between a seller's market, a flat market, and a buyer's market. In a strong seller's market, like the one we experienced in San Diego from 1998 thru 2005, a seller can be reasonably certain of selling a property quickly at a reasonable price. In a buyer's market, it can take months or years to sell a property, and even then, it is likely that the seller will receive less than anticipated.
Leverage: The use of borrowed funds to finance a portion of the purchase price of an investment. The ratio of borrowed funds to total purchase price is known as the loan-to-value ratio. The higher the loan-to-value ratio, the greater the amount of leverage. The financial impact of the use of borrowed funds depends on many factors. They include the amount borrowed, the interest rate on borrowed funds, the repayment terms, and the actual return on the investment. Leverage can have a positive, neutral, or negative effect on an investment.Savings:
      An investor is not likely to borrow money to invest in a savings account (unless of course, money could be borrowed at an interest rate lower than the interest rate being paid on the savings account).
Stocks & Bonds:
      Stocks may be purchased on margin. For every dollar invested, up to one additional dollar can be borrowed to acquire stock. This is called
margin borrowing. Real Estate:
    Real estate transactions can be more highly leveraged than most other types of investments.
Management: The cost associated with monitoring an investment. To maintain a productive and solvent investment, planning is needed and decisions must be made. There are two levels of investment management: asset management and property management. Asset management involves monitoring the financial performance of the investment and making changes as needed. Property management is exclusive to real estate investments.Savings:
      The investor usually manages individual savings accounts and certificates of deposit, as they require very little attention.
Stocks & Bonds:
      Stocks and bonds can be managed either by the investor or by professional managers. With the advent of e-trading, individual investors are able to trade investments at a much lower cost than through brokerage firms; but remember, quality management can have a significant effect on an investment's performance.
Real Estate:
    Property management includes the day-to-day operation of the property and the physical maintenance of the building(s). Properties can be managed either by the owner or by professional property managers. An owner gives either money or time in order to properly manage an investment property. The yield on an investment in real estate is directly affected by the quality of its management.
Taxation:Taxes have a significant impact on an investment's rate of return. Some investment vehicles may be tax-exempt. Some may be tax-deferred. Other investments may receive no preferential tax treatment, and are taxed at ordinary income-tax rates.Savings:
      Interest earned on savings and money-market accounts does not receive preferential treatment. The interest earned is taxed each year at ordinary income-tax rates.
Stocks & Bonds:
      Some investment vehicles, such as municipal bonds, may be tax-exempt. Some may be tax-deferred: for example, the earnings from Individual Retirement Accounts are not taxed until withdrawn. Profits from the sale of stocks may qualify for preferential long-term capital gains treatment.
Real Estate:
      There are major income-tax advantages for San Diego real estate investment property owners. They include:
    1. Interest on loans is deductible from rental income when the loan is used to purchase or improve rental property.
    2. Operating expenses such as property taxes, insurance, maintenance, repairs, management, etc. are deductible from rental income.
    3. Cost recovery (formerly called depreciation) is a non-cash tax-deductible expense, sometimes called a paper loss. It reduces taxable income but does not reduce cash flow.
    4. The $25,000 exemption under the passive loss rules allows certain investment property owners added tax benefits.
    5. If the property is held for more than one year, long-term capital gains treatment is allowed when the property is sold.
    6. Investors who own San Diego rental properties can qualify for Internal Revenue Code Section 1031 tax-deferred exchanges.
    7. Investors, when selling an investment property, can qualify for Internal Revenue Code Section 453 installment sale provisions.
Rate of Return (Yield):The rate of return is the percentage return on each dollar invested per period of the investment. Generally, the rate of return is greater for higher-risk investments. Investors often use the rate of return to compare various investments, looking for the greatest yield possible with the degree of risk they can tolerate.Savings:
      Investments such as certificates of deposit have a rate of return that is fixed for a specific period, while interest paid on passbook savings can fluctuate. These rates tend to be relatively low.
Stocks/Bonds:
      The rate of return or yield on certain bonds is fixed for the life of the investment. The return on money invested in a stock varies according to the perceived value of its earnings and overall consumer confidence in the marketplace.
Real Estate:
    Real estate investments usually produce variable returns. The income produced is dependent upon market conditions. Because of this, the amount and timing of the receipt of returns is an important issue for real estate investors. The full return of the amount invested usually does not occur until the property is sold.
Risk:Risk is the uncertainty associated with the expected performance of an investment. If the outcome is certain, there is no risk.Savings:
      Very low risk on federally insured deposits up to $100,000.
Stocks & Bonds:
      Many investors have built wealth by investing in the stock market; however, most people understand that the potential exists for the market to plunge. Over the past century the stock market has plunged more than 40% on seven different occasions. Some of these plunges have happened in as little as one year, while others have taken as many as six years to reach bottom. However, as holding periods increase, the risk associated with a stock or bond market drop is reduced.
Real Estate:
    When held for a reasonable time period, real estate is usually considered a low- to medium-risk investment. As with stocks, the longer the investment property is held, the lower the risk.
Comparing Investments
We have looked at the investment characteristics of a saving account, investment in stocks and bonds, and investment in real estate. Let's take a moment to determine the wealth accumulation potential of these types of investments. Savings: If we invest $40,000 in a certificate of deposit (CD) at 5%, compounded yearly, our investment will grow to $42,000 by the end of year one. $40,000 x .05 = $2,000 interest. $40,000 + $2,000 = $42,000. If interest is compounded monthly, the original investment will grow to $42,046. If it is compounded daily, it will grow to $42,051. In 15 years, an original investment of $40,000 with interest compounded daily will grow to $84,675. Would you consider this to be a good investment? What if the average rate on inflation during this 15-year period was 6%? Adjusting for inflation, the original investment of $40,000 would not be able to purchase as many goods in 15 years as it would today. Mutual Fund: Now let's invest $40,000 in a mutual fund growing at 10% annually. Our investment will grow to $44,000 by the end of year one. $40,000 x .10 = $4,000 interest. $40,000 + $4,000 = $44,000. In 15 years, an original investment of $40,000 that increases 10% each year will grow to $176,090. As you can see, there is a significant difference in the yield of a mutual fund earning 10% and a CD earning 5%. The increase in yield in this case explains why investors will take on the increased risk associated with stocks, bonds, and mutual funds. Which investment makes more sense -- a CD growing at a rate that may be less than inflation, or a long-term investment in a mutual fund? The answer to this question depends on an investor's objectives. Real Estate: For this example, we will invest $40,000 (20% down) in a $200,000 Mission Beach real estate investment(OK, I know it would be impossible to find a dog house in Mission Beach or Pacific Beach for $200K but it makes the example more simple). The property will be financed using a fully amortized 15-year loan. After payment of the taxes, insurance, maintenance, property management, and mortgage payments, let's assume that the income and expenses of the property break even. This allows us to focus on the increase in equity that results from paying off the mortgage along with the increase in equity resulting from 5% annual appreciation. The value of an investment property appreciating at 5% a year for 15 years will grow from $200,000 to $415,786. Let's take a look at the future equity potential of this investment.    
Future value of property in 15 years $415,785
- 7% overall cost of sale $29,105
- Loan Balance paid in full
= Net proceeds from sale before tax $386,680
  Review: In the above examples we determined that if we invested $40,000 for 15 years, we would be able to accumulate wealth (before tax) in the following amounts:    
1) Certificate of Deposit $84,675
2) Mutual Fund $176,090
3) Real Estate $386,680
  Which is the better investment for your client? Answer: It depends on your client's objectives. Each investor has a different:
  1. Need for liquidity
  2. Risk tolerance
  3. Yield requirement
  4. Desire for cash flow vs. equity growth
Advantages of Small Rental Properties?
  • Easier to Finance: Financing for up to four units is similar to single-family-home financing.
  • Easier to Manage: Tenants tend to stay longer in smaller apartment complexes. (Properties with high turnover rates require more maintenance and can be management-intensive.)
  • Easier Entry: Small rental properties cost less to acquire. (Smaller price equals smaller down payment.) First-time investors are often more comfortable investing in small rental properties.
  • Better Liquidity: More often than not, smaller, less-expensive investment properties can be sold more quickly than larger investment properties.
Advantages of Larger Rental Properties?
  • Economy of Scale: As the number of rental units increase, the cost per unit tends to decrease for maintenance, management, and other expenses.
  • Vacancy Factors: Losing a tenant in a duplex reduces your income by 50%. Losing a tenant in a larger the investment property is less dramatic.
  • Cash Flow: Larger investment properties tend to produce better cash flows than smaller rental properties.
Understanding Investor's Goals
Diversification The key to successful investing is a balanced portfolio. Most financial advisors recommend that investors have some liquid savings, some fixed-return instruments, and some investments with equity growth potential. Within these categories, a diversification of investments can protect the investor if the market drops in one area of his or her investment portfolio. Real estate, as one element of an investment portfolio, offers the potential for equity growth as well as monthly cash flow. Of course, if you want to invest in beach property where the demand is great and the supply is limited, few places have enjoyed such high appreciation as have Mission Beach and Pacific Beach.  
Determining an Investor's Objectives
A real estate agent should seek to understand an investor's tolerance or need for liquidity, marketability, leverage, management, taxation, yield, and risk. Does he enjoy taking risks? Does she want to spend time managing an investment? Does he want to invest in something tangible as opposed to a "paper" investment? Does she prefer short-term or long-term holdings? Understanding the answers to these questions makes it easier to determine an individual investor's investment preferences and goals.  
What Investors Want to Know
  1. How much do I need to invest to realize my goals?
  2. What kind of return can I make on my investment?
  3. When do I receive this return?
The remainder of this course is designed to help you answer the above questions.  
The Real Estate Agent's Task
The real estate agent's task is to help provide investors with the information they need to make a decision. Investors must decide for themselves whether or not an investment in real estate is right for them. A real estate agent should not necessarily express an opinion about an investment unless the client asks for it, and should never press a client to make a certain decision. In addition, the agent should encourage the client to seek professional tax and legal advice before choosing real estate as an investment.  
Investment Real Estate
What is Investment Real Estate Investment real estate is any type of real estate with the exception of the investor's personal residence(s). Examples:
  1. Single-family homes, condominiums, and multi-residential properties.
  2. Commercial properties such as office buildings, retail stores, and hotels.
  3. Industrial properties such as manufacturing plants, warehouses, and research facilities.
  4. Vacant land held for appreciation.
It's how you use a property that determines whether or not it is investment real estate.  
Four Major Advantages of Investment Real Estate
First Advantage: Income from Cash Flow After payment of all operating expenses and mortgage payments, the resulting income is called before-tax cash flow. This topic will be covered in greater detail as we study the cash flow model in our next chapter. For now, just remember: Positive cash flow is good! Negative cash flow, while not desirable, is not necessarily all bad! Keep in mind these guidelines:
  1. Choose the property that will produce the highest rents.
  2. Choose the property with the most reliable tenants.
  3. Choose the property that will return your investment the fastest.
Second Advantage: Equity from Loan Pay-Down When we obtain financing to purchase investment property, we are using the principal of leverage. Third Advantage: Equity from Appreciation In the real world, property values fluctuate. Investors generally purchase real estate on speculation that property values will increase over time. When a leveraged investment appreciates, equity in the property increases in two ways. In addition to the increase in equity obtained by paying down the mortgage, equity also increases as a property appreciates in value. Fourth Advantage: Tax Savings One of the tax benefits derived from an investment in real estate is the ability of an investor to pay taxes on an amount that is less than the income received. We will cover this more comprehensively as we study the cash flow model in our next chapter.  
San Diego Real Estate Cash Flow Concepts
Cash Flow DefinedBasic real estate investment analysis involves a careful calculation of the cash flows a property produces. Cash flows can vary significantly among alternative real estate investments. There are as many as three different cash flows involved in a typical real estate investment:
  1. At Acquisition: The initial outlay of cash for down payment, loan points, closing costs, etc. represents an investor's initial investment. (In this case, cash flows from the investor to the investment.)
  2. From Operations: Cash flow from the day-to-day operations of a real estate investment can be negative or positive. In addition, this cash flow can be evaluated before-tax or after-tax. (Positive cash flow indicates that cash is flowing from the investment to the investor. Negative cash flow indicates that cash is flowing from the investor to the investment.)
  3. At Disposition: The net gain received upon the sale of an investment is considered an additional cash flow. (If the property is sold for a profit, cash flows from the investment to the investor. If the property is sold for a loss, cash may need to flow from the investor in order to pay off mortgages and closing costs.)
Standard Cash Flow Model
The cash flow model is used by many different types of real estate professionals because of its versatility. It can be used to analyze all sorts of investments, from small residential to large commercial properties. There are two types of cash-flow analysis discussed in this course: before tax and after tax. Before Tax Cash flow analysis begins with the income received. Operating expenses are then subtracted to arrive at net operating income (NOI). Then the annual mortgage payments are subtracted to arrive at before tax cash flow. After Tax To arrive at after-tax cash flow, annual interest and depreciation are subtracted from the net operating income to arrive at real estate taxable income. Real estate taxable income is multiplied by an investor's marginal tax rate to determine the amount of tax that is owed or saved. The amount that is owed or saved is then subtracted from before-tax cash flow to arrive at the bottom line of the cash flow model, after-tax cash flow. (Confused? I will take you through this step by step.)  
Steps to Calculate Before-Tax Cash Flow
At first glance, before-tax cash flow can seem a bit overwhelming. We will take the following three steps to learn the concepts. Step One: I will start by showing the before-tax cash flow model without dollar amounts. Step Two: I will then define each component of the model. Step Three: I will complete the model using dollar amounts from a simple case study.  
Step One: Overview
Before-Tax Cash Flow    
1.   GROSS SCHEDULED INCOME $
2. - Vacancy & Uncollected Rents - $ ________
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $ ________
5. = GROSS OPERATING INCOME = $
6. - ANNUAL Operating Expenses - $ ________
7. = NET OPERATING INCOME = $
8. - ANNUAL Debt Service - $ ________
9. = BEFORE-TAX CASH FLOW = $
   
Step Two: Break it down
Cash Flow Definitions  
  1. Gross Scheduled Income (GSI) is the maximum amount of annual rent you would receive if the property were 100 percent occupied all year.
  2. Vacancy & Uncollected Rent represent an estimate of rental income that will be lost because portions of the property are not rented, or because existing tenants fail to pay rent. When expressed as a percentage, it is called the vacancy factor. When expressed as a dollar amount, it is referred to as the vacancy loss. Each market and sub market has its own vacancy factor, which can frequently be obtained by asking appraisers, property managers, and knowledgeable real estate professionals. Note: I can provide San Diego area-wide or specific community vacancies for analysis.
  3. Effective Rental Incomeis obtained by subtracting Vacancies & Uncollected Rents from Gross Scheduled Income. It represents the actual amount of money collected in rents for the year.Gross Scheduled Income - Vacancy and Uncollected = Effective Rental Income
  4. Other Incomerefers to income from sources other than rents. Other income can have a significant effect on cash-flow analysis. Typical sources of other income include:1. Laundry machines 2. Rental application fees 3. Storage fees 4. Parking fees 5. Vending machines 6. Late fees paid by tenants
  5. Gross Operating Income(GOI) is obtained by adding Other Income to Effective Rental Income. Gross operating income is the total pre-expense income investors are able to deposit in their properties checking account.Effective Rental Income + Other Income = Gross Operating Income
  6. Annual Operating Expensesare the actual costs involved in running the property. An annual expense budget should include sufficient funds to ensure that the property continues to produce market rents. If maintenance is deferred for a prolonged period, the property's ability to compete for the best renters will be diminished. Operating expenses include:
    • Property tax
    • Insurance
    • Maintenance and repairs
    • Management fees
    • Services (garbage, janitorial, pool, elevator, lawn, etc.)
    • Utilities
    • Supplies
    Loan payments are not considered an annual operating expense. Loan payments are a financial cost to an owner who chooses to borrow rather than pay cash. Also, operating expenses do not include cash outlays for major improvements. These outlays, called capital additions, must be placed on a cost-recovery or depreciation schedule and deducted over time.
  7. Net Operating Income(NOI) is obtained by subtracting Annual Operating Expenses from Gross Operating Income. NOI is a key component in cash-flow analysis. First, it is the estimated amount of money the property will produce to cover the annual debt service (twelve months' mortgage payments). Second, it is used by investors and appraisers, in conjunction with a cap rate (discussed later), to determine a property's value. NOI is a common factor that can be used to evaluate an investment regardless of whether an investor is paying cash or using financing to purchase a property.Gross Operating Income ? Annual Operating Expenses = Net Operating Income
  8. Annual Debt Service is the total of all monthly loan payments (principal and interest) paid throughout the year on all mortgages.
  9. Before-Tax Cash Flowis obtained by subtracting Annual Debt Service from Net Operating Income. Before-tax cash flow is what the investor has left of the property's income after all expenses are paid except taxes. If annual debt service exceeds net operating income, this number will be negative. (Cash is flowing from the investor to the investment.)Net Operating Income ? Annual Debt Service = Before-Tax Cash Flow
Step Three: Case Study 1
Mission Beach Four-Plex Rental Property A four-plex rental property in Mission Beach or Pacific Beach is listed for $200,000 (ya, right!). Two units are rented at $550 per month and two units are rented at $640 per month. The average vacancy in the area is reported to be 5%. The current owner averages an additional $418 per year from laundry machines. 80% financing is available at 7.75% on a 30-year fixed-rate loan with monthly payments of $1,146.26. Annual operating expenses are as follows:    
Taxes $2,200
Insurance $1,000
Property Management $2,204
Utilities
      Electricity: $600
      Sewer & Water: $800
    Total Utilities:
$1,400
Services
      Garbage: $550
      Landscaping: $800
    Total Services:
$1,350

Annual Operating Expenses $9,554
  What's the first year's before-tax cash flow?  
1. Gross Scheduled Income $28,560.00 ($2,380 x 12 months)
2. - Vacancy & Uncollected Rents - $ 1,428,00 (5% of $28,560)
3. = Effective Rental Income = $27,132.00
4. + Other Income + $    418.00 (laundry machines)
5. = Gross Operating Income = $27,550.00
6. - Annual Operating Expenses - $ 9,554.00
7. = Net Operating Income = $17,996.00
8. - Annual Debt Service - $ 13,755.12 (Mtg. $1146.26 x 12)
9. = Before-Tax Cash Flow = $4,240,88
   
TAX ASPECTS OF CASH FLOW
In Case Study #1 I used the first nine lines of the cash flow model to determine the Before-Tax Cash Flow for an investment property. As we study the Tax Aspects of Cash Flow (lines 10 through 17), we will build upon the answers from Case Study #1.    
Before-Tax Cash Flow
1.   GROSS SCHEDULED INCOME $ 28,560.00
2. - Vacancy & Uncollected Rents - $ 1,428.00
3. = EFFECTIVE RENTAL INCOME = $ 27,132.00
4. + Other Income + $ 418.00
5. = GROSS OPERATING INCOME = $ 27,550.00
6. - ANNUAL Operating Expenses - $ 9,554.00
7. = NET OPERATING INCOME = $ 17,966.00
8. - ANNUAL Debt Service - $ 13,755.12
9. = BEFORE-TAX CASH FLOW = $ 4,240.88
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $
11. - Interest (Mortgage 1) - $
12. - Interest (Mortgage 2) - $
13. - Points Amortization - $
14. - Cost Recovery (Depreciation) - $ ______
15. = REAL ESTATE TAXABLE INCOME = $
16. x Investor's Marginal Tax Rate x % ______
17. = TAX LIABILITY OR (SAVINGS) = $
After-Tax Cash Flow
18. BEFORE-TAX CASH FLOW (LINE 9) $
19. - Tax Liability or (Savings) (line 17) - $ ______ + or (-)
20. = AFTER-TAX CASH FLOW = $
   
The Difference
The only difference between before- and after-tax cash flow is the investor's tax liability (or potential tax savings).   Before-Tax Cash Flow - Tax Liability (Savings) = After-Tax Cash Flow  
How is Tax Liability (Savings) Calculated?
The deductions for cost recovery (depreciation), mortgage interest, and points amortization benefit an investor by allowing them to 'D.I.P.' into the IRS's pocket and pay tax on a lower amount called Real Estate Taxable Income. To calculate Real Estate Taxable Income we go back to line 7 of the cash flow model and take a detour at Net Operating Income.  
Before-Tax Cash FlowNET OPERATING INCOME - Annual Debt Service = BEFORE-TAX CASH FLOW Real Estate Taxable IncomeNET OPERATING INCOME - Cost Recovery (Depreciation) - Mortgage Interest - Points Amoritization = REAL ESTATE TAXABLE INCOME
  An investor's marginal tax rate is applied to Real Estate Taxable Income, not Before-Tax Cash Flow.  
After-Tax Cash Flow
Real Estate Taxable Income is multiplied by the investor's Marginal Tax Rate to arrive at the investor's Tax Liability (or Savings). Once the tax liability (or savings) is determined, it is then deducted from Before-Tax Cash Flow to determine the After-Tax Cash Flow for the investment.  
Before-Tax Cash FlowNET OPERATING INCOME - Annual Debt Service = BEFORE-TAX CASH FLOW Real Estate Taxable IncomeNET OPERATING INCOME - Cost Recovery (Depreciation) - Mortgage Interest - Points Amoritization = REAL ESTATE TAXABLE INCOME x Marginal Tax Rate = TAX LIABILITY (SAVINGS)
  BEFORE-TAX CASH FLOW - Tax Liability (Savings) = AFTER-TAX CASH FLOW Note: It is important to watch your sign convention when adding and subtracting negative numbers. Subtracting a negative number is the same as adding the number.  
Tax Aspects of Cash Flow Definitions
Cost Recovery (Depreciation) The deductions for operating expenses and interest require the property owner to pay first, then deduct. But with cost recovery (formerly called depreciation), you can deduct a non-cash expenditure. Remember to always consult your own tax professional to determine specific tax issues.
  • Only buildings and improvements can be depreciated, not land.
  • The cost recovery period is 27.5 years for residential investment properties and 39 years for nonresidential investment properties. Mid-month convention applies (see below).
  • Movable business property (also known as personal property), such as appliances and carpets, has a cost recovery period of five or seven years.
To estimate annual cost recovery(depreciation) for a residential rental, you must first determine the property's cost basis.
  • Sales price plus capitalized closing costs equals cost basis. (Loan points are not included in capitalized closing costs.)
  • Once you arrive at the cost basis for a property, the next step is to allocate the cost basis between land and improvements. Typically, an investor will use either the assessor's records or the allocations on the appraisal to determine the percentage allocation between land and improvements.
  • Once you have determined the improvement allocation of the cost basis, divide this number by 27 ½ years to estimate 12 months depreciation.
  • Mid-month convention allows only 11 ½ months of cost recovery in the year of acquisition and disposition. To calculate the maximum cost recovery for the first year of ownership, divide 12 months cost recovery by 12 and then multiply by 11.5.
Cost Recovery Practice Problem
Ignoring mid-month convention, what is 12 months cost recovery for the following property: A San Diego residential rental property selling for $200,000 with $2,400 in capitalized closing costs. The allocation for land is 20% of the cost basis. Answer ______(See below)_________  
Interest Deduction Rules
Interest paid on rental property loans is deducted from rental income, whereas homeowner's mortgage interest is deducted from personal income. Only the interest portion of a mortgage loan is deductible. There is no limit to the amount of interest a rental property owner may deduct against rental income, whereas homeowners can only deduct interest on the first $1.1 million borrowed. Finally, there are limitations regarding interest deductions for refinancing. If a rental property owner refinances and pulls out cash, that cash must be spent for a business purpose in order for the interest on it to be deductible. This situation is covered by a complex section of the tax code called the Tracer Rule (T.D.8145). With these regulations, a buyer should be aware of them and consult a tax professional if he or she is considering refinancing.  
Interest Deduction Practice Problem
If the first year annual debt service for an investment property is calculated to be $13,755.12 with $1,404.30 going towards principal, how much interest would be paid? Answer ______(See below)_________  
Amortization of Loan Points
If points are paid when obtaining financing for the purchase of an investment property, they are amortized over the term of the loan. The term of a loan can differ from the amortization period. For instance, if a purchase loan is amortized over 30 years but has a due date or term of 5 years, the points paid on this loan would be amortized over 5 years.  
Points Amortization Practice Problem
If one point is paid on a $160,000 loan amortized over 30 years with a due date or term of 30 years, what is the annual points amortization for this investment property? Answer ______(See below)_________ Tax Aspects of Cash Flow Example: If we use the NOI from Case Study #1 and the answers from the last three practice problems, we can calculate the following Real Estate Taxable Income:    
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $ 17,996.00
11. - Cost Recovery (Depriciation) - $ 5,888.00
12. - Interest (Mortgage 1) - $ 12,350.82
13. - Interest (Mortgage 2) - $ 0
14. - Points Amortization - $ 53.33
15. = REAL ESTATE TAXABLE INCOME = ($ 296.15)
  If the Real Estate Taxable Income for this example had been a positive number, we would multiply it by the investor's marginal tax rate to determine the investor's tax liability (how much tax would be owed) and enter that number on line 17 of the cash flow model. Since the Real Estate Taxable Income in this example is negative, there is no income to pay tax on, and therefore no tax liability. But there is a potential tax savings, which is determined by multiplying the Real Estate Taxable Income by the investor's marginal tax rate. The resulting potential tax savings is entered on line 17 in brackets ( ). Note: Note: It is important to use brackets ( ) in cash-flow analysis to indicate a negative number. This will help you to keep track of your sign convention when subtracting negative numbers. On line 17 in the example below you will notice brackets around the word (Savings). When the number on line 17 is negative, it is a potential tax savings. When the number is positive, it represents the investor's tax liability for this investment. Example: Suppose a San Diego real estate investor who is in the 28% tax bracket owns this property. When we multiply ($296.15) times 28% we arrive at ($82.92). Again, since line 17 is a negative number, it indicates there is a potential tax savings instead of a tax liability.    
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $ 17,996.00
11. - Cost Recovery (Depriciation) - $ 5,888.00
12. - Interest (Mortgage 1) - $ 12,350.82
13. - Interest (Mortgage 2) - $ 0
14. - Points Amortization - $ 53.33
15. = REAL ESTATE TAXABLE INCOME = ($ 296.15)
12. x Investor's Marginal Tax Rate x % 28
15. = TAX LIABILITY OR (SAVINGS) = ($ 82.92)
   
After-Tax Cash Flow
The final step in completing the standard cash flow model is to subtract the tax liability or (savings) from before-tax cash flow. Take a moment and complete lines 18, 19, and 20 below.    
Before-Tax Cash Flow
1.   GROSS SCHEDULED INCOME $ 28,560.00
2. - Vacancy & Uncollected Rents - $ 1,428.00
3. = EFFECTIVE RENTAL INCOME = $ 27,132.00
4. + Other Income + $ 418.00
5. = GROSS OPERATING INCOME = $ 27,550.00
6. - ANNUAL Operating Expenses - $ 9,554.00
7. = NET OPERATING INCOME = $ 17,966.00
8. - ANNUAL Debt Service - $ 13,755.12
9. = BEFORE-TAX CASH FLOW = $ 4,240.88
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $ 17,996.00
11. - Cost Recovery (Depreciation) - $ 5,888.00
12. - Interest (Mortgage 1) - $ 12,350.82
13. - Interest (Mortgage 2) - $ 0
14. - Points Amortization - $ 53.33
15. = REAL ESTATE TAXABLE INCOME = ($ 296.15)
16. x Investor's Marginal Tax Rate x % 28%
17. = TAX LIABILITY OR (SAVINGS) = $ 82.92
After-Tax Cash Flow
18. BEFORE-TAX CASH FLOW (LINE 9) $
19. - Tax Liability or (Savings) (line 17) - $ ______ + or (-)
20. = AFTER-TAX CASH FLOW = $
   
Potential Tax Savings
In the previous section, it was mentioned that a negative number on line 17 represented a potential tax savings. The rules governing whether or not the tax savings can be used fall under the passive loss rules and require an investor to meet certain guidelines in order to receive the full benefit of the passive loss deduction.  
Passive Losses
What Is Passive Loss? To understand passive loss, we must first define passive income. For tax purposes, there are three types of income: active, portfolio, and passive.
  • Active income consists of wages, salaries, tips, etc., plus income from activities in which the taxpayer materially participates.
  • Portfolio income is income from interest, dividends, and royalties.
  • Passive income results from any of three types of passive activity: rental activity, limited business interests, and activities in which the taxpayer does not materially participate.
  Most income from real estate investments is passive income. Passive loss results when all deductions related to a property-operating expenses, depreciation, mortgage interest, and points amortization-exceed the property's income for the year. For income tax reporting, passive loss is determined by combining all income and losses from passive sources for the year. Therefore, a loss from one property can offset income from another. How Can Passive Losses Be Used to Reduce Taxes? Passive losses can be used to offset passive income. If a passive loss cannot be fully used in the year it is generated, it can be carried forward to offset passive income in future years. At the time of sale of a property, any unused passive loss from that property may be used to offset the capital gain from the sale. Under the current tax law, passive losses cannot ordinarily be used to offset active or portfolio income. However, up to $25,000 of passive loss can be so used if certain conditions are met. (Fortunately, most small investors meet these conditions.) They are:
  • The investor must own 10% or more of the investment.
  • The investor must actively participate in managing the investment (this does not preclude the use of a professional property management company).
  • The investor's adjusted gross income (before applying passive losses) must not exceed $100,000 for the full deduction to be taken. If income exceeds $100,000, the offset is reduced by one dollar for every two dollars of income over $100,000.
What About Part Time Personal Use Of The Property Or "Vacation" Homes? There is no clear test for determining when a San Diego vacation home is a personal residence or when it is held for investment. However, many tax advisors look for guidance to IRC Section 280A which specifies when a taxpayer may claim losses on a second home. Under Section 280A, if a taxpayer uses the San Diego property in any one year more than the greater of 14 days or 10% of the number of days it was rented for fair market value, losses for rental investment cannot be deducted for that property. Many tax advisors recommend that, to establish that the property is an investment property, a taxpayer should at a minimum comply with the Section 280A requirements regarding the deduction of losses, but also go beyond them by treating the property as investment property to the greatest extent possible. For example, keeping records for the property that are separate from the taxpayer's records for his personal residence may help establish the intent to hold the property as investment property rather than for personal use. Should the owner personally use the San Diego investment property for greater than 14 days or more than 10% of the days it was rented then losses cannot be deducted. Expenses, on the other hand, can be deducted to the extent that they are expenses associated with running your rental "business" and not "personal" expenses. Another way to view this is that expenses that may be deducted are those which are in proportion to the amount of time that the property was used for rental purposes only. Also, days that the owner is in San Diego and on the property conducting maintenance, fix-up, etc., are not counted as personal days. What about a vacation home qualifying for IRC 1031 tax deferred (Exchange) treatment? In most cases, homes that are exclusively used for vacation residences will not qualify for treatment under section 1031. There is no specific formula to use and cases of "incidental use" have been permissible. If one were to look to section 280a which doesn't specifically deal with 1031 matters but talks about the deductibility of losses on vacation homes the rules are more straightforward. As noted above, 14 days per year or 10% of the time the property is rented throughout the year may be dedicated to personal use. While there are absolute rules for vacation homes and section 1031, Revenue Procedure 2008-16 does discuss a "safe harbor" under which a property will "qualify for an exchange even tho the taxpayer occasionally uses the property for personal purposes". One could also extrapolate then that if the property were held for personal use and then rented over a period of time, at least for a few years before doing an exchange one would be able to exchange it as property which has been used primarily for rental/investment. Exception for Real Estate Professionals If an investor materially participates in rental activities and spends at least 50% of his total working time in real property trades or businesses, for a total of at least 750 hours per year, he can deduct passive losses against his active or portfolio income up to the full amount of that income. Only one spouse must meet the test for a joint income tax filing. Real Property Trades or Business: A business with respect to which real property is developed or redeveloped, constructed or reconstructed, acquired, converted, rented or leased, operated or managed, or brokered. Caution! This is only a brief summary of the tax laws relating to passive losses. The regulations are quite complex, and a potential investor should consult accounting and tax professionals before making an investment decision based on passive loss potential. A real estate professional should avoid giving specific advice in these areas.  
Real Estate Investor vs. Real Estate Dealer
We have assumed the owner of rental property is classified by the IRS as a real estate investor rather than as a real estate "dealer." A dealer in real estate primarily holds property for resale to customers in the ordinary course of business. A real estate investor typically holds property for personal investment, not as inventory to be resold to customers. A real estate dealer is not allowed the same income tax benefits available to investors. A dealer is not allowed:
  1. long-term capital gain tax treatment when selling (all profits are taxed as ordinary income);
  2. the ability to perform an IRC Section 1031 tax-deferred exchange;
  3. the ability to receive IRC Section 453 installment sale treatment;
  4. depreciation deductions.
Listed below are some factors the IRS may review to determine whether the intent was to hold the property for personal investment or for resale to customers. The burden of substantiating the investment intent lies with the property owner. The items below are not an exhaustive list, but are useful indicators:
  • the nature and purpose of the acquisition of the property and the duration of ownership
  • the extent and nature of the taxpayer's efforts to sell the property
  • the number, extent, continuity, and substantiality of the sales
  • the use of a business office for the sale of the property
  • the character and degree of supervision or control exercised by the taxpayer over any representative selling the property
  • the time and effort the taxpayer habitually devoted to the sales
Case Study #2
A Pacific Beach single-family attached home (condo) is listed for $150,000. The tenant is currently paying $950 per month for rent. The average vacancy in the area is reported to be 5%. There is no other income associated with this property. Property taxes will be reassessed at 1% of sales price per year. Fire insurance has been quoted at $500 per year. Maintenance is expected to cost $800 per year. The purchaser will personally manage the property. The property will be purchased with 70% financing at 6.75% fixed rate amortized over 30 years with monthly P&I payments of $681. Buyer will pay one point for this loan (points amortization will be $35 per year). Mortgage interest for year one will be $7,053. Cost recovery will be $3,960. Use 28% as the investor's marginal tax rate.    
Before-Tax Cash Flow
1.   GROSS SCHEDULED INCOME $
2. - Vacancy & Uncollected Rents - $ ______
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $ ______
5. = GROSS OPERATING INCOME = $
6. - ANNUAL Operating Expenses - $ ______
7. = NET OPERATING INCOME = $
8. - ANNUAL Debt Service - $ ______
9. = BEFORE-TAX CASH FLOW = $
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $
11. - Cost Recovery (Depreciation) - $
12. - Interest (Mortgage 1) - $
13. - Interest (Mortgage 2) - $
14. - Points Amortization - $ ______
15. = REAL ESTATE TAXABLE INCOME = $
16. x Investor's Marginal Tax Rate x % ______%
17. = TAX LIABILITY OR (SAVINGS) = $
After-Tax Cash Flow
18. BEFORE-TAX CASH FLOW (LINE 9) $
19. - Tax Liability or (Savings) (line 17) - $ ______ + or (-)
20. = AFTER-TAX CASH FLOW = $
  Click here to download a blank PDF copy of "Tom's Before and After Tax Cash Flow Analysis" form, which you can use to analyze your property.  
COMMON USES OF CASH FLOW ANALYSIS
There are many uses for the information represented in the Before-Tax Cash Flow model. In this chapter, we will learn the following three uses:
  1. How to determining the value of investment property using cap rates and gross rent multipliers.
  2. How to calculate cash on cash.
  3. How to calculate debt coverage ratio (DCR).
Everything we need to calculate these three items is contained within the nine lines of the before-tax cash flow model. Of particular interest are Gross Scheduled Income (line 1), Net Operating Income (line 7), Annual Debt Service (line 8), and Before-Tax Cash Flow (line 9).    
Before-Tax Cash Flow
1.   GROSS SCHEDULED INCOME $
2. - Vacancy & Uncollected Rents - $ ______
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $ ______
5. = GROSS OPERATING INCOME = $
6. - ANNUAL Operating Expenses - $ ______
7. = NET OPERATING INCOME = $
8. - ANNUAL Debt Service - $ ______
9. = BEFORE-TAX CASH FLOW = $
   
Determining the Value of Investment Property
Two commonly used methods of determining the value of an investment property are the Gross Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.  
Gross Rent Multiplier (GRM)
The value of an investment property can be calculated using the estimated Gross Scheduled Income (GSI) for year one, multiplied by a factor known as the Gross Rent Multiplier (GRM). (Gross Rent, Gross Scheduled Rent, and Gross Scheduled Income are interchangeable terms.) Reminder: Gross Scheduled Income (GSI) is the maximum amount of annual rent you would receive if the property were 100 percent occupied all year. Since we only need the information from line one of the cash flow model, the GRM method of determining investment value is quick and easy. Using the Gross Rent Multiplier to Determine the Value of a San Diego Investment Property The gross rent multiplier used in evaluating investment property is typically derived from comparable properties in the marketplace and may be adjusted by the investor to reflect his or her specific requirements. First-year GSI x GRM = Value of investment property Example: Suppose a potential buyer's gross rent multiplier (GRM) requirement is 6.75. (This means the investor will pay no more than 6.75 times the gross scheduled rent to purchase an investment property.) The property the buyer is considering has an estimated first-year gross scheduled income of $28,560. The investment value, or the amount this investor would be willing to pay for this property, is: $28,560 x 6.75 = $192,780 Determining the Gross Rent Multiplier of an Investment If you want to calculate the Gross Rent Multiplier for a potential investment, divide the asking price by the first year Gross Scheduled Income. Example: A Mission Beach investment property listed for $200,000 with a Gross Scheduled Income of $28,560 would have a Gross Rent Multiplier of 7. $200,000
      = 7.00
 
     $28,560
Note:Note: Once the Gross Scheduled Income for an investment property has been determined we can make the following assumptions:
  • The higher the asking price, the higher the GRM.
  • Sellers generally try to list and sell their properties at the highest possible GRM.
  • Buyers typically try to purchase investment properties at the lowest possible GRM. The lower the GRM, the more attractive the investment becomes.
Pros and Cons of Using a Gross Rent Multiplier: Pros: The gross rent multiplier is a convenient tool because of its simplicity. Cons: The usefulness of the gross rent multiplier is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income past the first year.  
Capitalization Rate (Cap Rate)
Many appraisers and investors use a cap rate along with the first-year Net Operating Income (line 7) of an investment property to establish its value (price). A cap rate is the ratio between the first-year net operating income (NOI) and the purchase price of the property. An investor uses a cap rate to determine investment value, while an appraiser uses a cap rate to determine market value. In either case, the value of the investment property is determined by dividing the first-year NOI by a cap rate. Cap rates are market specific and can vary from neighborhood to neighborhood or even street to street. Certainly, in Pacific Beach or Mission Beach, cap rates will vary depending on whether the property is on the beach or somewhere near the I-5 freeway. They are affected by the principles of supply and demand and can vary significantly according to perceived risk. In addition, investor's may have different cap rate requirements. If you are trying to determine the appropriate cap rate for a specific marketplace, contact a real estate appraiser or real estate professional who is familiar with the marketplace. Using a Cap Rate to Determine Investment Value The following cap rate formula can be used to solve for the investment value (how much a buyer will pay) of a property, when the cap rate and the net operating income are known.     NOI        =   Interest Value (Price) Cap Rate Example: Suppose a potential San Diego buyer is looking at a property listed for $200,000 with an estimated first-year NOI of $17,996. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 9.25%. We can use the investors cap rate and the property's first-year NOI to determine the property's Investment Value (the price the investor would be willing to pay).  
    NOI        =   Interest Value (Price) Cap Rate     $17,996 NOI        =   Interest Value (Price) 9.25% Cap Rate
  Determining the Cap Rate of an Investment We can use a variation of the cap rate formula to solve for the cap rate of an investment property, when the net operating income is known and the price is fixed.         NOI     ___   =   Cap Rate Purchase Price Example: In our previous example, the investor was looking at a Mission Beach investment listed for $200,000 with an estimated first-year NOI of $17,966. If this property were to be purchased at the list price, the cap rate for this investment would be 9%.     $17,966        =   .09 or 9% $200,000 Note: Once the Net Operating Income for an investment property has been determined, we can make the following assumptions:  
  1. The lower the cap rate, the higher the sales price.
  2. The higher the cap rate, the lower the sales price.
  3. Sellers want buyers to accept the lowest possible cap rate.
  4. From the buyer's point of view, the higher the cap rate, the more attractive the investment becomes.
Pros and Cons of Using a Capitalization Rate (Cap Rate): Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and operating expenses. Cons:The reliability of using a cap rate is limited because it only looks at a one-year forecast and does not take into consideration any financing or tax implications.
Cash on Cash
Another measurement of investment performance is called Cash on Cash (C/C). This involves comparing an investor's initial investment to the potential before-tax cash flow an investment property is likely to produce. Let's assume the investor's initial investment is $44,000 ($40,000 down plus $2,400 in closing costs plus $1,600 for points). We will also assume the property produces a first-year before-tax cash flow of $4,240.88.   Before-tax cash flow  =  % Return Initial Investment $4,240.88 (cash) 
         =  .0964 or 9.64%
 
      $44,000 (on cash)
  Pros and Cons of Using Cash on Cash: Pros: Cash on Cash takes into consideration vacancy and uncollected rent, operating expenses, and debt service. Cons: Cash on Cash does not take into consideration anything past a first-year forecast. It does not take into account tax considerations.  
Debt Coverage Ratio (DCR)
Another use for the before-tax cash flow model is determining the Debt Coverage Ratio for an investment property. When lenders provide financing for apartment complexes with five units or more, they generally use a debt coverage ratio as a lending guideline. Formula: Debt Coverage Ratio (DCR) is determined by dividing Net Operating Income (NOI) by the Annual Debt Service (ADS). Remember, annual debt service is the total principal and interest for all mortgages.  
Net Operating Income Annual Debt Service = Debt Coverage Ratio or NOI ADS = DCR
  Example: From Case Study #1, observe the following Before-Tax Cash Flow model and the Debt Coverage Ratio derived from lines 7 and 8.    
1.   GROSS SCHEDULED INCOME $ 28,560.00
2. - Vacancy & Uncollected Rents - $ 1,428.00
3. = EFFECTIVE RENTAL INCOME = $ 27,132.00
4. + Other Income + $ 418.00
5. = GROSS OPERATING INCOME = $ 27,550.00
6. - ANNUAL Operating Expenses - $ 9,554.00
7. = NET OPERATING INCOME = $ 17,966.00
8. - ANNUAL Debt Service - $ 13,755.12
9. = BEFORE-TAX CASH FLOW = $ 4,240.88
  $17,996.00 (NOI) = 1.31 DCR $13,755.12 (ADS)  
Understanding Debt Coverage Ratios
To understand DCR, let's look at a break-even Pacific Beach property. A property with NOI of $5,000 and ADS of $5,000 would break even and have a DCR of 1.0 (one point zero). $5,000 NOI = 1.0 DCR $5,000 ADS The Before-Tax Cash Flow for this investment property would be zero and would not generally be acceptable to a lender. Because income and expenses vary from month to month, lenders reduce their risk by making loans where the ADS is less than the NOI. Lenders typically like to see Debt Coverage Ratios between 1.1 and 1.3 for low-risk properties. Solve for ADS: Let's assume that an investment property has NOI of $5,000 and the lender's minimum DCR requirement is 1.2. We can divide the NOI by the DCR to solve for the maximum ADS the lender will allow.  
NOI = ADS DCR $5,000 = $4,167 1.2
  You can divide the ADS in this example by 12 to arrive at the monthly Principal and Interest allowed by the lender. Enter this monthly amount into your financial calculator along with the appropriate interest rate and amortization period and then solve for loan amount. This will determine the maximum loan you can obtain from this particular lender. Bottom Line: Lenders want to make sure that the income produced by the property is more than enough to pay the mortgage (ADS). A higher DCR means there is less risk in making the loan. An aggressive lender may only require a DCR of 1.1, while other lenders have DCR requirements as high as 1.25 or more.  
Case Study #3:
What is the before-tax cash flow? ________________ (Bottom line of the before-tax cash flow model) What is the gross rent multiplier for this investment? __________ (Purchase price divided by gross scheduled income) What is the capitalization rate for this investment? ___________ Net Operating Income (NOI) = Cap Rate Purchase Price What is the cash on cash return on this investment? ____________ Before-tax cash flow = % Return Initial Investment What is the debt coverage ratio for this investment? ____________ Net Operating Income = Debt Coverage Ratio Annual Debt Service  
OBTAINING ACCURATE DATA
Obviously, your cash-flow analysis will only be as accurate as the information you plug into the cash flow model. Current information on a property's income and expenses may be available from the following sources:
  • The property manager's records
  • Copies of the current lease and rental agreements
  • A copy of the owner's Schedule E (rental property income tax schedule)
  • The owner's personal records
Important Questions to Ask
Gross Scheduled Income
  • What are the current rents, according to the lease and rental agreements?
  • If it's a Mission Beach or Pacific Beach "vacation/weekly" property, does the income vary according to the time of the year?
  • Are these market rents?
  • How long do these agreements run?
  • Are the tenants prompt payers?
  • When were rents last increased?
  • What did the owner report as rental income on his Schedule E?
  • If there is a property manager, what do his records show as collected rents?
Vacancy & Uncollected Rents
  • What is the current vacancy factor for the property?
  • What is the current market or sub market vacancy factor?
  • What is a reasonable forecast for future vacancies?
  • Is the property competitive, or does it need to be upgraded?
Other Income
  • Are the laundry and vending machines owned by (a) the property owner or (b) an outside vendor?
  • If (a), how long will the machines last, and how much will it cost to replace them?
  • If (b), what are the contract terms?
  • Are parking fees charged for extra or large vehicles?
Annual Operating Expenses Annual expenses should be broken down into categories. This will assist a buyer and his or her tax professional to properly analyze the property. In addition it makes it easy to enter the expenses on a Schedule E at tax time. The following is a typical breakdown of annual expenses:
  • Advertising
  • Cleaning and maintenance
  • Leasing commissions
  • Property insurance
  • Legal and other professional fees
  • Management fees (again, if it's a Mission Beach or Pacific Beach property, management rates can vary according to the time of year)
  • Repairs
  • Services (garbage, gardening, pest, pool, landscaping, etc.)
  • Supplies
  • Taxes
  • Utilities
  • Other
Annual Debt Service Remember to include only principal and interest payments; taxes and insurance have already been accounted for under operating expenses.  
Putting It All Together
So far we have learned to:
  • Gather accurate data
  • Calculate before- and after-tax cash flow
  • Use a Gross Rent Multiplier to determine the value of a property
  • Use Cap Rate to determine the value of an investment property
  • Calculate Cash on Cash
  • Calculate a Debt Coverage Ratio
Review
To reinforce what we have learned so far, we will use the entire cash flow model to answer the following questions:
  • What is the total initial investment?
  • What is the before-tax cash flow?
  • What is the gross rent multiplier for this investment?
  • What is the capitalization rate for this investment?
  • What is the cash on cash return on this investment?
  • What is the debt coverage ratio for this investment?
  • What is the after-tax cash flow?
Case Study #4
A ten-unit San Diego investment property is listed for $465,000. It has five 1bd/1ba units rented at $500/month and five 2bd/1ba units rented for $600/month. The average vacancy in the area is reported to be 5%. $1,100 per year in other income is expected. Property taxes will be 1.2% of sales price/year. Insurance will cost $1,800/year. Maintenance averages $2,500/year. Total utilities will cost $2,600/year. Total services will cost $5,000/year. Property management will cost 7% of Gross Operating Income. Buyer will pay one point for 80% financing at 7.5% fixed rate amortized over 30 years with annual P&I payments totaling $31,213. Closing costs will be 1.5% of sales price. Mortgage interest for year one will be $27,784. Cost recovery will be $13,158. Annual points amortization will be $124.00. Use 28% as the investor's tax bracket.    
Before-Tax Cash Flow
1.   GROSS SCHEDULED INCOME $
2. - Vacancy & Uncollected Rents - $ ______
3. = EFFECTIVE RENTAL INCOME = $
4. + Other Income + $ ______
5. = GROSS OPERATING INCOME = $
6. - ANNUAL Operating Expenses - $ ______
7. = NET OPERATING INCOME = $
8. - ANNUAL Debt Service - $ ______
9. = BEFORE-TAX CASH FLOW = $
Tax Aspects of Cash Flow
10. NET OPERATING INCOME (LINE 7) $
11. - Interest (Mortgage 1) - $
12. - Interest (Mortgage 2) - $
13. - Points Amortization - $
14. - Cost Recovery (Depreciation) - $ ______
15. = REAL ESTATE TAXABLE INCOME = $
16. x Investor's Marginal Tax Rate x % ______%
17. = TAX LIABILITY OR (SAVINGS) = $
After-Tax Cash Flow
18. BEFORE-TAX CASH FLOW (LINE 9) $
19. - Tax Liability or (Savings) (line 17) - $ ______ + or (-)
20. = AFTER-TAX CASH FLOW = $
  What is the total initial investment?________________ (Down payment plus closing costs plus points.) What is the before-tax cash flow? ________________ (Line 9 of the cash flow model) What is the gross rent multiplier for this investment? __________ (Purchase price divided by gross scheduled income) What is the capitalization rate for this investment? ___________ Net Operating Income (NOI) = Cap Rate Purchase Price What is the cash on cash return on this investment? ____________ Before-tax cash flow = % Return Initial Investment What is the debt coverage ratio for this investment? ____________ Net Operating Income = Debt Coverage Ratio Annual Debt Service What is the after-tax cash flow for this investment? _____________ (Bottom line of the after-tax cash flow model.)  
MARKETING INVESTMENT PROPERTY
Marketing Material Actual vs. Proforma: It should be noted in any marketing material whether you are using actual income and expense information or proforma income and expenses. (A proforma is an opinion/estimate of the potential income and expenses a new owner will experience.) There are many different types of reports or statements used for marketing investment properties. Two very common types are a Property Data Sheet and an APOD (Annual Property Operating Data).  
Property Data Sheet
A property data sheet often includes financial statistics and a scaled-down operating statement. Examples of data are reflected below:
  • Address
  • Name of complex
  • Number of units
  • Unit mix (size, number of bedrooms & baths, rents)
  • Age
  • Current Occupancy
  • Number of gas and electric meters
  • Size of lot
  • Roof type
  • Number of stories
  • Capitalization rate
  • Gross rent multiplier
  • Pictures of the property
Annual Property Operating Data (APOD) Sheet
An annual property operating data sheet is a detailed cash flow statement based on estimated income and expenses for the next twelve-month period. It includes proposed financing figures and a potential before-tax cash flow. It may also, for the purpose of calculating potential cost recovery (depreciation), show the allocation of value between land, improvements, and personal property. The information contained in this report can be used by investors and their financial advisors to determine the suitability of an investment. Folks, this concludes the basic portion of my course on San Diego Real Estate Investment Analysis. Two short notes:
  • I do hope that you have learned the "ins and outs" of how to analyze investment properties and I would enjoy any feedback or recommendations on how I could improve on the course material. One thing that I should certainly mention is that if you have a certain property in mind that is under purchase consideration and you do not necessarily want to do all of the math yourself, you can save yourself the time and aggravation... I have software that will do it all for you and also print it out the complete analysis as well. HOORAY!!!! Call me.
  • I want to once again stress that before undertaking any action which has an impact on finances and/or taxes, you should seek competent, experienced professional advice. Of course, I have folks who I would be pleased to refer you to.
Last, inasmuch as I have clients who live outside the U.S. I have attempted to provide below a few short paragraphs on foreign investment in U.S. real estate.  
Foreign Investment
It is difficult enough to try and understand the U.S. tax code and how it applies to U.S. citizens as it relates to real estate investment. Any attempt to try and understand the innumerable tax codes of foreign countries and how their tax codes would treat investment in U.S. properties by their citizens would be totally fruitless due to tax treaties between countries, etc. Thus, if you happen to live in a foreign country and wish to investigate ownership of San Diego or other U.S. property, you should seek tax advice with an individual who has specific expertise. The above said, I believe that there are some general rules which may, and I emphasize the word "may", apply to many foreigners:
  • How you are taxed in the U.S. is determined by your status as either a resident alien or non-resident alien. This is important because a resident alien is taxed on worldwide income in much the same manner as an American citizen. Such individuals are required to file U.S. income tax returns ad pay U.S. taxes on the worldwide income from all sources and all locations. A resident alien then is generally entitled to the same deductions and personal exemptions available to U.S. citizens. Non-resident aliens on the other hand, are generally taxed on their income from U.S. sources only3;with some exceptions. You will be treated for tax purposes as a resident through either of two tests: the lawful permanent resident, "green card" test or the "substantial presence" test. We are all familiar with the "green card" and those folks are considered to be residents for U.S. tax purposes. However, with regard to "substantial presence", if you do not spend more than 121 days in the U.S. in any one year, you should not be considered an American resident under the substantial presence test. And then even if you meet the "substantial presence" test, there are exceptions which allow you to be considered a non-resident thru either "closer connection exemptions" or "tax treaty tie-breaker provisions".
  • Let´s assume that you are a non-resident for tax purposes. Under U.S. tax rules, the IRS allows you to have your U.S. source income taxed in one of two ways: thru remittance of withholding tax on gross rents or thru the filing of Form 1040NR, the non-resident income tax return, and Schedule E. If you remit a 30% withholding tax on gross rents received from the property, your tax obligation has been fulfilled with the IRS. The way to lower your taxes however, is by filing a U.S. tax return on a net rental income basis and most folks will be substantially better off by filing the return. Should you have no tax liability, you are still required to file a U.S. tax return and report any net rental loss.
  • Now, since you are the citizen of your own country, you may be required to declare your worldwide income, any net rental income, adjusted for your own currency, on your country´s tax return. However, usually to eliminate any double taxation, you can take any tax paid to the U.S. as a foreign tax credit on your own country´s return.
  • When selling U.S. property, you are subject to U.S. income tax on any profit because the U.S. reserves the right to tax property within its borders. The profit is measured as the difference between the net proceeds from the sale and your cost basis -- referred to as "adjusted basis" in the U.S. Your adjusted basis is the total of your purchase price plus the cost of capital improvements less and U.S. depreciation taken3;which as we discussed earlier in this course, a mandatory deduction in the U.S. If your U.S. property has been held for at least one year, the tax rate for individuals is 15% except for that portion of the profit that represents that dreaded... "recaptured depreciation" which is gain, taxed at... 25%. And once again, the sale information probably needs to be reported on your own country´s tax return however, the tax paid in the U.S. may be taken as a foreign tax credit. And, don´t forget to take into consideration, currency gains and losses.
  • Under Section 1031 of the U.S. tax code, U.S. resident taxpayers are able to defer the tax on the exchange of investment real estate when they purchase another property. This is commonly referred to as a "tax deferred 1031 exchange". However, this provision is not available to non-residents.
  • Non-residents are also not able to exempt any realized gain if they purchase another U.S. residence. Under U.S. tax code 121, U.S. residents may enjoy either a $250K or $500K exemption on the sale of their principal residence. For U.S. income tax purposes, the principal residence is generally the residence which is used most. Therefore, if you do not wish to pay U.S. taxes on your worldwide income, you are a non-resident, only residing in the U.S. a limited time. And if you are a non-resident, you won´t be able to claim your U.S. residence as your principal residence because of your limited occupancy time.
  • When you sell real estate in the U.S., a tax of 10% of the gross sales price must normally be held by the buyer under the U.S. Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) and remitted to the IRS. This withholding is used to offset the actual U.S. income tax payable on any gain realized on the sale and is refunded if it exceeds the actual tax liability when you file your tax return. That said, if the property sells for less than $300K to a buyer who intends to occupy the property as his/her principal residence, the 10% withholding on the sale does not apply. Another way to reduce the withholding tax requirements under FIRPTA is to apply to the IRS before the sale for an exemption. It applies only if the expected U.S. tax liability on the gain will be less than 10% of the sale proceeds. To do this, you file IRS Form 8288B -- Application for Withholding Certificate for Disposition by Foreign Persons of U.S. Real Property Interests. If your application is accepted, the certificate will indicate the amount of tax that should be withheld by the buyer rather than the full 10%.
  • Always seek professional advice from someone who is experienced in foreign investment in U.S. real estate.

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