Investing in Real Estate

Real Estate Investing

In this article we will explore the pros and cons of owning real estate as an investment. We will discuss the many definitions and ratios uses in evaluating potential investments and how AskChristee can provide critical data.

Investing in income producing Real Estate is desirable for many reasons such as (a) a hedge against inflation (b) a source of income or (c) a tax shelter. This article will focus on the purchase of 1–4-unit residential property. However, much of the discussion is applicable to commercial real estate.

Here, you can launch the AskChristee ‘Investment’ module. 

Are you prepared to be a landlord?

Unlike investing in stocks or bonds, real estate can create emotional stress and become a time burden. You may wish to consider the pitfalls of being a landlord such as:

  1. Collecting Rent. Tenants do not always pay rent in a timely fashion, which can lead to cash flow issues and the additional burden of eviction procedures.
  2. Major Repairs. You will need to maintain a significant amount of money for major repairs such as HVAC, Roofs, Siding, Windows, Plumbing, and Appliances. At any given time, repairs can range from several hundred to several thousand dollars.
  3. General Maintenance. Beyond major repairs, you should anticipate repainting before each new tenant. Carpeting, appliances, and fixtures will have a much shorter life expectancy due to tenant wear and tear.
  4. Tenant Screening. In approving a potential tenant, you will attempt to verify their (a) employment and earnings (b) credit rating, and (c) landlord reference. Too often, life situations change and tenants are unable to pay rent or simply decides to move out – generally after not paying rent for several months.
  5. Tenant Damage. You should anticipate repairs after each tenant. It is important to be aware that some tenants will abuse the property. At a minimum, you should be prepared to paint the entire interior space, professionally clean the carpets, and a deep cleaning of kitchen, bathrooms, and appliances.
  6. Vacant Property. Generally, residential properties are rented on an annual or month-to-month cycle. You should anticipate the loss of one month’s rent with each turnover. This is referred to as vacancy allowance for lost rent. If a property turns over every 12 months, you will lose approximately 8% of annual income plus the cost of getting the property ‘tenant ready’.
  7. Landlord Tenant Court. The court system is not a landlord’s collection agency. A landlord files court action seeking a money judgment for unpaid rent and right of possession. Legal right to repossess the property can take several weeks or months. Collection on monetary judgments, against the tenant, can be very difficult to collect.
  8. Time. Unlike investing in the stock market, management of rental property can require a great deal of time. You may want to consider hiring a property management firm.

Landlords Legal Considerations

1. Discrimination. The Fair Housing Act prohibits landlords from discriminating based on disability, race, color, national origin, religion, sex, and familial status. The ADA prohibits discrimination against people with disabilities in employment, transportation, public accommodations, communications, and state and local government activities.

2. Security Deposits. How many months ‘deposit’ does your State allow? How does your State define ‘normal wear and tear’ allowing the landlord to forfeit the security deposit? How long does a landlord have to return the security deposit after termination of lease? What are the penalties, to the landlord, for failure to comply with security deposit laws?

3. Service Animals. Can you legally refuse to rent to potential tenants with animals? What is the definition of a ‘service animal’? When is the landlord required to make reasonable accommodations for tenants with disabilities?

To make sure you are in compliance with Federal and State laws as well as local ordinances applicable to landlords, you should consider hiring a real estate agent to represent you.

Mortgage Rules Applicable to Investment Properties

Interest Rates will be higher than primary home mortgages.

Down Payment requirements are higher. Typically, at least a 20% down payment is required.

PMI Insurance. Should your loan exceed 80%, private mortgage insurance is required and is more expensive when compared to a primary home loan.

Rental Income. Potential rental income will be used as part of the mortgage process.

Closing Cost. You will incur normal closing cost and the seller paid contributions toward closing cost.

Ownership Interest. You may be able to transfer title into an LLC after closing, provided that the original borrower holds a majority and controlling interest in the LLC. We suggest you check with your lender for further details.

Reasons for Investing in Real Estate

The potential purchase of income producing or rental property is evaluated differently depending upon individual circumstances. Some typical reasons for investing in real estate are:

1. Annual Income Stream – positive cash flow.

2. Tax Shelter – the investment creates a ‘paper loss’ each year which could shelter a portion of ordinary income from taxation.

3. Inflation Edge – historically real estate has provided a guard against potential inflation.

4. Long Term Gain – holding the property for a substantial period of time creates equity.

Financial Analysis for Investing in Real Estate

Whatever your investment reasons, a detailed ‘Investment Analysis’ is critical for a savvy Real Estate Investor. A complete analysis requires a vast number of calculations.

AskChristee’s platform provides the most comprehensive investment analysis. Try the ‘Investment Analysis’ for yourself!

Typical Calculations required for a Real Estate Investment Analysis:

  1. How much total cash is required and what is the rate of return on cash?
  2. Mortgage details including Debt Service and Debt Service Ratio
  3. Income Analysis Details including Net Operating Income, Cash Flow Projections, Tax Deductions, and Potential Tax Savings
  4. Future Value Projections including Future Equity, Gross Profits, and Cash Analysis
  5. Depreciation Report detailing Depreciation Basis, Annual Schedules for Straight and Accelerated Depreciation
  6. Potential Tax Overview including Capital Gains Basis, Net Profits, Capital Gain Taxes for both Federal and State, Recapture Amount, and Recapture Taxes. AskChristee’s report will include an estimate for both Federal and State Capital Gains taxes.
  7. All Investment Ratios such as ROI, Capitalization Rate, Debt Service Ratio, Return on Cash, GRM, and Return of Capital.

AskChristee provides all projections and data for you to review with your tax advisor.

Basic Real Estate Investment Definitions

1. Capitalization Rate. The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income that the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market. The formula is Capitalization Rate = [Net Operating Income / Current Market Value]

2. Return on Cash Investment (ROI). A metric used to evaluate many investments. The formula is [Current Value of Investment-Cost of Investment] / Cost of Investment x 100. The results show gross profit from investment as a percent of original investment.

3. Capital Gains. Capital gain, for income tax purposes, is the gain realized from sale of capital assets (such as investment real estate). The difference between the original purchase price and the sale price is the realized gain. If the asset was held for more than one year, the capital gain is long term. Federal Capital gain rates are based upon your income and are between zero and 20%. Some States also impose a Capital Gain Tax.

4. Recapture Tax. A tax due based upon the depreciation that was reported each year on your tax returns. As a result of depreciation, the owner of the rental property saved taxes each year. Upon the sale of the property a recapture tax is owed. The recapture tax is based upon ordinary tax bracket and is capped at 25%.

5. Straight Line Depreciation. Straight-line depreciation is the depreciation of real property in equal amounts over the dedicated lifespan of the property that is allowed for tax purposes which is 27.5 years.

6. Cost Segregation Depreciation. A cost segregation analysis helps you identify assets to count as personal property for the purposes of depreciation, giving you the opportunity to calculate their depreciation over a shorter period of time as compared to straight-line depreciation. A cost segregation analysis identifies structural and non-structural components of the improvement. Structural components must be depreciated based upon straight-line depreciation schedule. The primary downside to cost segregation relative to straight-line calculation is the cost involved in having a cost segregation report prepared.

7. Net Operating Income (NOI). NOI equals all revenue from the property, minus all reasonably necessary operating expenses. AskChristee allows for vacancy allowance, management fees, and maintenance cost when calculating NOI.

8. Cash Flow. Cash flow can be either positive or negative. Cash flow is defined as NOI minus debt service or rental income minus all expenses including mortgage payments.

9. Debt Service Ratio Coverage. Relationship between Net Operating Income and Debt Service. The formula is [NOI/Debt Service].

10. Annual Real Loss. The rental real estate loss allowance is a federal tax deduction available to taxpayers who own and rent property in the U.S. Up to $25,000 may be deducted as a real estate loss per year as long as the individual’s adjusted gross income is $100,000 or less. The deduction phases out for individuals earning between $100,000 and $150,000. People with higher adjusted gross incomes are not eligible for the deduction.

AskChristee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only; it is not intended to provide tax, legal, or accounting advice and should not be relied on as such. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.