Real Estate 011: Cash Flow Analysis and Market Research

Cash Flow Analysis and Market Research

When people ask me how I can invest thousands of miles away in the midwest while living in California, I tell them that your confidence build the more research you do on your markets as well as your local team on the ground. That is why I started to build my own team after purchasing a couple turnkey houses. Mainly, a realtor (who gets paid when you close a deal) is going to see a project differently from a contractor (who gets paid by the amount of work performed) and that will be entirely different from a property manager’s perspective (who gets paid by the amount of income it produces) By looking at a property and its market through the lens of a team who all have different opinions, you will get a better view of the whole picture.

Here is the recommendation I received from a local property manager when I was starting to research my market:

1. Using an Agent/Realtor

If you are buying a property through the MLS, have your realtor go out to the property and take photos/videos. Ensure that they get pictures of the roof, mechanicals, foundation, and plumbing/electrical systems. These will make a bigger impact on your investment as a new roof and furnace doesn't necessarily demand a higher rent rate but it may lead to loss of tenants and in turn, revenue for your business. These capital expenses don't usually have much impact on the rent rate, so if they need to be updated, you want to ensure that it's figured in the rehab budget. Unless you are doing a full gut-rehab, I always recommend getting a home inspection and having a General Contractor walk through the property as well. Your realtor should be able to coordinate these activities.

2. Researching the area

How is the crime? Is the school system a factor in vacancy? What conveniences and amenities are nearby? Are there any industrial areas nearby (landfills, recycling facilities, wastewater treatment facilities, train tracks, air ports, prisons re-entry program, etc.?) Is it in a flood zone (High insurance deductibles)? Are there problematic homes in the immediate vicinity (boarded up homes, illegal dumping, abandoned cars, unkept yards, etc.?). These potential issues should be communicated by your agent and/or property manager who are your local boots on the ground.

3) Tenanted Properties

If the home you wish to purchase is tenanted, make sure to get copies of the leases and rent rolls. What are the tenants paying? When does their lease end? Are they current? How much is being held in a security deposit? Is the security deposit going to be rendered to the buyer at closing? Newbie investors may think that “cash flowing on day one” is an advantage, but note you may be paying a premium to take on someone else’s problem. Buying a vacant property allows you to have your trusted/vetted PM place a qualified tenant, even though that may mean your property sits vacant for a month or two, and will be paying a lease up fee.

4) Proforma vs Actuals

Most of the time, an agent or the seller may provide you with a proforma, or estimated cash flow the buyer may expect to see with the purchase of the property. Based on my experience, these numbers are optimistic at best. Ensure that you get market rent rates from both the realtor and property manager (This information can also be cross referenced to websites like Zillow, hotpads and Rentometer). Frequently, realtors are not as accurate with their rental information unless they work heavily in that space, where as property managers should always have the most current data based on their experience and inventory.

You will also want to understand property taxes, HOA fees, and get an idea of insurance costs. Your realtor should be able to help with this as well and a good insurance company should be able to assist with the insurance costs (Obtain an actual quote).

After verifying against the location criteria, understanding the scope of any rehab and having a budget built, and getting a good understanding of the probable rent rate, you plug these new numbers in the original underwriting you did with assumptions and see if it fits the original plan. If it doesn't, negotiate the deal to better fit the criteria that you set up in advance.

Here's a checklist to help assist your research:

• Get opinions on specific location. Crime, School, Flood zone, Specifics to that location?

• Get market rates to determine ARV / Fair Market Value. In some markets you will want retail prices and as-is, distressed prices if investing in areas with lots of rehabs. A realtor should be able to provide a broker’s price opinion (BPO) or Comparative Market Analysis (CMA), sometimes for a fee.

• Understand the property taxes, HOA fees, property management fees, and insurance costs.

• Get rent rates for the location, size, amenities, condition, time of year, etc.

• Get a home inspection and have a General Contractor (GC) build a rehab budget.

• Verify tenant information (if tenanted).

Plug all of that data that you obtained yourself into your calculations and see if it still performs against your criteria. Do not fudge the numbers to make it work because you want to close. The only thing worse than no deal is a bad deal that loses money. Don't take a bad deal because you are eager, ensure that it's a deal and get a third party to help you put an eye on it.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.

Good Luck!

Real Estate 010: How to buy Real Estate through Seller Financing

How to buy Real Estate through Seller Financing

A lot of newbie real estate investors have a common problem when first starting out - lack of capital. As discussed in previous blog posts, there is more than one way to successfully invest in real estate, and that includes financing. An investor can save their money and purchase a property all cash, obtain a conventional or commercial mortgage, or look for private or hard money lenders. Another method that experienced investors love to use is seller financing, or owner-carry.

This simply means that the seller of the property becomes the bank and the buyer will now pay the monthly loan amount to the seller, and not a bank/private institution. Let's take a quick look at some of the advantages and disadvantages of seller financing:

Advantages:

1. Flexibility of terms (Interest Rate, Downpayment, Amortization period, payback period, balloon payment amount, etc.)

2. Easier to qualify (No bank involvement means less paperwork, as long as you and the seller agree)

3. Cheaper closing costs (No bank fees, appraisals)

4. Purchase through an entity (Corporation, LLC - this is generally not allowed for conventional mortgages)

Disadvantages:

1. Premium for flexibility (Higher interest rates/purchase price)

2. Balloon payment

3. No bank underwriting (No objective third-party that may identify blind spots in the deal that may make it a “dud”)

4. Property may not appraise for expected ARV (After repair value)
   

These are general pros and cons, and typically, the pros far outweigh the cons. Experienced investors know that conventional fannie mae or freddie mac mortgages are the cheapest money that an investor will find in the market. This is because they are backed by the government, have no balloon payment, and the loan is amortized over 30 years, which drastically improve your cash flow numbers as long as you are a long term buy and hold investor. However, there may be situations where investors have issues with repairing their credit, do not have enough reserves to meet fannie mae guidelines, or want to purchase a distressed property to rehab and refinance down the road. These issues may lead to the investor not being able to obtain a conventional mortgage, and where seller financing comes in handy.

Case Study: Bo’s seller financed deal.

Let me give you an example of a recent deal I took down with a partner of mine in the midwest. These two duplexes that were in the same neighborhood (Not same street) were being listed on the MLS for above what I thought market prices were at the time. However, I knew the market well and wanted to explore the option of “making” it into a deal that would work for me.

(Note: The best advice I got from my mentors is that in real estate, you only need to win ONE of the two: purchase price or terms. If the seller is focused on receiving an X amount for his properties (within reasonable range of course), then you can dictate the terms to make it into a good deal. Contrarily, if he was Y terms, you can negotiate the price to still win on the deal).

I flew out to the market and looked at both duplexes and knew that it needed a little bit of work to get it to my standards (read: meat on the bone). The properties have been on the market for quite some time so I knew I can negotiated. My first order of business was to talk to the seller and agent to understand why they are selling and what their motivation was. Through multiple conversations, I found out that the seller was an experienced investor who has owned the duplexes for 20 years free and clear, looking to retire and move to another state. I verified this information through online searches as well as looking at his other properties he had in the area that he was selling off one by one.

This taught me three things: 1) The seller is motivated 2) The seller may also benefit from a stream of cash flow, and not necessarily a lump sum. 3) The property is owned free and clear which is perfect for owner financing (No bank involvement and triggering of the “due on sale” clause).

I ran my numbers conservatively and made the following offer:

• 40K off of purchase price X

• 6% interest

• 10% downpayment

• 10 year balloon

• 20 year amortization
  

Quickly thereafter, the seller accepted my terms, but countered at only 20K off of the purchase price. I called the seller myself explaining my reasoning for requesting 40K off of the purchase price (read: its very important to build rapport with the seller/agent and not get emotionally tied down). He agreed at came down to 30K off of the purchase price. I agreed to the terms and we signed the contract.

I quickly performed full house inspections, sewer scoping, termite inspections on both properties and found multiple issues, and estimated that the property needed atleast $15-20K worth of work after closing. This was not too far off from my estimate at $10K, but still higher than expected.

I went back to the seller and told them I will need to go back to my original offer of 40K off of the purchase price for the above reasons. (At this point, the seller was irritated that I was attempting to “retrade”, however, the inspections discovered new issues that I was unaware of before, as such, this is normal in the due diligence process and I knew I needed to be courteous, but firm in my numbers and reasoning).

After multiple emails and not gaining any momentum, I decided to let go of purchase price X, and focus on terms Y. I adjusted the numbers in the calculator to make the deal still work for me. As I am a cash flow investor, I crunched the numbers with the following new terms:

• 30K off of purchase price X (Same)

• 5.25% interest (Down from 6%)

• 12.5% downpayment (Increased from 10%)

• 10 year balloon (Same)

• 30 year amortization (Increased from 20 years)
  

As you can see, I left the purchase price and balloon payment period the same, reduced the interest amount, and amortization period, thereby increasing my monthly cash flow, but also increased the downpayment amount by 2.5%.

Negotiations is a relationship game (refer to my blog post on Book Review: Never Split the Difference), and I knew that if I only “took” from the terms without giving anything back, the seller would feel it as another loss and possibly want to increase the purchase price or back out of the deal. As I realized from previous conversations that purchase price and cash at closing was somewhat important to him, I increased my downpayment by 2.5% (couple thousand dollars), but reduced the interest rate and amortized it over 10 more years. This move allowed my property to cash flow $150/month better than the previous offer and made this financing much more competitive that a traditional conventional mortgage which would have required 25% down for 2-4 units and had quotes for 5.875-6.125% interest rates at the time of this deal.

I knew that in 10 years, we would have heavily paid down the loan, property appreciate it value, and cash flowed enough that we could refinance the balloon or pay it all off if we wanted to. In the end, the seller accepted my terms and we created a win-win deal. The seller received steady monthly mortgage payments and a nice interest rate on top of his equity in the property, and I did not have to use my conventional mortgage slots, and obtained 4 units with only 12.5% down. Further, I feel with the relationship built with this seller, I can reconnect in 6-8 months to inquire about purchasing his other 10-15 properties in the area.

The biggest lesson learned for me was that to succeed in real estate, you have to have many tools in your toolbelt and think outside the box. Figuring out the seller’s why, solving their biggest problem, and offering multiple options is a sure method for you to get your deal accepted.

As Brandon Turner from biggerpockets often says, to an investor who only has a hammer, every problem is a nail. Many investors say, I cant invest because I dont have THIS: time, knowledge, money, confidence, etc. I highly encourage you to think outside the norm and ask yourself the question “how can I do X”. By changing your mindset from a fixed mindset to a growth mindset, you will be able to force your mind to come up with new solutions.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision.

Good Luck!

Real Estate 009: 5 Tax Benefits for real estate investors

Many real estate investors and those seeking financial freedom know that the biggest "enemy" to creating long term wealth is taxes. One of the huge benefits of being a real estate investor, is that the IRS tax code is written to support business owners including those with rental real estate. As such, I want to discuss some of the tax advantages that rental real estate could bring to your portfolio. Please note that I am not a CPA nor attorney, so please talk to a professional that can assist you in your specific situation.

Top 5 Tax Benefits for real estate investors

1. Depreciation
According to the IRS, the building (not the land) portion of your real estate investment is depreciated over 27.5 years for residential buildings and 39 years for commercial buildings (as of this writing). That means on a $100K midwest single family home where the building is valued at $80K, land at $20K, you are able to off set $2,909 worth of taxable income with a depreciation loss of the same amount. As this is a "paper" loss, even though your property may be in great condition physically, you are able to take this depreciation each year starting from the year of acquisition.

Note: There is a downside to depreciation called "depreciation recapture". If you ever decide to sell your real estate property, you will have to pay taxes on any gains made on the sale. Lets look at two scenarios:

A - You (taxpayer) buys the property for $100K, and the taxpayer has taken $40K worth of depreciation over time, bringing the cost basis of the rental property to $60K at the time of sale. If the taxpayer sells the home for $70K, they realize a gain of $10K. As they have taken depreciation over the years, they are required to pay $10K worth of ordinary income taxes.

B - Same situation above, except the market is hot and taxpayer sells the home for $130K, resulting in a $70K gain on the cost basis of $60K. In this situation, $40K of the total $70K will be taxed as ordinary income (equal to the amount of depreciation taken over the years) and the remaining $30K is taxed at a lower capital gains tax rate.

One way a savvy real estate investor can avoid the depreciation recapture is to defer tax liability with a 1031 exchange.

2. 1031 Exchange
The 1031 Exchange is named after section 1031 of the IRS tax code which allows investors to defer their tax liability when selling their property for a gain. In the example B above, the investor sold the property for a $70K gain, but if they use a 1031 exchange to buy a "like-kind" asset such as a single family, multifamily, land, etc. they can roll their gains onto the newly purchased property. There are strict rules when it comes to the execution of a 1031 exchange, so please do your due diligence in researching this option.

3. Tax Breaks for Pass-through entities
If you have a pass-through entity (Sole Proprietorship, Partnerships, LLC, S-Corp), the new Tax reform (TCJA 2017) provides a 199A pass-through deduction. In a nutshell, this allows landlords of residential real estate operating in a pass through entity, to deduct 20% of net income off the top. This means, if your 10 rental properties in an LLC makes $100K net income a year, only $80K will be deemed taxable. There are exceptions, however, where the 20% deduction is capped by the greater of 50% of the taxpayer's wages, or 25% of wages + 2.5% of the unadjusted basis of qualified property held by the business. A qualified property is a rental property that is subject to depreciation and the unadjusted basis is the property's original cost without any depreciation.

4. Deductions
There is a laundry list of items that relate to your real estate business that can be deductible:
   - property taxes
   - insurance premiums
   - utilities
   - repairs and maintenance
   - commissions, property management fees, legal and professional fees
   - travel costs to visit out of state rental properties
   - mileage to visit local rental properties
   - meals
  
The key is to keep a detailed log of your expenses to ensure that it was ordinary and necessary for your real estate business. Note that this list does not factor in the perks of being a qualified real estate professional and the additional deductions they can take. However, please note that the IRS is very strict on who qualifies to be a real estate professional, so again, please do your homework.

5. Long-term Capital Gains
If you decide to sell your real estate property, you will have to pay capital gains tax on the profits of the sale. There are two types of gains: short-term and long-term. If the investment was acquired and sold within 1 year, it is deemed a short-term hold and taxed as ordinary income. If the investment was held for longer than 1 year, it is considered a long-term hold and has a more favorable tax rate.

To put this in perspective, if you have purchased a property for $100K and sold it for a $50K profit in less than a year, at a tax bracket of 28%, you would be paying close to $14K in taxes. Conversely, if you held the property for more than 1 year and made the same profit, you would pay long-term capital gains of 15% in taxes resulting in only $7.5K, a whopping $6.5K in savings. Something to keep in mind when you are considering disposing of your assets.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!