Phils Olympian Editorials
EVALUATING INVESTMENT PROPERTY: CAP RATES, CASH FLOW AND APPRECIATION
Many clients ask me to assist them in evaluating potential investment properties. One question that comes up repeatedly is “What is the correlation between the Cap Rate and Cash Flow”. My response is that, generally, they are not correlated; rather they measure different aspects of a property, each of which is useful to investors. And other factors, such as appreciation, should be taken into account before an investment decision is made.
First, the Capitalization Rate (CAP Rate) represents the percentage annual rate of return before mortgage payments and income taxes on the total investment. Cap Rates are primarily used to compare a property to similar ones in the market (both recently sold and for sale). The Cap Rate (CR) is a ratio calculated by dividing the annual Net Operating Income (NOI) before debt service by the market value (MV). The formula is CR = NOI ÷ MV.
For example, a duplex listed at $300K (the MV), with a NOI of $28K, based on gross operating income of $40K minus property taxes ($4K), insurance ($2K), owner-paid utilities ($2K), vacancy allowance ($2K) and anticipated maintenance ($2K), yields a Cap Rate of $28,000 ÷ $300,000 or 9.3%. Note that the NOI is determined, in part, by information provided by the seller.
The Cap Rate formula is a powerful tool. As we all learned in algebra class, if you know two of three values, the third can be calculated. For example, if you know the CR that you want to obtain and the NOI of a property you can determine the MV a specific Cap Rate and NOI support using this formula: MV = NOI ÷ CR. Similarly, you can determine the NOI required to for a property given a target Cap Rate and the listing price using this formula: NOI = CR x MV.
As the above examples illustrate, Cap Rates are very effective in evaluating one property against others in the market, but Cap Rates don’t tell us anything about what a property will earn on a month to month basis as NOI does not include the cost of capital, i.e., the debt service for principal and interest.. Additionally, depreciation and other tax benefits are ignored, as are capital improvements.
This is where a second tool, Cash Flow Analysis, helps investors: To determine estimated cash flow simply deduct from the NOI the debt service (principal and interest), add back in any tax benefits (such as depreciation), and factor in any special circumstances: Further consideration should be given to the tax advantages of real estate ownership, which are substantial (please consult your tax advisor), and to annual property appreciation rates.
Finally, both Cap Rates and Cash Flow Analysis are “snapshots” in time. Appreciation rates however are forward looking and should be part of your evaluation. Appreciation rates in the Olympia area real estate market are driving investors to accept lower Cap Rates (and lower monthly returns) in return for higher future property valuations. As an investor I must factor in appreciation to realistically evaluate Cap Rates and annual cash flow in order to see if the overall financial picture they reveal fit my investment goals. Fortunately, our market has experienced appreciation rates of 6-12% a year for several years and I see no reason to expect a slowdown. We are located directly in the growth path for western Washington, and recent market appreciation rates reflect that fact. So I recommend that you add an appreciation rate (both for future rents and market value) that you are comfortable with into your calculations and see what that does for the bottom line. I personally feel comfortable with 6% a year for the foreseeable future.
Phil Sharp is a Realtor with Lighthouse Realestate Inc. in Olympia, this article was co-authored with his brother, Malcolm Sharp; their investment company, Sharp and Sharp Holdings LLC, has invested successfully in Real Estate in the Olympia area for the past six years. Phil can be reached at 360-970-9977, or via email at phil@sshllc.com
Investing in real estate as an owner occupant, a great opportunity for novice investors to enjoy the best of both worlds
Investing in real estate has always been considered the key to wealth in this country, and investing in real estate in Thurston County has made many investors very wealthy over the past few years. The local market has grown astronomically, when put into perspective with other markets around the country, and the local market is still booming.
The question asked by those who see this growth ( and haven’t seen it in the stock market lately) is “how do I get started”. A great way to do so is as an owner occupant of Multi-family housing. Duplexes, tri and four plexes may be considered by lenders to be “owner occupied” if the owner lives in one the units. The benefits to the owner are numerous, and allow buyers to get into the fabled “zero down or close to zero down” deal. Other benefits include tax advantages of owning your own home, no capitol gain tax if you own and reside in the home for two years, and potentially having your tenants pay all or a part of your living expense.
Typically, real estate investors pay 10 percent or more in down payments for investment properties. This number can go beyond 20 percent depending upon the type of property, its use etc. As an owner occupant, 95, 97, and even 100 percent of the loan to value (LTV) is common. What this means is that if the four-plex you would like to buy and live in is financed at 97% LTV, and we assume that your four-plex is valued at $200,000, your cost to purchase would be $6000 (3% of $200,000), and your lender would finance the remainder of the cost of the property. You could expect to pay an additional 3% in closing costs making your total purchase cost $12,000. Twelve thousand dollars is a lot of money? The bette3r your credit is will determine how much you can borrow, and at what interest rate. I mentioned earlier that 100% owner occupied loans are available, some will even roll closing costs into the loan, making your deal truly ZERO down!
IT GETS BETTER:
· If you own your own home, whether it is single or multi family, you can deduct from your taxes all of your interest payments and depreciate the value of the dwelling over the course of its useful life. Using the $200,000 example, the approximate annual mortgage interest expense would be $12,000, and depreciation would be about $6600, an $18,600 tax deduction.
· Investors pay capitol gains taxes when they sell property, and can’t avoid it. If the property is owned for less than one year, income tax is paid, which is significantly higher than capitol gain. As an owner occupant, residing in the property for a minimum of two years, the IRS has a provision that allows you to pay no tax on the gain in your property. Going back to the $200,000 property: Property is purchased for $200,000 (all expenses in closing the purchase are deductible), assume that the property is held for five years, and that it appreciates at 10% per year (that may seem like a large percentage, however, many investors have experienced 12-14% gains in our area over the past 5 years), so the property is sold for $300,000. As an investor, the tax liability is 15% of 100,000, or $15,000. As an owner occupied residence, the tax liability is zero.
· Who pays the rent? This is where it gets really good. Going back to the $200,000 example, the monthly payment; principle, interest, taxes, insurance (PITI), on a property of this value would be approximately $1600 (based on a 6% interest rate and estimated cost of insurance and property taxes). Assuming that each unit rents for $600 per month, rental income from three units would pay the mortgage payment, and put $200 per month back into your pocket. All of a sudden, you, the home owner is living in a building with no payment, and are actually making money every month for the effort.
So, all of this is great. Does anybody else know about it? Absolutely!! In order to pursue and acquire a property that will work for you, you must prepare yourself to act. Action is what intimidates investors who dream, and invigorates those that succeed. First, meet with a lender, get pre-approved and determine what your ability is as a buyer. Second, establish a relationship with a real estate agent that will comb the market for your potential home (A good agent should also be in tune with lenders, and may be your best source in locating a local mortgage lender). Finally, be patient, and be prepared to act. The real estate market in our town is on fire. Homes available are not keeping up with demand, and inventory is low. You and your agent will need to pursue every opportunity, and be prepared to make an offer on a moments notice…good deals go quick.
Investing in real estate can be fun, and profitable. The added benefit of living in your investment is obvious, and can start helping you build the leverage needed to continue investing in additional properties. As you get into your first investment, you will start to learn the creativity and skills that have made many investors rich; remember, however, none of that creativity and skill is magic, just knowledge and insight that is easily gained by talking to the right people, your real estate agent and lender are the first and primary sources for the information you need to succeed. GOOD LUCK!!
Phil Sharp is a Realtor with Lighthouse Realestate Inc. in Olympia, his investment company, Sharp and Sharp Holdings LLC, has invested successfully in Real Estate in the Olympia area for the past six years. He can be reached at 360-970-9977, or via email at phil@sshllc.com
Foreclosure, making the best of a bad situation
Foreclosures, bank owned properties, real estate owned (by lenders, REO’s) are at the top of the list of hot topics in the real estate and lending industries. A perceived slowdown in the national real estate market; new higher risk mortgages, and concerns about increasing interest rates have brought lots of attention to a sector of the market that has gone un noticed for the past few years.
Foreclosure is a disconcerting word; unpleasant to hear and unpleasant to talk about. Foreclosure, however, is a fact of life for some, and an opportunity for others. Weather you are in trouble and need help, or are interested in buying a foreclosure property, read on.
Aside from the traditional reasons that people get into trouble, a new and very significant foreclosure concern is that home owners may become overextended by adjusting mortgages, sub-prime loans, and other “creative” financing options that have become available in recent years. There are solutions available to those in this situation; a realtor experienced in what is called a “Short Sale” can literally save the day, creating a good deal for the homeowner, the lender, and a buyer. Confronting the problem is more than half the battle.
Many who are at risk for foreclosure are unaware of, or are unwilling to accept help during this difficult time. In this situation, a realtor experienced in foreclosures, and the multi-tiered negotiations required to resolve them are the homeowners best bet. Just as you would employ an attorney or CPA, you hire a realtor to confidently and confidentially take charge of the situation, negotiate resolution (usually in the form of a sale), and hopefully put some of your investment back into your pocket. The key to all of this is the bottom line$; Lenders know what is in their best interest, and their best interests are not met thru foreclosure. (You should also consult with an attorney; your realtor will be able to refer you to one who specializes in real estate)
What is referred to as the “Foreclosure Process” may take various courses depending on the type of mortgage and other factors, and consists of several phases. The first is default, which simply means “late on the payments”. After a period of time, if no payment is made, a notice of default is served (with demand for payment) and this notice is filed with the court. Ultimately, and typically, the foreclosure action is completed thru the sale of the property and/or repayment of monies owed. The time to resolve the problem for the homeowner is sooner rather than later. The longer the party in default waits before taking action, the less likely it is that the situation will be resolved before the foreclosure.
For homebuyers and investors, the time to take action is also sooner rather than later. Information is available thru realtors, as well as the internet, regarding property owners in default. The internet information/subscription services are useful, but the data provided is often dated, incomplete, and sometimes just plain inaccurate. If you are looking to buy foreclosure properties, by all means check them out on the web, and then get your realtor involved. Lenders would prefer to work with a professional third party, and they expect the third party realtor to be compensated for his or her efforts. A win-win for the buyer.
A realtor, working for a buyer; or a seller in distress, drives the process. After initial contact with the property owner, the agent will work with the lender to establish a sale price for the home acceptable to all, and get it sold. If the agent is representing a buyer he or she will first negotiate with the homeowner, and potentially with the lender; again with the goal of structuring a satisfactory deal for all involved.
A real estate mortgage in default is a bad situation; bad for the homeowner, bad for the lender, and bad for the general economy. In any situation, there are usually solutions; In the case of foreclosure, the solution can be found thru the knowledge and skill of a professional realtor, timely action on the part of the homeowner and buyer, and willingness to confront the problem. If you are interested in buying foreclosure properties, or if you are concerned that you won’t be able to keep up with your adjustable rate mortgage, contact your real estate agent….we have the answers.
Listing and Selling your Home in a difficult? Market
Coffee house chat has it that the real estate market has somehow changed for the worse, but can’t put a finger on it. I disagree; people are listing homes, they are selling homes; they are happy, and they are making money. The psychological effect of down markets in other parts of the country, record new construction numbers in Thurston County, and unreasonable expectations from some sellers has definitely had an impact on our collective perception of the market. The facts, however, are that we are buying and selling homes at a brisk pace, interest rates are great, and our geographic location and projected growth bode well for the future.
If you are thinking of selling your home, think of it just as you would selling yourself, your business, or anything else of value. You must stand out among the masses, you must not be distressed, and you must not be too expensive. Many sellers, who really are anxious to sell, are acting like unmotivated sellers; the highest price in the neighborhood, thinking the buyers will have “vision” when it comes to the yard devoid of grass, the little hole from the doorknob behind the front door….these things tell your buyers that they can keep looking, this home isn’t going anywhere.
I don’t mean to say that you should make your home like new before putting it on the market, but it is in your best interest to make it “Show” in its best light. Your agent should make suggestions regarding clean-ups, repairs, and weather or not you will get a return on the investment. Remember though, the return may not come in dollars; it may come in the form of a contract, resulting in a quick and hassle free sale. I have personally patched the hole behind the door, seeded the yard, and cleaned the windows in order to make a property show well and sell, the goal being to close the tranaction and make all concerned happy.
A number of techniques to help a home “show well” have come (back) into style. Not very long ago, there were so few homes on the market that price was the only consideration. Buyers were willing to seed the yard and patch the hole. Not anymore; an increase in inventory has created competition, and competition has become our collective “speed bump” in Thurston County. If you want to overcome the “bump”, curb appeal is the name of the game, and it applies to the entire property, from the attic to the crawl space to the price. Clean it up, pretty it up and paint it if needed. Don’t give YOUR buyer a “negative” to compare with the house up the street.
In addition to the obvious, staging is something else that can be very helpful. Demonstrate the use of space (as well as spaciousness) with small items of furniture, decorative curtains, vases with plants and flowers, and tasteful wall hangings; all help your buyers get a personal feel and ideas for what they will do upon moving in. Your realtor should be willing to help with some staging, and can also refer you to companies that provide this service for a fee.
There are several key elements to making a sale, not the least of which are the item which is for sale, and the needs of the buyer and seller. Two of the previous three are within your control. The third, the buyers, are out there; just look at the stats in the Sunday Olympian. The buyers that make up those stats bought the home that appeared to be the best deal for them, both in terms of price and desirability. Those buyers were looking for the same things you were when you bought; a solid home without questionable issues at a fair and reasonable price. People don’t come back for a second look if the home doesn’t meet those criteria. Not if you repeatedly drop the price, not if you fill the hole, and not if you seed the yard; get it right the first time or YOUR buyers just won’t come back for a second look.
Phil Sharp is a Realtor with Abbey Real estate Inc. in Lacey, Phil has helped his clients buy, sell and invest in Thurston County real estate for over 6 years, and his investment company, Sharp and Sharp Holdings LLC, has invested successfully in Real Estate in the Olympia area for the past ten years. Phil can be reached at 360-970-9977, or see other editorials by Phil at PhilSharpHomes.com
