David Frederick
David Frederick
David Frederick Realty, Inc. 
Huntsville, AL 
Huntsville's Apartment Brokerage Specialist

256-539-5393
Contact Me

Real Estate

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: 
Single-family homes, condominiums, and multi-residential properties. 
Commercial properties such as office buildings, retail stores, and hotels. 
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. In the following example, we will focus on the equity obtained by paying down the mortgage in a leveraged real-estate investment (as opposed to the equity obtained from appreciation of the property's value). 


Third Advantage: Equity from Appreciation 

In the real world, property values fluctuate. An increase in value is referred to as appreciation, while a decrease in value is referred to as depreciation. 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. 


Real Estate Cash Flow Concepts 


Cash Flow Defined 

Basic 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 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 huge 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? We will take you through this step by step.) 


Steps to Calculate Before-Tax Cash Flow 

At first glance, the cash flow model can seem a bit overwhelming. We will take the following three steps to learn the concepts. 

Step One: We will start by showing the entire model without dollar amounts. 

Step Two: We will break down the model and define each component. 

Step Three: We will put it back together 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 & Credit Losses 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 loan officers. 

3.    Effective Rental Income is obtained by subtracting Vacancies & Credit Losses from Gross Scheduled Income. It represents the actual amount of money collected in rents for the year. 

Gross Scheduled Income 
– Vacancy and Credit Losses 
= Effective Rental Income 


4.    Other Income refers to income from sources other than rents. Other income can have a significant effect on cash-flow analysis. Typical sources of other income include: 

Laundry machines 
Rental application fees 
Storage fees 
Parking fees 
Vending machines 
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 Expenses are 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 (see Chapter 5), 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 Flow is 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 


Four-Plex Rental Property 
A four-plex rental property is listed for $200,000. Two units are rented at $550 per month and two units are rented at $640 for a total of $2,380 per month. The average vacancy in the area is reported to be 5%. The current owner receives an additional $418 per year from laundry machines. 80% financing is available at 7.5% on a 30-year fixed-rate loan with monthly payments of $1,118.74. Annual operating expenses are as follows: 

Taxes    $2,200 
Insurance    $1,000 
Property Management $2,204 
Repairs & Maintenance    $1,400 
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 is the first year's before-tax cash flow? 


1. Gross Scheduled Income . . . $ 28,560    ($2,380 x 12 months) 
2. – Vacancy & Uncollected Rents . .    –    $ 1,428 (5% of $28,560) 
3. = Effective Rental Income. . . . . . . .    =    $ 27,132 
4. + Other Income . . . . . . . . . . . . . . . .    + $ 418 (laundry machines) 
5. = Gross Operating Income. . . . . . .    =    $ 27,550 
6. – Annual Operating Expenses . . .    –    $ 9,554 
7. = Net Operating Income . . . . . . . .    =    $ 17,996 
8. – Annual Debt Service. . . . . . . . . . – $13,424.88 (Mtg. $1118.74 x 12) 
9. = Before-Tax Cash Flow . . . . . . . .    = $ 4,571.12 

Note: Case study one information can be reviewed in Star Investment Analyzer's Sample Property: 4-Plex. (Before-tax cash flow will vary slightly because in this case study, the mortgage payment has been rounded to two decimal places.) 


Interest Deduction Rules 

  • Interest paid on rental property loans is deducted from rental income, whereas homeowners' 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). While these regulations generally do not concern an agent making a sale, a buyer should be aware of them and consult a tax professional if he or she is considering refinancing.


Cost Recovery (Depreciation) 

The deductions discussed so far–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, always recommend that your client consult his or her own tax professional to determine their 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. * 

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 their 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. 


Cost Recovery Practice Problem 

Ignoring mid-month convention, what is 12 months cost recovery for the following property: 

A residential rental property selling for $398,000 with $2,000 in capitalized closing costs. The allocation for land is 20% of the cost basis. 

Answer________________________ 

To check your answer, go to the end of this course material. 


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. 

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, mortgage interest, and depreciation–exceed the property's income for the year. 

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 income 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. 

Exception for Real Estate Professionals 

If an investor materially participates in rental activities and spends at least 50% of their working time in real property trades or businesses, for a total of at least 750 hours per year–they can deduct passive losses against their active or portfolio income up to the full amount of that income. 

Real Property Trades or Businesses: 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. 


The Annual Values chart in Star Analyzer shows you how Mortgage Interest and Cost Recovery Deductions vary with time.


Case Study #2 

A single-family home 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 principal and interest 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 $3,959. Use 28% as the investors tax bracket. 

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 Tax Bracket 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 =    $ 


Disclaimer 

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. David Frederick Realty is not engaged in providing legal or tax advice. Nothing contained in this course shall be construed as providing such service. Every investor should always seek the advice of his or her tax and/or legal advisors regarding his or her specific situation. 


David Frederick
David Frederick Realty, Inc. 

702 McKinley Avenue 
Huntsville, AL 35801
Phone: 256-539-5393 
Fax: 256-536-5533
Contact Me

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