What is Your Marginal Tax Rate, and Why is It Important to You?

marginal tax rateUnless you make your living by helping people complete their returns, you probably prefer to spend as little time as possible thinking about income taxes. The rules and forms are generally opaque and the process is often stressful. However, there is at least one concept in the U.S. tax system that is both very simple and really important, and yet I find that it is unfamiliar to many. That concept is the Marginal Tax Rate, and the short version goes  like this:

Your marginal tax rate is the rate at which your next dollar of income will be taxed.

Now let’s see just how that works and why it matters to you.

Tax Brackets

If the U.S. had a so-called “flat tax,” then each person would pay a fixed percentage of his or her income. For the sake of example (and putting all political agendas aside), let’s say the flat rate were 10%:

$10,000 income x 10% = $1,000 tax

$1,000,000 income x 10% = $100,000 tax

Simple enough, and the person with the higher income would pay a proportionally higher tax.

However, the U.S. has instead what is called a “progressive” tax system. It’s like a layer cake. The bottom layer is taxed at a certain rate; the next layer is taxed at a higher rate; the next at a still higher rate. We call these layers “tax brackets.” Here is what the brackets for a married couple filing jointly looked like in 2015:

Screenshot 2016-02-03 10.37.06

The logic here is that the higher your income, the higher the rate at which that income will be taxed. The tax rate becomes progressively higher as income increases, hence the name.

What Is Marginal Tax Rate?

Your marginal tax rate is simply the rate at which your next dollar of income will be taxed. Let’s say that our married-filing-jointly couple, Jack and Jill, had income only from their jobs in 2015. After deductions, they had a taxable income of $74,900. They are at the top of what we would call the “15% tax bracket.”

Then Jill received a one-time year-end bonus of $1,000, raising their total family income to $75,900. How much of that bonus will be lost to federal tax? Recall our table:

Screenshot 2016-02-03 10.47.12

Every dollar earned starting with dollar # 74,901 (and continuing until 151,200) is going to be taxed at 25%. So she will pay $250 of that bonus in federal tax.

$1,000 x 25% = $250

What Marginal Tax Rate Isn’t

If someone were to ask our couple what tax bracket they were in, they would say, correctly, “25%.” Many people assume, incorrectly, that this would mean they are paying 25% of their total income in taxes. But that is not the case. This couple is paying 10% of their first $18,450 of income, 15% of the next $56,450, and 25% of the last $1,000.

And so, they are actually paying an effective rate that is just a bit less than 14%.

Screenshot 2016-02-03 10.32.27$75,900 income / $10,562.50 tax = 13.92% effective tax rate

Why Does It Matter to You?

Now that you understand how it works, you ask the obvious existential questions: So what? Why do I care?

Knowing your marginal tax rate is essential to anticipating the tax consequences of new income or new deductions. Consider some examples:

Our couple knows that their effective tax rate is currently around 14% but their marginal rate is 25%. What if they decide to acquire a profitable new investment property? They need to recognize that the additional income, which is layered on top of their employment income, is going to be taxed at their marginal rate of 25%. That information may factor into their decision as to whether the income from that property, after-taxes, is attractive enough to justify the cost and the effort.

What if they were thinking about making a $1,000 donation to charity at the end of 2015, or possibly waiting until next year to do so? If Jill’s bonus is indeed a one-time event, she would save $250 on their joint taxes if she makes that donation this year, while she is in the 25% bracket; but she would save only $150 if she waits until next year when she expects to drop back under the 25% marginal rate and into the 15% bracket.

Perhaps in 2016 this couple encounters a fantastic real estate opportunity where they make a quick $85,000 profit. Short-term gains are treated as ordinary income, so add this profit to the $74,900 taxable income they had expected from their jobs and you can see that they will catapult across two tax brackets. At $159,900, assuming the bracket table remains the same, their marginal rate is going to jump to 28%.

Screenshot 2016-02-03 10.47.32

By being aware of their new marginal rate and where it is that they may fall within that 28% tax bracket, they can do some sensible tax planning. It looks like $8,700 of their income (i.e., the amount that their 2016 income is over $151,200), will be taxed at 28%. Are there some 2017 deductions that they could accelerate into 2016? Perhaps they could pre-pay the property taxes on their home. All or part of that deduction would save 28% if they took it the year of atypically high income, versus 15% in a year where their income returned to the 15% bracket.

One word of caution to so-called high-income investors (and that could mean folks with income as low as about $200,000 for individuals or $250,000 for joint filers): There are a variety of potential gotchas lurking for you in the ever-changing tax code. Certain deductions or exemptions may phase out, and the Net Investment Income Tax may kick in. Don’t try parsing this at home; consult a professional tax advisor.

For most people, however, awareness of your marginal tax rate and where you fall in the tax-bracket chart can be a big help in understanding the consequences of changes in income and making informed tax-planning decisions.

—-Frank Gallinelli

Want to learn more about real estate investing? Visit learn.realdata.com

Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

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Copyright 2016,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles and blog posts that appear on realdata.com is provided as general information and is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

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Loan payments, escrow and other monthly considerations

Question from a Customer:

“With regards to the loan amortization, does the loan calculation take into account an escrow account or is there a section to enter separate escrow account payments? Or is it easier to book the annual taxes and insurance separate letting the loan calculator calculate just the payment and loan balance?”

Answer:

Thanks for your question. The amortization schedule on the RealData Calculator is designed to focus strictly on the loan itself, tracking the principal and interest portion of each payment, and the ongoing balance. It gives you the option of dealing with  lot of real-world loan scenarios, such as interest-rate changes, extra payment to principal, and skipped payments. The escrow account, however, is something that is separate from the loan, and we think it’s best not to let that obscure the tracking of the loan.

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Real Estate Expense Recoveries—What are they, how do they work? (part 3)

In Part 2 of our discussion of real estate expense recoveries, we looked at several different methods that property owners use to recover some of their operating costs from tenants:

  • Simple pass-throughs — These typically work well in single-tenant properties, or in properties with no common area. The expenses chosen for reimbursement are billed to the single tenant; or if there are multiple tenants, then the charge is divided according to each tenant’s share of the total space.
  • Expense-stop pass-throughs — Some pass-through arrangements require the tenants to pay a just portion of the recoverable expenses. The landlord pays up to a certain amount, called an “expense stop,” and the rest is passed through to the tenants. The “stop” can be a dollar amount defined in the lease, or it can be a “base-year stop,” where the landlord pays whatever amount comes due in the first year of the lease and the tenants pay any increase in subsequent years.
  • CAM — In larger properties, where there is common space for the benefit of all tenants as well as for the public, the landlord my collect CAM (Common Area Maintenance) charges—expenses related to the maintenance of these common areas.

We left off at sticking point, however, regarding larger properties. If there is a significant amount common area, then the landlord will surely be thinking about the fact that this space accrues to the benefit of the tenants but doesn’t earn anything for the landlord. There must be a way to remedy this apparent inequity.

 

The Load Factor

Enter the “load factor.”

Fotolia_42618982_XSload factor

Recall two definitions near the end of the previous article:

usable square feet (usf): The amount of space physically occupied by a tenant.

rentable square feet (rsf): The amount of space on which the tenant pays rent.

The load factor represents a percentage of the common area, which is then added onto a tenant’s usable square footage to determine the tenant’s rentable square footage.

Let’s say a shopping center has a total area of 100,000 square feet. 90,000 is the usable area, occupied by tenants, and 10,000 is common area.

Load Factor = total area / usable area

Load Factor = 100,000 / 90,000

Load Factor = 1.11

What this means is that each tenant’s usable square footage will be multiplied by 1.11—in other words, bumped up by 11%—to determine its rentable square footage, the amount on which it pays rent.

Say for example that you operate a 2,000 square foot boutique in this 100,000 center, and have contracted to pay $40 per rentable square foot.

2,000 usable sf x 1.11 load factor = 2,220 rentable sf

2,220 rsf x $40 = $88,800 per year rent

Unlike what you did in the earlier pass-through models, you’re not paying an additional charge on top of your base rent here. Your base rental rate remains the same, but now it is applied to a greater number of square feet—the space you actually occupy plus a proportional share of the common area. This combination of your private space plus a pro-rata portion of the common space is what we now call your rentable square feet.

You and the other tenants are paying rent for your proportional shares of the common area from which you all benefit, and the landlord is receiving rent for all the space in the property. Cosmic equilibrium is restored.

 

Is It More Income or Less Expense?

Regardless of the name we give it—reimbursement, recovery, or pass-through—the end result is the same. The bottom line of our Annual Property Operating Data (APOD) form, Net Operating Income, is increased. The final issue to confront is how do we account for this additional money when we assemble a presentation or analysis?

more lessOne way that I see often, and which I believe to be incorrect, is to treat the reimbursement as if it were a negative expense—in other words, to show the expense reduced by the amount reimbursed. For example, if the actual property tax bill were $10,000 and the amount reimbursed were $9,000, then by this method the property tax expense would be shown as $1,000. Why do I say this is incorrect?

The purpose of an APOD, or of any income-and-expense statement, is to convey information that is both accurate and useful. The taxes for this property are $10,000. If you were a broker or property owner and handed me a report that showed taxes of $1,000, I would…

a) suspect you were trying to con me

b) doubt all of the rest of the numbers on your report

c) be denied essential information I need to evaluate the property (e.g., the true cost of property taxes and the lease terms regarding expense reimbursement)

d) find another broker or owner to work with

e) all of the above

The correct answer, of course, is “e.” You’ve missed a key ingredient of successful business discourse: clarity. You should convey your analysis of a property in terms that are unambiguous, accurate, and relevant to your audience.

If you don’t treat the reimbursement as a negative expense, then how should you handle it?

You should treat it as revenue, the same as rent.

  • It is rent. The amount may be based on a calculation involving one or more operating expenses, but it is still money paid by a tenant to a landlord under a lease agreement. If it walks like a duck, etc.
  • Many lease agreements will in fact describe the reimbursement as additional rent.
  • You can then apply a vacancy allowance to the total of base rent plus recoveries to account for the loss of both from a vacant unit. The top portion of your APOD might look like this:

(One side note on the interplay of vacancy on expense recoveries: Some leases will contain a gross-up clause. In such a lease, if there is less than full occupancy (which is defined in the lease, and is often pegged at 90 or 95%), then the landlord may take certain variable expenses that would be directly affected by the level of occupancy, such as janitorial cost, and “gross them up” to the amount they would be at full occupancy.)

In these three articles I’ve given you the abridged version of simple, single-tenant pass-throughs; pro-rated multi-tenant pass-throughs; expense stops; base-year stops; CAM charges; load factors; and even presentation issues. But there is no limit to the creativity of landlords and tenants in their pursuit of successful dealmaking. If you’ve been part of novel expense-recovery design, please share it with us.

—-Frank Gallinelli

Want to learn more? Visit learn.realdata.com

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

Copyright 2016,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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Real Estate Expense Recoveries—What are they, how do they work? (part 2)

Expense recoveries (aka reimbursements or pass-throughs) serve as a customary ingredient in leases for non-residential property. In part 1 of this article, I discussed some of the typical ways such an arrangement might play out.


The Simple Pass-Through

Fotolia_84790892_XS_split_costsIn a single-tenant property the tenant may be expected to pay all or a portion of certain operating expenses, such as property taxes and insurance, in addition to its base rent. If the tenant is obliged to pay just a portion of the expense, that amount is the excess over what is called an “expense stop.” Let’s say the property taxes are $12,000 and the lease requires the tenant to pay the excess over an expense stop of $4,000. The tenant would have to pay $8,000.

property tax expense — expense stop = expense reimbursement

$12,000 — $4,000 = $8,000 expense reimbursement

If this were a multi-tenant property, the recoverable amount would typically be pro-rated among the tenants—that is, it would be divided up according to the square footage of each tenant’s space in relation to the whole.


Base-Year Expense Stop

A variation on the expense-stop theme is the “base year expense stop.” In this scenario, the parties agree that the landlord will pay the full amount of the recoverable expenses for the first year, and in future years the tenant will pay any increase over that base.

An arrangement like this certainly seems straightforward enough, but prospective tenants sometimes view it with a jaundiced eye. What if the landlord tries to maneuver the timing of base year expenses in order to minimize them? Then the excess in subsequent years would be artificially inflated. If that’s a concern, then perhaps the tenant would prefer a pre-defined expense stop, as in the earlier example.

Keep in mind that the tenant does not pay these expenses directly to the original source of the bill. The landlord pays the tab and passes the appropriate charge through to the tenant, hence the term “expense recovery” or “reimbursement.”


Common Area Maintenance

furniture in small spaceNot every property will fit into a nice, neat, divisible mold. Take, for example, an office building or a larger shopping center. Properties like these may include areas such as lobbies, hallways, elevators, escalators, rest rooms, and parking lots—areas provided for the benefit of all the tenants, as well as for the public served by those tenants (i.e., their customers or clients). In addition, there may be services that the landlord provides for everyone’s benefit, such as security, trash removal, and janitorial. How does the property owner pass these costs through to tenants?

One approach is to bundle up the cost of common services into an item called CAM— Common Area Maintenance charges— and to pass that charge through based on square footage, just as one might pass through a property’s tax expense. Let’s take a tenant who occupies 2,000 square feet out of a total of 10,000; and let’s also say that we have identified $1,000 in total CAM charges for a given time period.

pro rata share of space x CAM charge
= expense reimbursement

20% x $1,000 = expense reimbursement

= $200 expense reimbursement

This method may be fine in situations where the CAM charges are based mainly on services, but the property owner might be less than satisfied with this approach if the property has a significant amount of physical area devoted to common use. Why?


Usable vs. Rentable

Perhaps the answer lies in that we mean by “space.” Let’s pause for two definitions:

usable square feet (usf): The amount of space physically occupied by a tenant.

rentable square feet (rsf): The amount of space on which the tenant pays rent.

The common area represents space from which the tenants benefit, but that space is not part of their private, usable square footage. The common space is being used for lobbies and hallways and rest rooms, so it’s not available to lease out and earn rental income. This would not appear to be an ideal business plan for the landlord. Should the landlord absorb the loss? Is there an alternative?

The answer, and more, in our final installment about expense reimbursements.

—-Frank Gallinelli

Want to learn more? Visit learn.realdata.com

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

Copyright 2016,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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New Edition of Frank Gallinelli’s “What Every Real Estate Investor Needs to Know..”

book1 ed3Frank Gallinelli’s popular book, “What Every Real Estate Investor Needs to Know about Cash Flow…” is now available in a new third edition. Frank has added detailed case studies while maintaining the essentials that have made his book a staple among investors. The new cases show how to evaluate an apartment building, a mixed-use, and a triple-net leased property — not just running the numbers, but also looking beyond the surface data to see how you might discern what’s really going on with a potential investment.

See the new edition at Amazon here.

McGraw-Hill first published Frank’s book in 2003 and has since sold over 100,000 copies. For more than a decade it has been a top title in the real estate section at Amazon.

For those seeking reviews from readers, look to the 100+ reviews of the second edition at Amazon, which collectively rate the book at 4.6 out of 5 stars.

And finally, a visual clue: Second edition has a blue cover, new third edition has a green cover.

 

 

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New Online Course—Introduction to Real Estate Investment Analysis

REIA Course Logo croppedReaders of my books—especially What Every Real Estate Real Estate Investor Needs to Know About Cash Flow…—have been asking if I would ever be teaching a course. The answer, finally, is “yes.” I’ve just released a comprehensive online course with more than 30 video lessons (including case studies) plus quizzes, practice problems, and other resources.

Real estate investing is all about the numbers, and in this course I teach you about the metrics, concepts and techniques used by successful investors—how to make smart and profitable investment decisions, and how to be alert to dicey deals. In my case studies, I show you not only how to run the numbers, but also how to look beyond the raw data for clues about potential opportunities and pitfalls.

You can scope out the course and the complete syllabus at learn.realdata.com

Wishing you successful investing,

Frank Gallinelli

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Real Estate Expense Recoveries—What are they, how do they work? (part 1)

If you’ve gotten involved as a landlord or tenant with non-residential real estate, such as retail or office buildings, then you have probably encountered a phenomenon that may go by any of several names: expense recoveries, expense reimbursements, pass-throughs, or common area maintenance (CAM) charges. What exactly is this phenomenon and how does it work?

The typical commercial lease will specify a base rent, sometimes as a dollar amount per month or year, but more often as an annual number of dollars per rentable square foot of space occupied by the tenant. Many leases also call for additional rent over the base amount in the form of expense reimbursements.

How it Works—The Math

Vector modern flat business background. Eps 10Let’s take a simple example. Say that you own a single-tenant property with 10,000 rentable square feet. The lease specifies a base rent of $30 per square foot. It also says that the tenant is obligated to reimburse you, the landlord, for all property taxes in excess of $4,000 per year. The $4,000 cut-off is called an expense stop.

In the first year of the lease, the total property tax bill is $12,000. How much will the tenant pay during the first year? Start with the base rent:

area x rate = base rent

10,000 square feet x $30 per sf = $300,000 base rent

Now calculate the reimbursement:

property tax expense — expense stop = expense reimbursement

$12,000 — $4,000 = $8,000 expense reimbursement

So the tenant is going to pay a total of $308,000 in the first year.

What happens if the space is divided among multiple tenants? While the leases for these tenants could be structured in any way to which the parties agree, the most common arrangement would be to allocate the reimbursements according to each tenant’s pro-rata share of the total rentable square footage.

Let’s say now that instead of occupying the entire rentable area, the tenant we’ve been discussing takes up only 2,000 square feet and the remainder is rented to other businesses. The calculation of the base rent works just as it did before (area x rate = base rent), but the reimbursement involves an additional factor, the tenant’s pro rata share. Since the tenant occupies 2,000 of the 10,000 square feet total, its share is 20%

pro rata share x (property tax expense — expense stop)
= expense reimbursement

20% x ($12,000 — $4,000) = expense reimbursement

20% x $8,000 = $1,600 expense reimbursement

As before, we add that to the tenant’s base rent

2,000 square feet x $30 per sf = $60,000 base rent

to get a total of $61,600.

In this example, we have been passing through just one expense, but the landlord and tenant can agree to pass through as many or as few as they like. Property tax is probably the most common, and a lease that has just that single reimbursement is called a net lease. If the lease passes through both taxes and insurance, it is called a net-net lease. And if it adds tenant responsibility for repairs and maintenance into the deal, it is called a triple-net lease.

How it Works—The Practical Issues

All this is nice in theory, but how does it work in practice? Does the property owner let the tenant pay the bills?

doodle building earthquakeHardly ever. If you as a property owner pass property taxes or insurance cost–or any other expense for which you are responsible–on to a tenant, what you should do is pay those expenses directly yourself and send your tenant a bill for the reimbursable amount. A moment’s reflection will make the reason for this immediately obvious. Do you really want to rely on a third party to pay your tax or insurance bill on time? What if they don’t? You’re probably already picturing the nightmare scenario, where the insurance bill was left unpaid by the tenant, and then a catastrophic uninsured loss occurred. Or the tax bill was ignored, and you end up with a lien against your property and a black mark on your credit. If it’s your bill, pay it yourself and then collect from the tenant.

More…

Now that we’ve nailed down the basic mechanics of expense reimbursements, we want to go a bit further. There are some variations we should look at, like base-year reimbursements and CAM charges; there are some accounting and presentation issues worth considering; and there is the fundamental question as to why commercial landlords and tenants follow this pass-through practice at all. Come back for Part 2 to find out more.

—-Frank Gallinelli

Want to learn more? Visit learn.realdata.com

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2015,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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New Short-Term Analysis Mode in REIA Pro

Today we are releasing build 1.07 for Windows and build 1.13 for Macintosh of our REIA Professional product to add a third “short term” analysis mode.  This is a free update for all those who have a license for REIA Pro v17.

Select the mode on the General Settings worksheet:

By making this selection, the software reveals a set of worksheets that are specific to a 24 month analysis.  In a typical short-term scenario, you plan to purchase a property, do some renovations, and then resell within two years.

With the addition of this feature, we can now say that REIA Pro has all the features that REIA Express has, plus many more.  See a feature comparison of the two REIA Products for more information.

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Reserves for Replacement and Income-Property Investing

It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.


What are “Reserves for Replacement?”

Nothing lasts forever. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. Think HVAC system, roof, paving, elevator, etc. The question is simply when, not if, these and similar items will wear out.

A prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future.

Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.”


Where do “Reserves for Replacement” Fit into Your Property Analysis?

This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios.

reserves for replacement, after NOI

Now let’s move the reserves above the NOI line.

reserves for replacement, befeore NOI

The math here is pretty basic. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases.


Which Approach is Correct?

There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation.

That approach, which you will find in most real estate finance texts (including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income.

This makes sense, I believe, for a number of reasons. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes.

Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. It is still our money, unspent.


What Difference Does It Make?

Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. The formula is familiar to most investors:

Value = Net Operating Income / Cap Rate

Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. If reserves are below the NOI line, as in the first example above, then this is what we get:

Value = 55,000 / 0.07

Value = 785,712

Now let’s move the reserves above the NOI line, as in the second example.

Value = 45,000 / 0.07

Value = 642,855

With this presumably non-standard approach, we have a lower NOI, and when we capitalize it at the same 7% our estimate of value drops to $642,855. Changing how we account for these reserves has reduced our estimate of value by a significant amount, $142,857.


Is Correct Always Right?

I invite you now to go out and get an appraisal on a piece of commercial property. Examine it, and there is a very good chance you will find the property’s NOI has been reduced by a reserves-for-replacement allowance. Haven’t these people read my books?

The reality, of course, is that diminishing the NOI by an allowance for reserves is a more conservative approach to valuation. Given the financial meltdown of 2008 and its connection to real estate lending, it is not at all surprising that lenders and appraisers prefer an abundance of caution. Constraining the NOI not only has the potential to reduce valuation, but also makes it more difficult to satisfy a lender’s required Debt Coverage Ratio. Recall the formula:

Debt Coverage Ratio = Net Operating Income / Annual Debt Service

In the first case, with a NOI of $55,000, the DCR would equal 1.41. In the second, it would equal 1.15. If the lender required a DCR no less than 1.25 (a fairly common benchmark), the property would qualify in the first case, but not in the second.

It is worth keeping in mind that the estimate of value that is achieved by capitalizing the NOI depends, of course, on the cap rate that is used. Typically it is the so-called “market cap rate,” i.e., the rate at which similar properties in the same market have sold. It is essential to know the source of this cap rate data. Has it been based on NOIs that incorporate an allowance for reserves, or on the more standard approach, where the NOI is independent of reserves?

Obviously, there has to be consistency. If one chooses to reduce the NOI by the reserves, then one must use a market cap rate that is based on that same approach. If the source of market cap rate data is the community of brokers handling commercial transactions, then the odds are strong that the NOI used to build that market data did not encorporate reserves. It is likely that the brokers were trained to put reserves below the NOI line; in addition, they would have little incentive to look for ways to diminish the NOI and hence the estimate of market value.


The Bottom Line – One Investor’s Opinion

What I have described as the standard approach – where reserves are not a part of NOI – has stood for a very long time, and I would be loath to discard it. Doing so would seem to unravel the basic concept that Net Operating Income equals revenue net of operating expenses. It would also leave unanswered the question of what happens to the money placed in reserves. If it wasn’t spent then it still belongs to us, so how do we account for it?

At the same time, it would be foolish to ignore the reality that capital expenditures are likely to occur in the future, whether for improvements, replacement of equipment, or leasing costs.

For investors, perhaps the resolution is to recognize that, unlike an appraiser, we are not strictly concerned with nailing down a market valuation at a single point in time. Our interests extend beyond the closing and so perhaps we should broaden our field of vision. We should be more focused on the long term, the entire expected holding period of our investment – how will it perform, and does the price we pay justify the overall return we achieve?

Rather than a simple cap rate calculation, we may be better served by a Discounted Cash Flow analysis, where we can view that longer term, taking into account our financing costs, our funding of reserves, our utilization of those funds when needed, and the eventual recovery of unused reserves upon sale of the property.

In short, as investors, we may want not just to ask, “What is the market value today, based on capitalized NOI?” but rather, “What price makes sense in order to achieve the kind of return over time that we’re seeking?”

How do you treat reserves when you evaluate an income-property investment?

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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The Cash-on-Cash Conundrum – a Postscript

A while back, I posted a two-part series called “The Cash-on-Cash Conundrum.” In the first installment I explained the calculation and underlying logic of CoC, and in the second I discussed some of the pitfalls of overreliance on this particular measure.

big pile of dollars

I try to keep my ear to the ground by reading and sometimes contributing to investor forums, where I continue to see a good deal of discussion on the question of what is or what should be the metric of choice for real estate investors. My unofficial and unscientific gauge of the general sentiment is that most investors agree that cash flow is king. Although I would be reluctant to crown any single measure as the absolute be-all and end-all for property analysis, I agree that cash flow is indeed a critical measure of the health of an investment property.

So what’s the big deal? What concerns me is that I see a kind of tunnel vision on this topic. I frequently hear some variation of these two statements bundled together: “Cash-on-cash return is the only reliable metric and the only one I really need,” and “IRR and Discounted Cash Flow analysis are bogus – they’re a waste of time because you just can’t predict the future.” To put it simply, these folks are saying that they trust CoC because it looks at the here and now, and they distrust IRR/DCF because it tries to look into the future.

On the surface, that argument might seem reasonable enough. Cash-on-Cash return is the property’s expected first-year cash flow before taxes, divided by the amount of cash invested to make the purchase; it’s quick and easy to calculate, and it does indeed focus on a more-or-less tangible present. A strong CoC unarguably provides a good sign that your investment is off on the right foot.

Is that the end of the story – or should it be? I think this narrow focus can cause an investor to miss some vital issues.

By adopting the “can’t predict the future” argument, aren’t you ignoring what investing is all about? You don’t have a crystal ball, but still — isn’t investing about the future, and isn’t the ability to make sensible choices in an uncertain environment a key trait of the successful investor?

I find it difficult to accept the argument that I should make a decision to buy or not to buy an investment property based on its first-year cash flow alone and without regard to projections of future performance. Ironically, there is a hidden message in this point of view: If the first year performance data is sufficient, then apparently I should believe that such data will be representative of how well the property will perform all the time. In other words, it really is OK to predict the future, so long as I believe the future will always be like the present.

I would argue that it is in fact less speculative to make the kind of projections that you typically see in a Discounted Cash Flow analysis, where you look at the anticipated cash flow over a period of time and use those projections to estimate an Internal Rate of Return over the entire holding period.

With any given property, there may be items that you can forecast with a reasonable degree of confidence. For example, on the revenue side you may have commercial leases that specify the rent for five years, ten, or even more. You may even be able to anticipate a potential loss of revenue at a point in the future when a commercial lease expires and you need to deal with rollover vacancy, tenant improvements, and leasing commissions.

You could be looking at a double- or triple-net property where you are insulated from many or most of the uncertainties about future operating expenses like taxes, insurance and maintenance.

Or, with residential property, you may have a history of occupancy percentage and rent increases that permit a credible forecast of future revenue.

Then there is the more basic question, why are you analyzing this property at all? Why are you running the numbers and making this CoC calculation? Are you trying to establish a current market value, as a commercial appraiser might? Or are you trying to make a more personal decision, i.e., will this particular property possibly meet your investment goals? And what are those goals?

Seems like I just took a nice simple metric and wove it into a more complicated story. Sorry, but in your heart of hearts you know if investing really were that simple, then everyone with a pulse would be a huge success. At the same time, it doesn’t have to be so complicated either, so long as you approach it in a reasonable and orderly way.

That orderly approach begins with deciding what you are looking to get out of this investment. Maybe you want to hold it for a few years to get strong cash flow and then sell it, hopefully for a profit. Perhaps you intend to hold it long term, less concerned with immediate cash flow (so long it as it positive), and then sell the property much later to fund your children’s college costs or your own retirement. In either case, if your plan is to buy and hold then there is one thing you can’t ignore: the future.

This approach continues with projection of the revenue, expenses, potential resale, and rate-of-return metrics, running out to your intended investment horizon. Perhaps key here is the realization that you shouldn’t really expect to nail your projections with a single try. Consider several variations upon future performance: best-case, worst-case and somewhere in-between scenarios to give yourself a sense of the range of possible outcomes.

All this brings us back to the duel between the Cash-on-Cash metric and DCF/IRR. I believe if you rely only on the former, then you are not just saying, “You can’t predict the future.” You’re saying, “If the first year looks good, then that’s all I need to know.” This is, quite literally, a short-sighted investment strategy. The takeaway here is that there should be no duel between metrics at all; that prudent investors can use Cash-on-Cash to get an initial reading of the property’s immediate performance, but they should then extend their analysis to encompass the entire lifecycle of the investment. To quote the folks at NASA (who, after all, really are rocket scientists), “It takes more than one kind of telescope to see the light.”

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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