# Category: articles

## The Cash-on-Cash Conundrum, Part 2

In the first part of our discussion, you looked at the simple math that underlies Cash-on-Cash Return. The short version goes like this:  First you calculate your property’s first-year cash flow before taxes—essentially all the cash that comes in from operating the property minus all the cash that goes out. Then you divide that by your initial cash investment, and that percentage is your Cash-on-Cash Return. Nothing could be simpler.

Simplicity is a good part of CoC’s appeal. Unfortunately, that is also part of its weakness. If you are using this metric to help you decide whether a potential income-property purchase is a promising investment or not, then you need to look carefully at the story—or stories—that may lurk behind these numbers. In keeping with our literary metaphor, let’s call them our subplots.

Subplot #1: A Point in Time

Clearly, when you take the first-year’s cash flow and divide it by the cash used to purchase, you are looking at a property’s performance essentially at a point in time, a single year. To be sure, the reliability of your cash flow projection is likely to be greatest in that one, immediate time frame. I often hear investors say that they are not comfortable trying to predict the future, that they would rather just look at what is happening now; and they are quite justified in saying that if the return looks grim or perhaps negative right out of the box, then they have no interest in looking further.

Understandable, but potentially shortsighted—literally. By looking at a single year, you are looking at what may be an improbable investment horizon.  Will you keep this property for just one year? If not, if you plan to hold on to it longer, then you’re not taking into account anything having to do with its possible future performance.  Do you believe each future year will be exactly like this year, or could reasonably anticipated changes in cash flow (such as schedule increases in commercial lease rents, or large expenditures for needed repairs) push the needle far to one end or the other?

Subplot #2: The Time Value of Money

“All right,” you say, “then I’ll estimate the Cash-on-Cash Return for each of the next several years.” That may look like a step in the right direction, and I talk to a lot of folks who insist on doing just that, but it won’t take into account the time value of money.  You’ll be looking at the face value (undiscounted) of expected future cash flows, and weighing them against the present value of your cash investment today. Go back to that original example, where you invested \$100,000. If you predict a \$20,000 cash flow ten years from now, does that really mean your investment is returning 20%?

To be fair, future-year Cash-on-Cash can impart some useful information. For example, if the metric is both positive and increasing, then you can infer that your cash flow is improving each year. The trend can help inform your decision, but the actual percentage return may not have a great deal of meaning.

Subplot #3: Smoke and Mirrors

You retreat and say, “OK, let’s go back to thinking about just the first year of operation. Surely the Cash-on-Cash should give me a good sense of initial performance.” Do you remember the old computer chestnut, “Garbage in, garbage out?” Your results are only as good as the assumptions and data that you put in the dispose-all, and perhaps things aren’t always (or ever) what they seem.

Consider:

You are looking at in income-and-expense statement (what we call an APOD in real estate investing—Annual Property Operating Data) provided by the seller of the property. The cash flow is based, in part, on operating expenses, one of which is Maintenance and Repairs. The figure in the example above is \$6,000; you secure the owner’s tax return and confirm that this is indeed the figure he declared.

That is how much he actually spent, but the figure seems a bit low to you. Does it mean the owner performed as little maintenance as he could get away with and never fixed anything until it was absolutely necessary?  Perhaps the owner did this to prop up the property’s cash flow in anticipation of selling. Despite the fact that the expense disclosed is technically correct, you decide you shouldn’t use it as a forward-looking assumption. Instead, you will probably have to project spending more once you take ownership, resulting in a diminished cash flow and a lower Cash-on-Cash Return. In addition, the property may actually be worth less than you assumed, since it does not throw off as much net income as you were led to believe.

Now take a different point of view. Based on your experience, you think the maintenance and repair expenditure shown is surprisingly high. Could there be an explanation for that? Perhaps the owner used the past year to catch up on deferred maintenance so the property would look more presentable when he put it up for sale.  You might be tempted (but only in your most private thoughts) to test the impact of lower maintenance costs on your cash flow and CoC return.  Once again, the amount that was disclosed, although correct, may not be the amount that gives you the best estimate of future cash flow or Cash-on-Cash Return.

Subplot #4: The Forecast—Cloudy, with a Chance of Cash Flow

Finally, there is the larger issue of the structure of the cash flow statement itself. What you decide to include or exclude in your forecast of future cash flow will almost certainly be driven by your personal agenda in creating that cash flow statement.  Are you the seller of the property, looking to make its income stream appear as strong as possible? Are you the buyer, trying to make a realistic projection of how this property will really perform, and perhaps also conveying that stark realism back to the seller as part of your price negotiation?

In either case—as well as in any of several others, such as buyer looking for financing, general partner looking for equity investors, etc.—you might be putting a bit of a spin on the data, the better to support your point of view and the message you want to deliver.

If you’re the seller, then a bit of topspin seems like a good idea to you. In the example shown in Part 1 of this discussion, you might argue that, not only did you provide accurate and verifiable income and expense data, but that you were being exceptionally open and above-board by suggesting an allowance for vacancy and credit loss even though you experienced no such loss.  Group hug.

But if you’re the buyer, you might return this with some backspin. You thank the seller for being so forthright, but add that you believe the vacancy and credit loss allowance should be closer to 5%, not 3%. In addition, you point out that routine maintenance is great, but will not prevent big-ticket items from wearing out eventually. For example, the heating boiler is barely hanging on, and the flat roof has less than 10 years of life left in it. Hence you propose reconstructing the cash flow statement to reflect the higher vacancy allowance, as well as need for an immediate capital improvement and an ongoing set-aside of cash flow into a reserve account to deal with future replacements, such as the roof.

What previously was a robust 10.4% return now becomes an anemic 2.1%.

The seller objects that this isn’t entirely fair, since the boiler repair is a one-off event, and removing that cost would bring us up to 6.1%.

The seller’s argument cycles you right back to Subplot #1 about the hazards of relying on a rate-of-return metric that looks only at a point in time in what is probably going to be a long-term investment.

Is There a Bottom Line?

What should you conclude about Cash-on-Cash Return? Is it, as some contend, the only metric worth looking at?  Is it of no use at all? The best answer probably lies somewhere in between, that you need to recognize both CoC’s strengths and its limitations, and not rely on it as your sole investment decision-making tool.

On the plus side:

• It is quick and easy to calculate.
• It can give an immediate comparison to the return on other short-term investments.
• It focuses on the most current performance of the property; the more recent the data, the more likely it is to be reliable.

Among the negatives:

• It focuses on single point in time; you may be intending to buy and hold for an extended period, and the future performance of the property can differ greatly from the short term.
• It does not take into account the time value of money; if you use it beyond the current period, you may be comparing a future, undiscounted cash flow to the amount invested today.
• It is easy to manipulate the results; hence, a novice investor who relies on this metric alone can be misled by what a third party chooses to include or exclude from a property’s cash flow statement.

So are there some bottom-line recommendations here?  Of course.

Start off by trying to develop a CoC calculation in which you can have reasonable confidence.

To do so, remember that there is no substitute for due diligence. At the most basic level, you need to confirm whether the data you see on the cash flow statement for a particular property is reasonable and accurate. Then you need to go further and examine the physical property and the market to see if there are issues that may affect your confidence in those numbers. Is there any reason to doubt that the current revenue stream will continue as it is now? Is the demand for space in this market changing, for good or ill? Is there deferred maintenance that you will have to deal with? Based on what you find, you may have to reconstruct that cash flow statement.

Don’t just look at what is on the cash flow statement; look for what might be missing. A seller may not volunteer an allowance for vacancy or a need to fund a reserve account, but such items are going to be part of your reality as an owner.

So long as you approach it with sufficient care and due diligence, the Cash-on-Cash Return can give you a useful first look at how a property might perform; but before you commit your investment dollars, you need to do more.

If you plan to operate this property for several years, then you need to take the long view. You should identify your likely investment horizon, and then build a series of pro formas to forecast how the property might perform over time.

A series? Yes. Don’t try to nail your projections of future performance in one pass. Do a best-case, worst-case, and in-between forecast of future cash flows and ultimate resale of the property. Look at the ongoing Debt Coverage Ratio in each case. Examine the IRR or MIRR. Even compare this property to others you might be able to acquire.

Be thorough. Be wary of shortcuts. You’re buying a future income stream; do your homework and run your numbers so you can understand just what it is that you’re buying.  Your investment success depends on it.

— 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.

## The Cash-on-Cash Conundrum, Part 1

Life is too complicated; we have too many choices, too many options, too many channels on cable TV. It’s not surprising that sometimes we crave simple answers to complex questions.

I see that mindset very often in my interactions with real estate investors. They yearn to embrace the “50% rule” or the “2% rule” or some other shortcut that will help them cut to the chase and decide if a particular property is a good deal or not.

One metric that is relatively simple and historically very popular is the Cash-on-Cash Return (CoC). I encounter many real estate investors (more than a few of whom have a net worth significantly greater than that of this writer) who zero in on that metric like a heat-seeking missile whenever they consider buying a property.  What exactly is Cash-on-Cash Return? How do you calculate it? What are its strengths and weaknesses? Is it a good metric, and perhaps more important, is it good enough?

Cash-on-Cash Return may be one of the few bits of financial terminology whose name could almost serve as its definition. You’re expecting to get a cash return on your cash invested, i.e., to earn cash on your cash. If you express the return as a percentage of the amount invested, then you have the Cash-on-Cash metric.

Let’s see this with some actual numbers.  You are considering the purchase of a particular income property. For this discussion, the purchase price of the property is not the number you want to focus on. Rather, it’s the amount of your own money—the cash you actually put on the table—that you’ll be looking at. You need \$100,000 to close the deal.

You’ve obtained information about the rental income, the operating expenses and the expense reimbursements paid by the tenants. To that information you’ve added your own allowance for vacancy and credit loss, as well as your expected annual debt service on the mortgage that you’ll need to complete the purchase. You put this all together into a cash flow statement that looks like this:

Now you do the cash-on-cash math:

So now you see your Cash-on-Cash Return is apparently 10.4%. What are you to make of this?

First, you recognize that this was a very quick and easy calculation to perform. You needed just the amount of your cash investment and some basic information about anticipated revenues and expenditures. No heavy lifting here.

Second, you observe that your cash-on-cash (and therefore your cash flow) is a positive number. That’s really important, because it means you don’t expect to reach into your own pocket to pay the bills. You have more coming in than going out.

Third, you recognize that this really quick calculation allows you to compare the first-year return on this investment to that of other short-term opportunities like CDs or T-Bills. You look at 10.4% and that strikes you as a fairly good rate of return.

In short, your initial take here is that this metric was really easy to calculate; that it told you that the property seemed likely to enjoy a positive cash flow in the first year; and that the rate of return on your cash investment appeared to be significantly better than you might get from a bank or a bond.

Are you satisfied that you can make an informed decision to buy or not to buy this property based on your calculations here? You shouldn’t be. Yes, you believe the rent and expense figures are accurate, and you did the math correctly, but are you confident that you’re seeing the complete picture? My continual mantra to my finance students is, “Look beyond the numbers, look for the story that’s behind what you see on the surface.”

It’s tempting to think that this calculation of cash-on-cash has given you an adequate perspective on how this investment will perform, but there is really a great deal more to look at and to think about here. That’s what we’ll do in the next installment.

(to be continued)

— 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.

## Real Estate Investing: Time to Remember the Lessons of History

As the summer 2013 begins to cool off, many real estate markets are finally starting to heat up. For a lot of folks, who have slogged through five of the worst economic years in memory, it feels a bit like we’ve just been released from the locked trunk of a car.

The temptation now is to celebrate our release from investing confinement by jumping back into the market with both feet. Before we do so, however, it would be wise to reflect on a few of the lessons of recent history.

There were many reasons for the financial meltdown, but one of the biggest surely was the belief that real estate inexorably increases in value over time. To many people, that looked like a law of nature. The reality turned out to be different, and now, as property values start to rise, we have to resist the temptation to start believing this all over again. If not, we will simply create another bubble and repeat the cycle.

Another cause of that meltdown was the tendency to dismiss or completely ignore investment fundamentals.  Real estate simply couldn’t fail to do well (after all, they’re not making any more of it), and we didn’t really need to think too hard about our investments because, surely, they would work out happily in the end.

Savvy investors always knew that this wasn’t necessarily true; they knew that income-producing real estate could go up, down, or sideways.  Time, all by itself, does not create value; the ability of a property to produce income is what creates value, and so the prudent investor would take nothing for granted and always carefully weigh a property’s prospects for generating income today and in the future.

The beginnings of a general economic recoveryand, in particular, a real estate recovery may signal that we can and should get back into the game, but it doesn’t mean that we can return to pre-2008 thinking and disregard the fundamentals that ought to guide our investment decisions:  For example:

Due Diligence: This is just as important in good times as in bad. We need to examine thoroughly and critically all of the financial data we can get our hands on about a potential investment property.  Are the rents really as represented? Are the operating expenses as portrayed by the seller reasonable and complete? Have we done a thorough assessment of the property’s physical condition?

It is essential to remember that a property doesn’t live in a vaccum, so our due diligence needs to extend beyond the individual property and include the local market as well.  What is the prevailing capitalization rate for properties of this type in this market? What kind of rents are similar buildings actually getting, and what are the asking rents in properties that may be in competition with us for tenants? What is the current vacancy rate in this market, and has it been rising or falling? What is the general business climate, and in what direction is it headed?

Cash Flow:    We always need to make hard-headed projections about the prospects for current and future cash flow. Too often we see investors, motivated to make a purchase and get on the presumed gravy train, put together the numbers they want to see.  They ignore the potential for vacancy and credit loss. They ignore setting some of their potential cash flow aside each year as a reserve to pay for that new roof or new HVAC system a few years down the road. We should make best-case, worst-case, and in-between projections to give ourselves a sense of the range of possible outcomes.

It is important to be realistic about cash flow projections. Excessive leverage may seem like a great advantage on the day you close the purchase, but the high debt service may also result in very weak or even negative cash flow. Are you really prepared to support your property out of your own pocket, to absorb unexpected expenses or loss of revenue?

The Long View: We seldom buy an income property with the expectation of flipping it for short-term profit. Rather, our plan is probably to buy and hold so we can derive an annual cash flow plus a long-term gain when we sell. If that is indeed our plan, then we need to forecast the property’s performance not just for one year, but for a likely holding period—perhaps five, seven or ten years—and to compute an Internal Rate of Return for that holding period. Doing so can be especially valuable when we are looking at more than one property that we might purchase.  Which one appears likely to give us the best overall return within our investment horizon?

The Last Word: Investing in real estate can be a profitable move in just about any economic climate if we proceed wisely, so to answer our initial question: Yes—if we’ve been on the sidelines, then this is a fine time to get back in.  But as with any other kind of investment, we can just as easily lose money as make it if we charge ahead without doing our homework and without going through the kind of fundamental analysis and projection that is essential to smart investing. Success in real estate investing, as in most endeavors, doesn’t just happen by good luck or chance. We have to work at it and have our head in the game. The luck will follow.

— 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.

## April 1: RealData Announces New Sales Prevention Initiative

April 1, 2013, For Immediate Release: RealData Announces New Sales Prevention Initiative

In an attempt to stem the inexorable tide of its growing popularity, RealData announced today the formation of a new Sales Prevention Department within the company. “Quite simply, it is time for us to take the bull by the tail,” said company founder and President Frank Gallinelli. We can’t allow these sales increases to go unchecked, so we have assembled a new mismanagement team to deal with the problem. Once we get sales under control, we believe we can go from there to put an end to productivity once and for all.”

Heading the new team will be a specialist in customer alienation. According to Gallinelli, the company needs salespeople who are unencumbered by product knowledge or professional expertise, and technical support personnel who can be relied on to provide cryptic and irrelevant responses or to ignore customer questions entirely. “We need to put the ‘us’ back into user-friendly. There’s no room in the software business for customers who can’t take care of themselves.”

Galvanized by their mantra — “Don’t swim with the sharks, float with the flounder!” —-the team has already begun work on the company’s new support infrastructure called, “FAQ – Frequently Avoided Questions.” Said the CEO, “We must strive to please none of the people all of the time.”

The company’s sales prevention initiative is expected to last throughout most of April 1. 😉

## Investing in Real Estate: How Much Analysis Do You Really Need?

More than once – in my writing, my teaching, talking in my sleep – I have been known to say that real estate investing is all about the numbers. There is, of course, great truth in that pithy statement, or so I believe; but there is perhaps more to the story that you should be careful not to overlook.

The data that you collect about an income-property – the current rental income and operating expenses, the financing options, and the resulting cash flows and potential resale– are all essential to making an informed analysis of a property’s value and its appeal as an investment. So too is an understanding of the key metrics. What are the expected Debt Coverage Ratio, Capitalization Rate and Internal Rate of Return, and what do they all mean?

A wise investor realizes that this information represents the foreground, but not the complete picture. There is a context, a background, in which these data reside, and you ignore it at your peril.

When I teach real estate investment analysis to my graduate students, I begin by telling them that they absolutely must learn how to run and interpret the numbers. But I also stress (sometimes to the point of becoming really annoying) that they have to look behind the numbers, to read the information about the property as if it were a story. The financial facts and figures about a property that you uncover today may be entirely accurate, but can you rely on them them to persist? What are the long-term risks and opportunities, the indirect factors, and how do they inform the numbers that you will plug into your projections?

For example, if you have commercial tenants, how strong are their businesses? One of the case studies I give my students is a mixed-use property with retail tenants whose business models are on the decline. Those tenants have leases with options to renew, but if their customer bases are shrinking, isn’t it more prudent to suspect that they may not choose to renew? Shouldn’t you also consider what could happen to your cash flow in a worst-case scenario, where they go bankrupt before their current leases are up?

Rather than simply assuming an ongoing revenue stream from the current leases, perhaps, as I tell my students, you need to look beyond the current numbers. If you see some significant risk going forward, maybe you should build rollover vacancy, leasing commissions and tenant improvements into your projections of future performance. You’re still going to run the numbers, and they still matter; but now, taking a broader view may alter your perspective on possible future cash flows.

One way to widen your field of vision is to go beyond the specific property and take into account some intangibles, both local and global. Real estate, like politics, is very much a local game. How strong is the local economy? Is unemployment a problem? What is the trend in the absorption of space – are vacancies growing or declining? Where is your city or town’s budget heading? Are there bond issues on the horizon that could materially affect your property taxes? The answers to questions like these will connect directly to the kinds of assumptions you make concerning the risk of future vacancy loss, and the rate of growth, if any, in your rents.

Then there’s the global view. You want to look at how the overall economy might affect your property. For example, it is typically the case that in times of tight credit, or in a miserable economy such as we’ve seen for the past several years, demand for apartments tends to increase. There is nothing surprising in this. Folks can’t get mortgages because their incomes have dropped and perhaps because banks aren’t lending freely. People who would otherwise be prospective homebuyers or who would be able to stay in their current homes are now renting apartments, thus reducing vacancy and often pushing rents upward.

The same causes – a wounded economy and lack of credit – might lead to an opposite effect on office and retail space, where businesses have to downsize because their customers have less money to spend.

So, if you find yourself rolling into a particular economic cycle, then you will want to adjust your projections for the future accordingly. In the example above, you would begin with whatever revenue stream you find in place; then, in the case of apartments, you would probably project declining vacancy loss and increasing rental rates for a few years, but you would probably do the opposite for retail and office. Same starting point, but different paths into the future.

What is our takeaway here? First, that real estate investing really is about the numbers. You’re going to scrutinize every lease, every operating expense, every financing option to understand how you believe the property will function on the day you acquire it. There is no substitute for crunching these numbers, and no reason to dismiss what they tell you.

But then you’ll pause to recognize that you’re probably going to own the property well beyond that first day. That’s when you need to look up from your spreadsheet. You need to look both at and beyond the current data and metrics, to visualize the property and your expectations for it in the context of its larger environment. The numbers truly matter, but so does the sometimes dicey, not-so-tidy real world in which they dwell.

–Frank Gallinelli

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 blog posts and 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.

You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

## Real Estate, Healthcare, and Your 2013 Taxes – Some Surprises Waiting for You?

Champagne, funny hats, and the ball-drop in Times Square might not be the only significant events to mark the New Year in 2013. If you are a real estate investor or a home-seller, you could have a couple of surprises lurking in your federal taxes.

The Medicare Tax

One of those surprises found its way into the Health Care and Reconciliation Act of 2010 at the last minute. If, as the the National Association of Realtors® states, it was added to the legislation at the last minute, then one has to wonder just how carefully our elected officials studied this before passing it.

What It Is Not

There has been a lot of talk and many email blasts, claiming that this is a sales tax on real estate. It is not. It doesn’t apply to every real estate transaction, and it doesn’t get tacked on at the point of sale, the way a sales tax would. That much is clear.

What It Is, Sort Of

The details may seem a bit daunting, but let’s try to summarize:

• It is a 3.8% surtax on “net investment income,” which appears to include rental income, capital gains on the sale of investments (and to a limited extent on the sale of a personal residence), interest, dividends, royalties, and annuities, all net of the expenses to achieve that income.
• It does not apply to withdrawals from IRAs and 401ks, or from veterans benefit,  life-insurance proceeds and several other types of income. (For a further discussion, see this article in Forbes.)
• But wait, it can actually get even more complicated. According to an article in SmartMoney, there is an exception for income from sources that come from business activities. Presumably this would mean that if you derive your livelihood solely from operating rental property or from flipping houses then your rental income or capital gain from those activities is business- and not investment-related; hence it doesn’t go into the bucket of items subject to the Medicare surtax. But that same article notes an “exception to the exception” if the income is from a “passive business activity.”
• It will never apply (should we ever say never?) if your adjusted gross income is less than \$200,000 as an individual or \$250,000 for a married couple filing jointly. Fire up your spreadsheet now, because there is a further test: The tax applies to the lesser of your total net investment income or the excess of your Modified Adjusted Gross Income over the \$200,000 (single) or \$250,000 (joint return) thresholds. (MAGI is the same as AGI for most taxpayers.) Keep in mind a couple of potential “gotchas” in regard to these thresholds. Even though your conventional (not Roth) IRA or 401k withdrawal is not considered investment income for the purpose of this law, it’s still income and could potentially push you over the threshold. Likewise, the gain from the sale of an investment property could catapult you over the line.
• If you are selling your personal residence, you will continue to get the \$250,000 exclusion for individuals, or \$500,000 for a married couples filing jointly, so it is only your gain over that amount that is in play. As before you still have to pay the capital gains tax on your profit in excess of those exclusions. More about capital gains in a moment.
• Congress did not learn its lesson from the Alternative Minimum Tax debacle, because there does not appear to be any provision to index the threshold amounts for inflation, so the tax may affect more people as time goes on.

For more information about this tax, you can refer to the articles noted above as well as a PDF summary put out by the National Association of Realtors®. You’ll find a link to that PDF here.

Capital Gains and the Fiscal Cliff

Another sobering New Year’s Day adventure is what is being called the “fiscal cliff.” Part of the wild ride into the abyss is the scheduled expiration of the Bush-era tax cuts on January 1, 2013. Here, in brief, is what it means for those of us in real estate:

• If you sell your real estate investment property for a profit, that profit is taxed at the capital gains rate. Currently that capital gains tax rate is 15%, but if we go over the fiscal cliff on January 1, 2013, the rate will go to 20% with the potential to add the 3.8% Medicare tax to part of the gain.
• If you sell your home for a profit and if you have a gain that exceeds the \$250,000 or \$500,000 exclusion (not an unrealistic possibility, especially for older homeowners who bought several decades ago – especially in what are now the more costly markets on the coasts like Fairfield County, Connecticut where I live) you may be faced with a similarly higher tax on that gain.

The Bottom Line

I believe the significance of the Medicare tax may be not so much the money it raises – probably not very much – but rather in the anti-investor mindset it reveals. The same would seem to underlie the proposals to raise the capital gains tax. Both taxes suggest to me a policy that puts investing and risk-taking in the crosshairs, that seeks to discourage rather than encourage the activities that are essential to making an economy grow.

This writer shares the opinion of many that higher tax rates on capital gains are a bad idea generally, and a terrible idea during a struggling economy. Existing businesses need capital to grow and startups need capital to launch. If our tax structure is changed to impose a disincentive to invest, then we shouldn’t be surprised to see our economy shrink even further. This WSJ article says it well.

Those who invest and who see investing as vital to our society need to keep careful watch on every new tax proposal and to keep ourselves in the conversation about those proposals. And as this Wall Street Journal article put it: “If you’re planning to sell rental real estate or other investment property, run, don’t walk, to a trusted tax expert.”

–Frank Gallinelli

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 blog posts and 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.

You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

## A book review with some insights for investors

Among the first rules you learn when you become an author are these:

1. Don’t get upset when you get a bad review;
2. Don’t get too excited or too full of yourself when you get a good review.

I believe I am about to sneak up to the very edge of violating rule #2.  That is because my book, What Every Real Estate Investor Needs to Know About Cash Flow…, recently received a customer review on Amazon that was not only lavish and humbling, but which also identified what I had hoped my readers would discover as the key “deliverables” in this book. I want to thank the reader — unknown to me, I promise, but who signs the review as “J. Newman” — for the kind words. I also want to reinforce some important observations made in that review; and so, please permit me a few quotes from the review along with my comments:

“If you think you can get rich investing in real estate in your spare time, with no money down– you are fooling yourself.”

FG: A basic premise of all my writing, and of this book in particular, is that real estate investing is really about building wealth over the long term, and about a realistic commitment of time, effort and resources.

“If you are already a pro– this book will hone your skills and refresh your memory on what is important.

But let me be clear— this is not just a book for the experts– it is a book that will teach a beginner, advance a professional…”

FG: Another bullseye. It doesn’t matter if you are a beginner or an expert; there is always something more that you can learn, and I wrote the book with the intention of helping both novice and experienced investors. When I teach my grad students at Columbia, I am supposed to be the expert. Still, every year, without fail, I find that I learn something from them.

“Now– this is not brain surgery— but ANY investment— (stocks, bonds, real estate etc…) to be successful, requires thoughtful analysis on the front end. This book explains how to properly analyze a real estate investment. This is what all the pros do. This is what the successful guys do. This what the guys who fail do not know how to do.”

FG: This comment speaks for itself. There are no shortcuts. Success in any endeavor requires the mastery of certain critical skills.

“But beware…..the calculations can be done by machine— but you still have to understand how to interpret the answers. And you still need to understand what information to “plug” in—, where to find it and why its important.”

FG: Yes, my company provides software that can do a spectacular job of analyzing an income-property investment. But that doesn’t exempt you from understanding what kind of source data you need or how to interpret the results of an analysis. That’s why investor education is so important. It is a central part of our mission, and always will be.

“This book explains all of that– with wit and wisdom and in a way that makes it fun and understandable.”

FG: A book filled with formulas and numbers could turn out to be truly mind-numbing – then no reader would get anything out of it and the book would be a waste of glue, paper, and space. Fun is good; we should have more of it. I tried to make this book enjoyable to read, and I’m glad you found it so.

—Frank Gallinelli

## Ten Commandments for Real Estate Investors: Commandment #1

Recently I had the honor of being asked to speak at the BiggerPockets Real Estate Investment Summit in Denver. Although I tried to warn them that I was a graduate of the Fidel Castro School of Public Speaking and could talk for four hours from a three-by-five note card, my time was limited. My plan was to conclude with “Ten Commandments for Real Estate Investors,” which I did, but briefly. Thanks to the wonders of modern blog posting, however, I can now share the unabridged version.

Commandment #1: Thou shalt take nothing for granted.

There is a witticism attributed to American humorist Finley Peter Dunne, “You trust your mother but you cut the cards.” In real estate, of course, the parallel concept is due diligence. If you assume that things are as they appear and if you fail to vet your potential deals independently, you’re setting yourself up for unwelcome and expensive surprises.

The cast of characters you may encounter in a real estate deal is almost archetypal. First there is the liar. I still remember well the kindly grandmother who recited to me her property’s rent roll. When I uncovered her perfidy, she explained that she had been telling me how much her tenants should be paying.

Another character is one I call the alchemist. He wants you to look at lead paint and see gold leaf, so he tries to take uncomfortable information and give it a positive spin. “It’s not too small; it’s compact and requires less maintenance.”

Finally there is the person who simply doesn’t volunteer information. He’ll tell you the truth if you ask, but assumes – perhaps justifiably – that it’s not his responsibility to supply the right questions as well as the right answers.

If you have a plan for due diligence and stick to it then you won’t have to rely on information from parties whose interests may not be in concert with yours. That plan should involve both the property and the market in which it is located.

Start with a physical inspection of the property. Deferred maintenance can cut both ways. On the one hand, it represents an expense and may signal that tenants are unhappy.  On the other, it can be an opportunity to remedy a problem, increase revenue and create value. Also look for capital improvements, both completed and needed. Check for code and zoning compliance, and certainly don’t assume that the property’s current use is permitted.

Then consider the financial issues. Examine the leases and look for unusual provisions. Commercial leases in particular can harbor some exotic covenants.  If possible, require estoppel certificates where the tenants can tell you if the lease terms are true and accurate and if there are any outstanding issues or litigation with the landlord. Independently verify expenses like property taxes and assessments, insurance costs and utility expenses. Ask to see historical rent and expense data.

Many investors neglect to go to the next important step, which is to scrutinize the market. What are the prevailing lease rates for properties of this type in this area? How much space like this is vacant in this market? What are the local cap rates for this type of property? What’s going on with employment and municipal budgets? You should know everything possible about the economics and politics of the area where you are buying property – or as I’ve told many investors, you should know where the cracks in the sidewalk are.

And so our first commandment is to take nothing for granted. Rely on your own independent research about the local market and about the particular property. Ronald Reagan may have said it best when negotiating a nuclear treaty with the former Soviet Union: “Trust, but verify.”

The complete “10 Commandments for Real Estate Investors” is available as an ebook on Kindle, Nook, and iBooks.

All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

## Refi Existing Investment Property to Purchase Another?

One of our Facebook fans, Tony Margiotta, posed this question, which I’m happy to try my hand at answering here:

“Could you talk about refinancing an income property in order to purchase a second income property? I’m trying to understand the refinance process and how you can use it to your advantage in order to build a real estate portfolio. Thanks Frank!”

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The Good News

Your plan – to extract some of the equity from an investment property you already own and use that cash as down payment to purchase another – is fundamentally sound. In fact, that’s exactly what I did when I started investing back in the ‘70s, so to me at least, it seems like a brilliant idea.

Of course, you need to have enough equity in your current property. How much is enough? That will depend on the Loan-to-Value Ratio required by your lender. The refi loan has to be small enough to satisfy the LTV required on the current property, but big enough to give you sufficient cash to use as the down payment on the new property.

For example, let’s say your bank will loan 70% of the value of your strip shopping center, which is appraised at \$1 million. So, you expect to obtain a \$700,000 mortgage. Your current loan is \$550,000, which would leave you with \$150,000 to use as a down payment on another property.

Given the same 70% LTV, \$150,000 would be a sufficient down payment for a \$500,000 property, i.e. 70% of \$500,000 = \$350,000 mortgage plus \$150,000 cash.

But Wait… Some Issues and Considerations

Unfortunately, it’s not the ’70s or even ’07 anymore, so while the plan is sound, the execution may present a few challenges. Best to be prepared, so here are some issues to consider:

• In the current lending environment, financing can be hard to find, and the terms may be more restrictive than what you experienced in the past. Notice that I used a 70% LTV in the example above. You might even encounter 60-65% today, while a few years ago it could have been 75-80%.  In order to obtain the loan, you might also have to show a higher Debt Coverage Ratio than you would have in the past – perhaps 1.25 or higher, compared to the 1.20 that was common before.
• How long have you had the mortgage on the current property?  Some lenders will not let you refinance if the mortgage isn’t “seasoned” for a year or even longer.
• How long have you owned the property? A track record of stable or growing NOIs over time will support your request for a new loan.  You need to make a clear and effective presentation to the lender showing that the refi makes sense, especially in a tight lending environment.
• You need to run your numbers and not take anything for granted. For example, will your current property have a cash flow sufficient to cover the increased debt?
• Keep in mind that you’re adding more debt to the first property, so the return on the new property has to be strong enough to justify the diminution of the return on the first.
• Have you compared the overall return you would achieve from the two properties using the refi plan as opposed to the return you might get if you brought in some equity partners to help you buy the new property?

In a nutshell, refinancing an existing income property to purchase another is a time-honored and proven technique, but it in a challenging lending environment be certain you do your due diligence and run your numbers with care.

Of course I never miss an opportunity to promote my company’s software, so consider using that not only to analyze the deal and its variations, but also to build the presentations that will optimize your chances of obtaining the financing and/or the equity investors.

Frank Gallinelli

## 5 Mistakes Every Real Estate Investor Should Avoid

In my nearly 30 years of providing analysis software to real estate investors, and almost a decade of writing books and teaching real estate finance at Columbia University, I’ve had the opportunity to talk with thousands of people who were analyzing potential real estate investments. Some of these people were seasoned professionals, many were beginners or students, but just about all were highly motivated to analyze their deals to gain the maximum advantage.

I’ve seen some tremendous creativity in their analyses, but I’ve also seen some huge missteps. Here are some of the pitfalls you will want to be sure to avoid.

1. The Formula That Doesn’t Compute

If you are attempting any kind of financial analysis, then a full-featured spreadsheet program like Excel is almost certainly your tool of choice. You might opt for professionally built models, like my company’s RealData software, or you could attempt to construct your own.

• One of the most common problems I see in do-it-yourself models is the basic formula error. A robust financial analysis involves the interaction of many elements, and it is really easy to make any of several errors that are hard to detect. The simplest of these is an incorrect reference.  You entered your purchase price in cell C12 and meant to refer to it in a formula, but you typed C11 in that formula by mistake. You may (or perhaps may not) notice that your evaluation of the property doesn’t look right, but it can be difficult for you to find the source of the problem.
• You used to have a formula in a particular cell, but you accidentally overwrote that formula by typing a number in its place. The calculation is gone from the current analysis, and if you re-use the model, you’ll always be using that number you typed in, not the calculated value you expect.
• Cutting and pasting numbers seems innocent enough, but it can scramble your model’s logic by displacing references. Simple rule: Never cut and paste in a spreadsheet.
• Perhaps the most insidious is the formula that doesn’t do what you thought it did. Let’s say you have three values that you enter in cells A1, B1, and C1. You want to write a formula that adds the first two numbers and divides the result by the third. It’s easy to say this in plain English: “I want A1 plus B1, divided by C1.” So you write the formula as =A1+B1/C1. Wrong. Division and multiplication take precedence, so the division happens first and that result gets added to A1. Not what you expected. The formula that does what you intended would be =(A1+B1)/C1, where the sum of A1 and B1 is treated as a single value, divided by C1.

2. The Modern Art Syndrome

Even if you get all of your formulas correct, your job is only half done. I harangue my grad students constantly with this pearl of wisdom: Sometimes you create a pro forma analysis of a property strictly for your own interest. You will never show it to anyone else. Most of the time, however, successful completion of a real estate investment deal means you have to “sell” your point of view to one or more third parties:

• You may be the buyer, trying to convince the seller that your offer is reasonable;
• You may need to convince the lender that the deal should be financed; or
• You may need to show an equity partner that his or her participation would be profitable.

Most of the homebrew presentations that I see look to me like a Jackson Pollock painting with numbers superimposed. The layout usually has a logic that I can’t discern, and I find myself hunting for the key pieces of information that the presenter should have designed to jump off the page.

The layout needs to be orderly and logical: revenue before expenses and both before debt service.

Labels need to be unambiguous:

• If you mention capital expenditures, are they actual costs or reserves for replacement?
• Is the debt service amortized or interest only?
• When you label a number as “Price,” are you talking about the stated asking price, or your presumed offer? Be clear.

Lenders and experienced equity investors will be looking for several key pieces of information before they scrutinize the entire pro forma, items like Net Operating Income, Debt Coverage Ratio, Cash Flow and Internal Rate of Return.  If these items don’t stand out, or if the presentation is disorganized, you might as well add a cover page that says, “ I’m Just an Amateur Who Probably Can’t Pull This Deal Off.”

3. Errors, We Get Errors, Stack and Stacks of Errors

You may be too young to know Perry Como’s theme song (by the way, it was “letters,” not “errors”), but the tune goes through my head when I look at some investors’ spreadsheets.

• The #NUM error can appear when you try to perform a mathematically impossible calculation, like division by zero, or also when attempting an IRR calculation that can’t resolve.
• #VALUE usually occurs when you type something non-numeric (and that can include a blank space, letters, punctuation, etc.) into a numeric data-entry cell. If there are formulas in your model that are trying to perform some kind of math using the contents of that cell, those formulas will fail. In other words, if you try to multiply a number times a plain-text word, you’re violating a law of nature and Excel is going to call down a serious punishment on your head, a sort of high-tech scarlet letter.

It can get really ugly really fast because every calculation that refers to the cell with the first #NUM or #VALUE will also display the error message, so the problem tends to cascade throughout the entire model. Unfortunately, I often see investors who then go right ahead and print out their reports with these errors displayed and deliver the reports to clients or lenders.

Your objective in giving a report to a third party is typically to try to convince the recipient to accept your point of view. You will not accomplish that if your report has uncorrected errors.

4. What’s Wrong with This Picture?

It’s the errors you overlook – the ones that don’t have nice, big, upper-case alerts like #VALUE – that can cause the greatest mischief of all; and these can be troublesome even if the analysis is for your eyes only.

It may be an unwanted and unintended side effect of the computer age that we tend to accept calculated reports at face value. Be honest: How often do you sit at a restaurant with a calculator and verify the addition on your dinner check?

This presumption of accuracy can be dangerous when you are evaluating a big-ticket item like a potential real estate investment. As I discussed earlier, you could have bogus formulas that give you inaccurate results. But even if you use a professionally created tool like RealData’s Real Estate Investment Analysis software, you are still not immune to the classic “garbage in, garbage out” syndrome.

The mistake that I see far too often is a failure to apply common sense. For example:

• “Gee, this investment looks like it will have a 175% Internal Rate of Return. Looks good to me.”  (Reality: You entered the purchase price as \$1,000,000 instead of \$10,000,000. You should have been saying to yourself, 175% can’t be right; what did I do wrong?)
• “Wow, this property shows a terrific cash flow.” (Reality: You entered the mortgage interest rate as 0.07% instead of 7%.) Again, results outside the norm, either much better or much worse than you would reasonably expect, are your tip-off that a mistake is lurking somewhere. It is essential that you develop the habit of examining every financial work-up – those you create, and also those that are presented to you – very closely to see if the calculations appear reasonable.

5. What You Don’t Know CAN Hurt You

The final item in our list of big-time mistakes goes beyond the mechanics of spreadsheets and formulas and into the realm of fundamentals. You can be the most proficient creator of spreadsheet models on the planet, but if you don’t really understand the essential financial concepts that underlie real estate investment analysis, then you will neither be able to create nor interpret an analysis of such property.

The examples that I’ve seen are numerous – I can’t possibly list more than a few here – but they all revolve around the same issue:  A lack of understanding of basic financial concepts as they apply to real estate.  Some of the most important:

• Net Operating Income – This is a key real estate metric, and calculating it incorrectly can play havoc with your estimation of a property’s value. Basically, NOI is Gross Operating Income less the sum of all operating expenses, but I have frequently seen all kinds of things subtracted when they should not be. These have included mortgage interest or the entire annual debt service, depreciation, loan points, closing costs, capital improvements, reserves for replacement, and leasing commissions. None of these items belongs in the NOI calculation.
• Cash flow – I have seen NOI incorrectly labeled as “cash flow,” and have seen cash flow miscalculated with depreciation, a non-cash item, subtracted.
• Capitalization rate – Cap rate is another key real estate metric and is the ratio of NOI to value. Unfortunately, I’ve encountered some folks who have used cash flow instead of NOI when attempting to figure the cap rate and have ended up with a completely erroneous result – not only for the cap rate itself, but then also for the value of the property.

Clearly, there are two vital problems with these kinds of basic errors. First, is that they completely derail any meaningful analysis. If your NOI is not really the correct NOI and your cap rate is not really the correct cap rate, then nothing else about your evaluation of the property can possibly be correct. And second, if you give this misinformation to a well-informed investor or lender, your credibility will evaporate.

The Bottom Line

What is our take-away from these five disasters waiting to happen? You could avoid many of these errors by using the best, professionally developed analysis models – but then, of course, you would expect me to say that because that’s what we do for a living.

Let me suggest three other important steps you can take:

• Understand that there is no substitute for careful scrutiny of any financial presentation, whether it is someone else’s or your own. Be diligent always and  apply the test of reasonableness.
• Recognize that any real estate analysis you create is likely to be a representation to a third party of the quality of your thinking and professional competence. You wouldn’t be careless or casual with a resume; you should give the same care to your real estate presentations.
• Finally, recognize that you need to make a commitment to mastering the fundamental concepts and vocabulary of real estate investing. There is no substitute for knowledge.

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