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

####

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 2013,  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.

How to Create Best-Case and Worst-Case Property Analyses in REIA Professional

You already know that pro forma property analysis is an essential part of due diligence before jumping in and spending your money on a real estate investment.  You also know the value of the pro forma analysis is only as good as the care and consideration you give to all your assumptions about the purchase, operation and sale of the property.  Part of being a cautious and calculating investor is to consider best-case assumptions, worst case assumptions and some case in between.  Fortunately, this is an easy matter with RealData’s REIA Professional.

Here’s how:

  1. Create your initial analysis with REIA Pro with a complete set of assumptions.  It does not matter whether these are conservative or aggressive, just save the file with an appropriate name such as “300 Main Street conservative.xltm”
  2. After saving, use Excel’s Save As function to save a copy of the file with a new name.  That file might be  “300 Main Street aggressive.xltm”  Repeat the process for your third case.
  3. Adjust the data in the second two files to match the case.  Save the files.
  4. Open our Comparison Analysis add-on for REIA.
  5. Click the Add Property button to include all three of the files you have created for your property.  You will then see a side-by-side comparison of key metrics for all of the three cases.

Also consider using our new Decision Maker worksheet right within REIA Pro.  This unique dashboard tool allow you to see how 21 metrics (such as Cash on Cash and IRR) change as you change key assumptions about your purchase.  Change purchase price, vacancy rate, loan terms, etc.

Use these exercises to determine just how well your property might perform under a variety of future occurrences.

 

Update – Personal Financial Statement for Macintosh

We have just rolled out a small but significant update, build 1.79, to the Mac edition of our Personal Financial Statement (PFS) product.

This update brings the popular Import utility from PFS Windows to the Mac along with the User Worksheets feature which is common to all our products.

personal-financial-statement-new-features

 

For those of you unfamiliar with this feature, User Worksheets gives one the ability to add / edit / delete additional worksheets within our product to extend and customize product functionality to fit your specific needs.

The Import utility makes quick work of drawing in all your information from an earlier PFS version 4 workbook.  Just open your old financial statement along with the new blank financial statement template – with one click, all data copies to the new file.

Note that RealData maintains two separate editions for all our products for Windows and Macintosh.  This is essential to assure our products work correctly as intended.  We always develop and test each release on respective Windows and Mac computers.

 

New Software Updates to our Macintosh Products

We have just completed a series of important updates to most of our Macintosh products which address printing and other issues for those users who have Excel 2011. These products include Real Estate Investment Analysis (REIA) Professional, REIA Express, Commercial/Industrial Development, On Schedule and Personal Financial Statement. Please see our software updates page for release dates and build numbers.

We encourage all registered users to download these free updates.  If you need to download the latest build, login to your customer account or open a support ticket and we would be happy to assist you.

These Macintosh updates follow our release of REIA Professional version 17 for both Windows and Mac.  We were busy this spring coding such new features as waterfall returns for partnerships, revised tax calculations, updates to our Commercial Income worksheet including individual base years for expense pass-throughs, and the addition of tenant improvements to the new unit and tenant rollover “wizards.”  See all the details of the upgrade on the REIA product page.

Real Estate Investment Courses Enter the E-Learning Revolution

As many of you know, I teach real estate investment analysis in the Master of Science in Real Estate Development program at Columbia University. About a year ago I agreed to teach a similar course at a new online school dedicated exclusively to commercial real estate: Homburg Academy.

During the past several months I’ve been busy recording lectures for their academic program. The more I’ve worked with these folks, the more impressed I’ve become with their professionalism and their commitment to providing quality education for our industry.

On May 16, they are launching an online e-learning portal as an extension of the Academy; the courses in this portal will be available on-demand.

I’m very honored that they’ve chosen my course as one they are including in the launch. Attached below is a copy of their announcement; I encourage you to check them out. You’ll find a link at the bottom where you can sign up if you would like to attend the launch online.

Frank Gallinelli

================================


Real Estate Investment Courses Enter the E-Learning Revolution!

Homburg Academy, an online university specialized in commercial real estate, will launch its proprietary e-learning portal on 16 May. This is an extension of the university’s efforts to provide accessible, affordable real estate education entirely online.

The portal will provide real estate investors and students with 24/7 worldwide access to the entire body of Homburg Academy’s online course materials and video lectures. These courses encompass a wide range of pertinent and interconnected subjects in real estate accounting, appraisal, capital markets, finance, investment analysis, management, risk and portfolio management – to name a few.

Homburg Academy’s current faculty includes 70 of the world’s top real estate professors and professionals in 13 countries – numbers that will continue to grow as new online programs and courses are launched in the coming months. Faculty members include such renowned experts as Frank Gallinelli, author of the bestselling guide, What Every Real Estate Investor Needs to Know about Cash Flow (McGraw-Hill, 2004), and Mastering Real Estate Investment: Examples, Metrics And Case Studies.

Each course contains 10 hours of lecture presentation. They are professionally produced by a team of course designers and multimedia editors to make viewing engaging and interesting. E-learning specialists have optimized each course to maximize knowledge and understanding. Each hour is broken down into easily digestible segments of 15 minutes, followed by a self-assessment quiz. There is also a discussion forum that is open to everyone taking that course to encourage discussion.

By providing easy access to courses by real estate industry’s most qualified experts, the Homburg On-Demand portal ensures that real estate investors can enrich their knowledge base with the highest quality courses available, by leading experts, giving them an edge in today’s competitive global marketplace.

Join the launch event! The Homburg On-Demand launch will stream live on the internet on May 16th at 2 PM (Atlantic Standard Time). Anyone interested may sign up for the live broadcast through Homburg Academy’s On-Demand sign-up page at: http://www.homburgacademy.org

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. 😉

for investors:
RealData Software
Real Estate Investment Analysis
Commercial / Industrial Development
On Schedule – Subdivision, Land & Condominium Development
Comparative Lease Analysis

Books by Frank Gallinelli
What Every Real Estate Investor Needs to Know About Cash Flow
Mastering Real Estate Investment
10 Commandments for Real Estate Investors
Insider Secrets to Financing Your Real Estate Investments

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

Copyright 2012, 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 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

Copyright 2012, 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 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.

And again – thank you J. Newman for your comments and your insights.

—Frank Gallinelli

You can read the complete review here on Amazon.