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Seven Mistakes to Avoid When You Invest in Rental Property

financial success with rental property

Real estate has probably been the best vehicle for building wealth since, well, forever – and income-producing real estate (aka rental property) may be the type of real estate that offers the greatest opportunities to small and mid-size investors.

But nothing worthwhile comes without a few potential pitfalls. You can and certainly should prosper as an investor, but to do so means being mindful of some mistakes that could derail your success. Let’s consider a few of the most important:

 

Mistake #1: Lack of Due Diligence

Pardon my Latin, but due diligence is the sine qua non of real estate investing. As I have written in many places before, two types of research are essential to investing successfully in real estate.

One is to vet the property itself. That means a physical inspection with an eye out for any underlying issues such as deferred maintenance and possible code violations. If you don’t feel at home around power tools and electric panels, hire a professional inspection firm. They should provide you with a comprehensive report and perhaps save you from costly surprises.

The second part of your due diligence concerns the market. No property lives in a vacuum, and you need to understand the local market dynamics before you jump in. How strong is the demand for rental properties in this location; how much inventory is there for units like the ones in this property; what are the prevailing rental rates; what is the business and employment climate, and are the any changes on the horizon? Ready to add artificial intelligence to your toolbox? A source of multifamily market data that I encountered recently is HelloData.ai, which claims to have real-time data on over 25 million units nationwide. Use every means at your disposal to understand the market that you’re about to become a part of.

(Please note that the HelloData link is an affiliate link, which means that we may earn a commission at no cost to you. I only add links that I believe will add value for my readers. For a 10% discount at HelloData.ai, use this link or enter this promo code: realdata10)

Mistake #2: Misjudging Financial Info

A very common mistake that investors, especially beginners, make is overestimating the potential rental revenue and underestimating the operating expenses. The seller or the seller’s broker will probably give you some revenue and expense data for a property they want to sell, but be cautious about taking all or even some of this data at face value. Get copies of the current leases, and, if possible, inspect accounting reports that show actual revenue collected and expenses paid. Gaps in the revenue stream can be a tip-off to chronic vacancy.

Don’t simply look to see if the amount of any expense item seems suspicious. Look also to see what might be missing from the data handed to you. The most common expense I see omitted in seller presentations is property management. Even if you think the current owner – or you as the new owner – are treating ownership as a DIY project, the bank appraiser won’t agree. Time is money and any time you spend on management is a cost.

Are you going to have professional fees for lease and tax preparation? Do you need someone to shovel snow, or cut grass? Put yourself in the shoes of the owner before you buy, and project your cash flow realistically.

Mistake #3: Inadequate Financial Planning

Related to the previous caveat is the lack of financial planning. Are you budgeting realistic amounts for repairs and maintenance? Do you put money aside in a reserve fund so you won’t be blind-sided the day the heating system gives out, or the roof needs replacement, or some other unforeseen expense occurs? Are you accounting for revenue that might be lost in future years due to turnover, vacancy, or leasing commissions? Keep in mind that your property taxes, insurance, and mortgage payments are going to come due, and you can’t play kick-the-can with these. You need to forecast future cash flows realistically.

Mistake #4: Not Buying at the Right Price

Speaking of forecasting future cash flows (shameless self-promotion here): that’s what our Real Estate Investment Analysis software has helped investors do for more than 40 years.

What a seller is asking for a property should not be the driving factor in what you decide you’re willing to pay for it. Keep in mind that buying a rental property is akin to taking on a business. It’s not like putting money in a bank account and collecting a nominal return, but involves both a degree of risk and a measure of personal effort. You need to make a multi-year forecast of the likely revenue, vacancy, expenses, and debt service, as well as an estimate of funds to earmark for reserves, needed improvements, and replacements (like that heating system I mentioned). In that way, you can forecast your future cash flows and make a data-driven decision about the price at which this property will give you an acceptable return on your capital invested.

Mistake #5: Poor Tenant Screening

You probably wouldn’t buy something on Amazon without first checking some of the reviews. As a landlord, it’s even more important to be proactive and maintain a thorough screening process for potential tenants. But also keep in mind that there are some legal and ethical Dos and Don’ts you should observe, as described in this National Association of Realtors® article. Perhaps your best move is to use a professional service. Investopedia has reviewed what it feels are the 7 best for 2024, including First Advantage and RentPrep.

Mistake #6: Not Having a Professionally Drafted Lease Agreement

A comprehensive and well-written lease agreement serves to protect both landlord and tenant. It specifies key provisions like rent payment terms, security deposits, termination date, and renewal options. But it can also provide clarity for both parties about tenant and landlord obligations, maintenance responsibilities, trash removal, recycling policies, quiet hours, pet restrictions, and other practical day-to-day concerns. Keep in mind that there may be state or local laws that govern the content of leases, particularly for residential property. A well-written lease is a good way to avoid misunderstandings that can escalate into legal disputes or financial losses.

Mistake #7: Ignoring Legal and Regulatory Requirements

Being in business of any kind – and investing is a business – seems to grow more complicated and more regulated every day. If you’re into residential, be sure you’re up on fair housing laws and landlord-tenant ordinances. Be aware of all disclosures and forms you could be required to give to new tenants and any rental licenses you may need to secure. With all types of real estate, be aware of local zoning and building codes and make it your business to be compliant. Ignorance of codes or regulations, or trying to cut corners, is not likely to end well.

A Final Word

Income-producing real estate can be your vehicle for generating passive income and building long-term wealth, as it has for many others, so long as you commit yourself to careful due diligence, thorough financial analysis and planning, and effective management. Invest wisely. By avoiding the mistakes I’ve discussed here you should be able to optimize the success of your rental property investments.

 

–Frank Gallinelli
online course for real estate investors
Image: nattanan23 at pixabay https://pixabay.com/users/nattanan23-6312362/

Copyright 2024, 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. Photo by Brandon Griggs on Unsplash
The software programs, applications, and websites mentioned in this blog post are provided for informational purposes only. The inclusion of these tools does not constitute an endorsement or recommendation by the author or the blog.
Readers are advised to exercise their own discretion and make informed decisions when considering the use of any software programs or applications mentioned in this blog post. Users are solely responsible for their actions and are advised to carefully review and adhere to the terms and conditions, privacy policies, and licensing agreements of any software they choose to use.

Property Management: Exploring Trends and Tools for Savvy Investors

multifamily property management

For those of us whose experience with rental property goes back a few decades (maybe even more than a few), the term “property management” conjures up images of ledger books for recording rent payments and expenses, receipt pads for tenants who paid by cash, and a plumber or two on our landline’s speed dial.

Things have changed, and much of that change is being driven by technology.

Perhaps what hasn’t changed is that sound and effective property management still plays a vital role in your success as a real estate investor, giving you the best opportunity to maximize returns, promote tenant satisfaction, and ensure property longevity. Let’s explore a few of the key trends and tools that make up today’s property management landscape.

Tech-Driven Solutions for Property Management:

“Proptech” stands out as the industry buzzword du jour. Today you can find a tremendous number of platforms and applications serving the residential and commercial real estate industries – more than we can cover in this blog post – but let me mention a few that may be of particular interest to owners of rental properties.

            Data Analytics and Performance Tracking:

Several platforms can help you streamline your day-to-day operations, such as financial reporting, maintenance tracking, lease management, rent collection, tenant screening, and more. Most offer detailed reporting and analytics capabilities where investors can track key performance indicators. Among the most frequently reviewed providers in this space are Buildium, Yardi Breeze, Rent Manager, Appfolio, and Rentec Direct.

            Real Estate Investment Analysis Software:

The certain precursor to successful property management is in first choosing the right properties to buy and manage. Professional-grade investment analysis software can take the guesswork out of forecasting future cashflows and return-on-investment, and help you make informed buy/don’t buy decisions. You won’t be surprised to learn that we believe that our RealData software, with its 40-year track record, will be your best choice to help you make those decisions. The Express Edition of Real Estate Investment Analysis stands out as a robust and affordable option for multifamily and small commercial, while the Professional Edition can help you discover the true investment potential of virtually any type of commercial or residential income property.

            “Internet of Things” and Smart Home Integration:

You can integrate smart devices such as thermostats, security systems, and locks into your property management toolbox, allowing you to monitor and control various aspects of your properties remotely. Tools like Nest, Ring, and SmartRent offer features such as remote access control, energy management, security monitoring, and automated maintenance notifications, all of which can improve tenant satisfaction and save you both time and money as a landlord.

            Virtual Tours and Online Marketing:

With the rise of virtual 360-degree tours, you can certainly grab some attention and market to potential tenants by offering online property viewing. Tools like Matterport and Realync enable property managers to showcase their properties remotely, saving time and resources. If a picture is worth a thousand words, then…

 

Sustainable and Environmentally-Friendly Practices:

Sustainability is gaining prominence in the property management industry as more investors recognize the long-term benefits of environmentally responsible, aka “green,” practices. By implementing eco-friendly measures, such as energy-efficient lighting and appliances, low-flow plumbing fixtures, and the use of sustainable materials, you can reduce operating costs while aligning with sustainable development goals. I discussed some important sustainability issues in greater detail in a previous blog post and invite you to check it out.

 

A Final Word:

Property management continues to evolve, and investors need to stay updated with the latest trends and leverage relevant tools to maximize their returns. The integration of technology, data-driven decision making, and sustainable practices are shaping the industry. By embracing these trends and tools, investors should be able to achieve greater profitability in their real estate investments.

What tools and techniques are you using in your property management, and what are you finding to be most valuable? Please tell us about your experience implementing best property management practices.

–Frank Gallinelli
online course for real estate investors
Copyright 2024, 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. Photo by Brandon Griggs on Unsplash
The software programs, applications, and websites mentioned in this blog post are provided for informational purposes only. The inclusion of these tools does not constitute an endorsement or recommendation by the author or the blog.
Readers are advised to exercise their own discretion and make informed decisions when considering the use of any software programs or applications mentioned in this blog post. Users are solely responsible for their actions and are advised to carefully review and adhere to the terms and conditions, privacy policies, and licensing agreements of any software they choose to use.

Is it Good to be Green?—The Long-Term Benefits of Implementing Energy-Saving Improvements in Commercial Property

energy-saving improvements to commercial real estate

Environmental awareness and sustainability have become increasingly important in recent years, and this is certainly true of the commercial real estate industry. Commercial property owners who implement energy-saving improvements can not only help the environment but at the same time unlock a number of long-term benefits for their businesses.

     1. Cost Savings

According to energy.gov, commercial buildings waste up to 30% of the energy they consume. Investing in energy-saving improvements can significantly lower overall operating costs. Some common measures include:

• Lighting upgrades17% of all electricity consumed by commercial building is from lighting. Incandescent bulbs are energy hogs. Replacing them with LED bulbs can result in a significant cost savings. According to EnergyStar, LED’s provide the same brightness as tradition bulbs, but use 90% less energy and can last 15 times longer. Traditional bulbs also release 80% of their energy as heat, raising the cost of air conditioning.

• Utilizing natural lighting — Increasing natural lighting via skylights and south-facing windows where possible, and using energy-efficient blinds and shades can help reduce the need for artificial lighting.

• Insulation and weatherization — Ensuring that the building is properly insulated and weatherized can prevent energy loss and reduce heating and cooling costs by as much as 10% according to the EPA. Windows, doors, and walls are the first places to look, but don’t forget the roof, HVAC ducts, outlets, and pipes.

• Using power management settings on computers and other hardware — Per EnergyStar, each office desktop computer wastes up to $50 a year. This is an easy way to reduce electricity use.

• Getting an energy audit — Contact your utility company to learn what services are available, but in many locales there are different audit levels, varying from free to paid. Some utility companies offer rebates or other incentives to customers who follow through on audit recommendations. An energy audit can help define what options are worthwhile and what their costs and potential savings could be; and a consultation with your CPA to review the cost-benefit balance can reveal the actual tangible return on investment for any of the cost-saving strategies.

• Getting a competitive quote for electricityIf you’re in a deregulated state, you may be able to choose your electricity supplier and lock in a rate that is lower than what you would get from your utility company.

• Installing solar panels — While solar can be good for your bottom line and for the environment, and perhaps even reduce your dependence on the grid, it’s important to weigh some potential offsetting factors. Does the roof have adequate structural integrity, or must you upgrade that first? Does the building get enough days of full sun? Could future adjacent development block direct sunlight? Are there regulations about hookups or fire department roof access that you need to anticipate? Is your electricity bill — especially if you’re a landlord responsible solely for common area utilities — sufficient to justify the initial capital outlay? A professional solar company should be able to give some reasonable projections of the time need to recover your costs, and help you make an informed decision.

2. Increased Property Value and Rental Premium

From a strictly metrics-based viewpoint, energy cost savings should increase net operating income and therefore increase value.

On a more subjective scale, energy-efficient buildings are highly sought after by environmentally conscious businesses and tenants, as they offer lower operating costs for tenants as well as owners, and present a reduced environmental impact. Does that translate into sales and rental premiums?

Although it may be difficult to quantify, there seems to be widespread agreement that the so-called “green premium” is alive and well. The US Green Building Council cites significant sales premium in LEED-certified buildings and CBRE offers a detailed study of rent premiums. Such premiums are of course a function of location as well as property type and class, but in general they all seem to confirm that energy efficiency measures have a positive impact on asset value and on rent.

And on the other side of the coin is the so-called “brown discount.” The value of buildings that don’t measure up in regard to energy conservation may take a hit, sometimes up to 30%, due to the growing demand for “green” buildings.

3. Enhanced Tenant Satisfaction and Retention

Commercial tenants increasingly favor buildings that prioritize sustainability and energy efficiency. Implementing energy-saving improvements sends a strong message to tenants that the property owner is committed to providing a high-quality and sustainable environment.

By reducing energy costs and creating a comfortable and healthy indoor environment, commercial property owners can significantly enhance tenant satisfaction. Satisfied tenants are more likely to renew their leases, leading to higher occupancy rates and reduced turnover, which ultimately improves the property’s long-term financial stability.

4. Management Benefits

Energy efficiency measures can extend the lifespan of a building’s systems and increase its overall value. This can make the property more attractive to potential buyers or tenants, potentially leading to higher rental income or sale price.

5. Tax Incentives

The tax regs are always a moving target, but you can find the IRS regs for “Energy efficient commercial buildings deduction” as of this writing (1/2024) here. In short, it appears that eligible improvements for years 2023 and later are for interior lighting, HVAC, hot water systems, and building envelope. The deduction amounts are the lesser of:
The cost of the installed property, or
The savings per square foot calculated as:
$0.50 per square foot for a building with 25% energy savings
Plus $0.02 per square foot for each percentage point of energy savings above 25%
Up to a maximum of $1.00 per square foot for a building with 50% energy savings

A final note: Kermit the Frog didn’t find it easy to be green, but you might find it much more appealing. Energy-saving improvements in commercial properties can provide you with substantial financial returns and management benefits, making them worthwhile investments for you as a property owner.

 

Have you implemented any energy-saving improvement in your commercial property? Please share your experience.

— Frank Gallinelli

 

software to analyze real estate investmentsonline video courses for real estate investors


Copyright 2024, 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. Image generated with AI – January 13, 2024 at 3:45 PM

The Evolving World of Short-Term Rentals

short-term rentals

The rise of home-sharing platforms like Airbnb has been a boon to property owners, especially owners of smaller income properties, but it has also prompted municipalities to introduce regulations on short-term rentals (STRs). Many places impose restrictions, such as requiring permits or licensing, limiting occupancy, and restricting the number of days permitted.

Regulations vary widely from state to state, city to city, and perhaps even within neighborhoods. For example, California provides a statewide definition of what constitutes a short-term rental — a residential dwelling rented out for a period of fewer than 30 consecutive days — but also has a matrix of local regulations and nuances. 

Some areas of the State may prohibit STRs entirely, while others impose a variety of restrictions. Los Angeles, for example imposes a 120-day annual cap. San Diego has a tiered licensing system. San Jose has a 180-day cap but is more lenient toward owner-occupied properties. Clearly, one size does not fit all

New York City imposed new rules in September, 2023 requiring hosts who list their properties as STRs to register with the city or face fines of up to $5,000.  

This apparently augments their underlying law (known as the “Short-Term Rental Registration Law”) which provides

  • “You cannot rent out an entire apartment or home to visitors for less than 30 days, even if you own or live in the building.
  • You must be present during your guests’ stay if it is for less than 30 days.
  • You may have up to two paying guests staying in your household for fewer than 30 days, only if every guest has free and unobstructed access to every room, and each exit within the apartment.
  • Internal doors cannot have key locks that allow guests to leave and lock their room behind them. All occupants need to maintain a common household, which means, among other things, that every member of the family and all guests have access to all parts of the dwelling unit.”

Critics of the law say that it amounts to a de facto ban on STRs, protecting the city’s hotel industry. 

Chicago also has restrictions on STRs, perhaps the most notable being that one-night rentals are prohibited. Apparently, this may have been driven by the desire to curb the use of one-rentals parties for loud parties.   

If there is one thing we can safely say about STR regulations is that there is a lack of consensus. They may even be related to specific neighborhood. 

The demand for STRs seems to grow unabated. They can provide extra income for property owners, and affordable accommodations for visitors. But at the same time, restrictions try to ensure public safety, limit noise and disturbance, and maintain adherence to zoning ordinances in order to protect the interests of owners, renters, and neighbors.

As the STR industry continues to evolve, it is essential for property owners and managers to stay informed about current and changing regulations, so as to ensure both their compliance and success.

Do you own or operate short-term rental property? Share your experience navigating the opportunities and restrictions.

— Frank Gallinelli

 

software to analyze real estate investmentsonline video courses for real estate investors


Copyright 2024, 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. Photo by Sonnie Hiles on Unsplash

What Does the Future Hold for Commercial Real Estate?

Inflation, interest rates, concerns about recession, pandemic-inspired work-style changes, taxes. There are enough wild cards in the deck to give any economic forecaster vertigo.

Not all real estate markets or all sectors are created equal, so to paraphrase an old TV auto ad, your mileage may vary. Nonetheless, we think it’s possible to make at least some reasonable and general forecasts about the near-term prospects for commercial real estate. Here is some of what we’re hearing, and thinking.

Multifamily

The multifamily sector seems likely to continue showing positive revenue growth. Freddie Mac predicts 3.5% increase in gross income nationally from apartment rentals in 2023, and a 5.1% vacancy rate. The multifamily market was outrageously strong in 2021, has cooled off somewhat since then, but still looks like a propitious place for investor dollars. With mortgage rates at their highest level in years, and the inventory of single-family homes for sale in short supply in many areas, there should be a lot of folks who must opt for apartments — hence, continued strong demand. Globest suggests that “multifamily remains a front-running investment choice.”

Office

The office market seems a bit harder to get a handle on. Many office workers have become very comfortable with working from home and are reluctant to go back into the office. They’ve been saving on commuting costs, especially in a time of high gas prices, on child care, and sometimes even on the cost of business attire. Some employers are demanding that workers return full time, but many are agreeing to a hybrid model, a few days a week in the office and a few at home. For many businesses, this means they need less office space. An in-depth interview on Co-Star with three industry analysts concurs that hybrid work is here for the long term and that demand for space is likely to decrease.

These analysts also noted that the suburban office market has been more resilient than the central business districts, and that suburban vacancies have actually been lower than those in CBDs. Finally, they note that while office leasing appears to be stabilizing, rising interest rates have been putting a damper on sales.

Industrial

If there is one clear winner right now, it would appear to be the industrial sector. In an article on trends in industrial real estate, commercialsearch.com says, “Onshoring efforts, coupled with a continuation of last year’s e-commerce boom, have only added to the already sky-high demand for industrial real estate.” It further quotes an analyst who believes this sector will be “among top performers across the commercial real estate sector in 2023.”

Similarly, NAIOP’s Industrial Space Demand Forecast says, ”Despite rising interest rates and growth in the supply of new space entering the market, the outlook for industrial real estate remains bright as supply chain conditions steadily improve. Low vacancy rates will continue to support growth in rents and property values.”

Retail

Retail, like politics, tends to be hyper-local. A recent article in the Wall Street Journal, The Decline of the Five-Day Commute Is a Boon to Suburban Retail, puts this in the context of the post-pandemic environment. The trend of businesses moving their office out of the central business district has led to fewer people shopping in downtown locations; but on the flip side, the suburbs have generally been the beneficiaries. “In the second half of last year, urban retail availability surpassed suburban availability for the first time since at least 2013, according to real-estate firm CBRE. Asking rent growth in the suburbs also outpaced urban areas last year.”

Overall — Sustainability

One phenomenon that looks like it will cut across all sectors is the growing interest in sustainability. It seems very likely that this will drive demand for green buildings. As we all become more aware of the impact that buildings can have on the environment, there is a growing demand for green buildings that are designed to be energy-efficient and environmentally friendly. This is creating opportunities for developers who can build green buildings. There are also financial incentives to commercial property owners, including reduced operating costs, increased asset value, and higher rents. We’ll be having a follow-up post with more on this soon, so stay tuned.

Frank Gallinelli



         


Copyright 2022,  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.  Building photo by John Unwin on Unsplash Solar array photo by Trinh Trần on pexels.com

The Case of the Mysterious Sinking IRR

Users of our Real Estate Investment Analysis program sometimes call us with questions that are not about the software but about the underlying analysis. If we had a “greatest hits” list for those questions the all-time winner would be this: “My cash flow goes up each year; the value of the property goes up each year; but when I look at the Internal Rate of Return, it goes down almost every year. What’s up with that?” To see how this can happen, let’s take a look at two very simple examples.

Example #1: We purchase a property for $100,000 all cash. It has a Net Operating Income of $10,000, so the capitalization rate is 10%. We are going to assume that 10% is the right cap rate for this market (primarily because it make the math in our example easy to follow). Because we bought the property for cash there is no debt service and so we can also assume that the cash flow is the same as the Net Operating Income. For those who require an instant (and very abbreviated) refresher course on these concepts, use the following:

  • Gross Income less Operating Expenses equals Net Operating Income
  • Net Operating Income less Debt Service equals Cash Flow
  • Net Operating Income divided by Capitalization Rate equals the property’s Present Value

The property is in good shape and is running well when we buy it. Our initial cash flow occurs on Day One when we spend $100,000 in cash to make the purchase. We project that we can raise the rent 4% during the first year to $10,400. The property is well-located, so we believe we can get a bit more aggressive over time. We’ll project that we can increase the revenue 5% in the second year, 6% in the third, 7% in the fourth and 8% in the fifth. Here is what our projections look like:

 

Notice that, if we sell the property at the end of one year for its full value (i.e., with no selling costs, to keep matters simple), our Internal Rate of Return (IRR) is a pleasing 14.4%. If we sell at the end of year two, our IRR for that holding period is even better, 14.92%. If we hang on to the property for five years, we see that we can expect a 16.38% IRR. The rents go up each year, the value goes up and so does the IRR. All is right with the world.

Example #2: At the same time we buy another property, also for $100,000 cash. It too has a $10,000 NOI, but this property needs immediate management improvements to control expenses and to get rents in line with the market. We feel sure that we can get the NOI (and hence the cash flow) to $12,000 in the first year. That should get it on a stable footing, from which we expect a more modest 3% increase in rent each year thereafter. The rents go up each year, the value goes up each year, but what about the IRR?

 

At the end of the first year, we’re thrilled by a robust IRR of 32%. We worked hard; we deserve it. But if we hold the property for a second year the Internal Rate of Return drops to 22.76% — still not shabby but significantly lower than at the end of the prior year. Indeed, the longer we hold the property, the lower the IRR becomes. What, to coin a phrase, is wrong with this picture? Nothing is wrong, actually. The numbers are correct. Remember that Internal Rate of Return is a time-sensitive measurement. The biggest jump in cash flow and in the property’s value came early. The earlier it arrives, the less severely it gets discounted — it’s the “time value of money” concept. The increases that occur in years two through five are smaller to begin with and they get discounted over a greater number of years, shrinking their worth to us today even more.

Simply put, if we hold the property two years instead of one, then that second year dilutes the overall rate of return because it didn’t contribute as much (especially after an extra year of discounting) as the first year did. If we hold the property for three years, the return gets diluted still further.

At this point, someone in the back of the room is surely asking the insightful question, “So what?” Here’s what: The first property is telling us that it will perform better as an investment if we hold onto it for a while. Its rent increases are accelerating each year. Even though the increases have to be discounted — it’s that time value of money again — they’re growing at a pace that makes them worth waiting for. Hence the IRR gets higher with each year we hold on. The second property, however, has a bit more of a roman candle quality to its performance. The big flash comes early; after that, it just sputters along.

Does this mean you should immediately sell such a property? If you’re happy with the long-term IRR and could not find a replacement property with a greater yield, it might make sense to hold. Or you might be more comfortable following the words of immortal Janis Joplin: Get it while you can. To put that in more businesslike terms, you might decide to sell the property when the IRR peaks; then take the proceeds and reinvest them. Whichever way you go, the important thing is that you’ll be making an informed decision.

Better than being like this guy.


If you found this example helpful, I have a lot more educational material for real estate investors and developers. For example, check out these video lessons…

Real Estate Investment Case Studies where I take you step-by-step through the evaluation of five different property types: apartment, mixed-use, triple-net leased, retail strip center, and single-family property

Value-Add Real Estate Investments where I show how you might do something tangible or intangible to a property, but in either case, something that increases how much a person would pay to acquire that asset from you when you’re done.

Or if you’re ready for a complete training series in real estate investment, development, finance, partnerships, and more, consider Mastering Real Estate Investing.

—— Frank Gallinelli  

 

Copyright 2023,  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.


What Happened to Your Property Management?

If you’ve taken my video course, read any of my books, listened to some of the podcasts I’ve been on, then you’re very aware that I often rant about how important it is for you to account for just the real operating operating expenses when you evaluate the worth of a property — no more and no fewer.

There is one mistake I see really often, and I want to call it out here in this video blog.

 

Copyright 2021,  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.

New Version of our Income-Property Video Tutorial

Screenshot 2016-06-30 09.36.08We’ve just released an updated version of our video tutorial, How to Evaluate an Income Property Investment with REIA Pro. We’ve given the video a serious makeover — additional content, better audio and graphics, greater emphasis on how to use RealData’s REIA software to perform an analysis — and have added a seventh video that provides an overview of some of the software’s more advanced features.

•    You get access to the web-based video series on our new e-learning platform. Watch it online at your convenience — on your desktop or mobile device.
•    The property analysis is based on a sample case study of a mixed-use property.
•    The series uses our REIA Pro product to analyze the investment, but many of of the features portrayed in the videos are found in the REIA Express edition.
•    The series is presented by Frank Gallinelli, founder of RealData, Inc.
•    Includes seven videos with over 2 hours of instruction

If you’ve already purchased the original release of this series, you’ll receive an email with instructions on how to get the new version at no charge. If you haven’t purchased it before, we invite you to download the case study and view a lesson-by-lesson synopsis.


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.

 


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 2016-2023,  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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