The future of real estate is more than just buying and selling homes. As I have discussed in previous articles about The Housing Market and Inflation and Lessons I Have Learned While Working with Successful Real Estate Investors the opportunity to invest in real estate has never been more appealing.
As the housing market has yielded significant gains for sellers over the past 3 years, many people have listened to and heeded the advice of experts such as Andrew Carnegie who said, “Ninety percent of all millionaires become so through owning real estate,” or Russell Sage who added, “Real estate is an imperishable asset, ever increasing in value. It is the most solid security that human ingenuity has devised. It is the basis of all security and about the only indestructible security”.
1031 Exchanges
With fear of inflation and in order to defer capital gains tax liabilities, several of my clients have sold and used 1031 Exchanges to help them to grow their portfolios and increase their net worth more efficiently than would otherwise be possible.
Under Section 1031 of the Internal Revenue Code like-kind exchanges occur, “when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type of ‘like-kind’.” This strategy has been a part of the IRS code prior to the Great Depression to encourage reinvestment in real estate without the penalty of paying high capital gains taxes by delaying payments until a later time when taxes would be less; based upon the investor’s lower tax bracket.
To qualify for a 1031 Exchange, an investor must follow a strict timeline and use an intermediary who specializes in 1031 Exchanges in order to accurately defer taxes. Below is a list of just a few of the key items that you should investigate prior to considering a 1031 Exchange:
The replacement property should be of equal or greater value than the one being sold, or you will be taxed on the remaining portion – this is called a “boot”.
You must identify an eligible property within 45 days of the sale of the property where the proceeds will be taken.
The identified property must be purchased within 180 days.
Opportunity Zones created by the Tax Cuts and Jobs Act of 2017 offer new opportunities that should be explored and considered.
1031 Exchanges can be used even if there is a mortgage on the property.
With proper estate planning, accrued deferred capital gains tax can be eliminated when real estate passes to heirs.
How Do You Make Money with Investment Properties?
Now that you understand that you can take proceeds from the sale of your home and use excess funds to build a real estate portfolio, how do you know if your new investment will make money and continue to grow your investment? Although you can have a long-term buy and hold strategy and build equity as you hold onto your property, the monthly income that can be generated through leasing investment properties opens a world of untapped possibilities.
Capitalization Rates
Investors use a metric called “Capitalization Rate,” or “Cap Rate,” to determine the rate of return. Most often you will hear this term when dealing with commercial property investments, however, it is frequently used for residential investments as well. To calculate the cap rate for a property, take the property’s net operating income and divide it by the property’s market value. For a property you are looking to purchase, simply substitute, the expected purchase price in place of the market value.
A property’s net operating income is the income it generates minus the expenses of managing and operating it. It does not include any debt payments. If you have a mortgage on a property, you should calculate its net operating income without subtracting the costs of the mortgage payments. Net operating income also does not include any capital expenditures or depreciation deductions.
Here are the steps to calculate cap rate for an investment property.
1- Ask the seller for the gross income figures for the property or determine what rents on the property could be.
2- Subtract the expenses of managing and owning the property except debt payments, capital expenditures, and depreciation. This gives you the property’s net operating income.
3- Divide the net operating income by the property’s market value or your expected purchase price for the property.
4- Multiply the result by 100 to convert it to a percentage.
Here is an example: Assume that you are researching a property as a potential rental investment. The asking price for the property is $1 million dollars and the gross annual income is $130,000. After subtracting for property management costs, taxes, insurance, etc. you subtract $60,000 from the rental income to arrive at the expected net operating income of $70,000. Divide 70,000 by $1,000,000 and you arrive at 0.07. Multiply this number by 100 to get a Cap Rate of 7%.
So, is a 7-Cap a good number? Depending on the type of property you are investing in, you will see a range between 4% and 10% as an acceptable Cap Rate. With this in mind, most investors seek for a 6% to 7% Cap for their property. A Cap Rate is an important number to understand because it gives you a basis point to analyze the current and future performance of the property. For example, if there were 5 similar properties that you were evaluating, you can calculate the expected Cap Rate for all 5 of them to help determine which would be the best investment.
In addition, the Cap Rate can help you to know what price you should look to purchase a property for by rearranging the formula to Market Value = Net Operating Income / your minimum acceptable Cap Rate.
Here is an example: Assume you are seeking a 6% cap rate and identify a retail/office building that has a current asking price of $650,000 with a net operating income of $37,500. Take $37,500 / 6% = $625,000. Because the current asking price is $650,000, this would not be a good investment as you would be paying $25,000 more than you should to achieve your goal Cap Rate. At this point, you could sit down with the seller and negotiate for a better price, or choose another property.
Cash-on Cash Returns
Another method of calculating returns on an investment is the Cash-on-Cash method which measures the investment’s net income including the debt repayment. The calculation takes the net income of the property and divides it by the actual cash you invested.
Here is an example: Assume you purchase a $625,000 retail/office building and you place a 25% down payment ($156,250). Including all expenses to acquire the property (closing costs, appraisal, loan fees, etc.) your total out of pocket is $168,000.
The property generates $65,000 in annual rental income and after expenses nets $37,500. In addition to this, you pay $18,000 per year to the mortgage. This makes the property’s total cash flow $19,500. When you divide $19,500 into the $168,000 it cost to acquire the property, you find that it produces a cash-on-cash return of 11.6%.
Whatever rate of return you are aiming for, make sure the projected income leaves you with a healthy amount of cash after the mortgage payment has been paid. If you have a tenant who doesn't pay for a few months, your investment property might quickly become a liability. Be sure to consider worst-case rent loss scenarios when calculating your potential return—that way, you'll have a good sense of whether you can afford to carry the property when it's unoccupied.
Now that you are armed with a few quick methods to determine the potential return on your investment, you should sit down with your tax advisor and realtor to determine your plan of attack to create and build your real estate portfolio. As always, if you have any questions, please contact me at brandonrwood19@gmail.com or 801-885-2558.