Introduction to Real Estate Investing Workshop

If you’re like most homeowners, you have considered the idea of making a real estate investment. You’ve seen your property value go up since you purchased your home. If you personally weren’t hurt in the stock market bubble and subsequent scandals, you probably know someone who was. The current mortgage crisis has softened real estate prices somewhat creating a buying opportunity we haven’t seen in years.

Is making a real estate investment right for you? If it is, how do you do it correctly? These are the questions I am going to try to answer. Drawing on my personal experiences as a real estate investor for 25 years and what I’ve learned from my clients, I am presenting you with the information you’ll need to know to make your investment a profitable one.

To begin with, investing in real estate is a business and you need to treat it as such. Suppose you decided to invest in the stock market. No matter how much time and effort you invest in picking a stock to buy, once you buy it, you have no influence on the decisions made by that company. The only decision that you need to make is when to sell the stock. When acquiring a piece of real estate for investment, you are the only one responsible for making it a profitable venture. You will be selecting the investment property. You will be selecting tenants. You will be maintaining the property. You will decide what improvements are to be made and when they are to be done. You will see to it that rents are received when they are due and have tenants evicted when necessary. There is a commitment of time and energy that you need to make before going any further. Real estate investing is by no means a passive investment.

Recognizing the work involved is your first step. Once you’ve accepted this you can move on. Now you need to decide how much money you are planning to invest in this new business. Yes, you will need to invest money. Despite all the books that have been written and infomercials broadcasted, promoting the concept of investing in real estate with no money down, you are going to need cash to work with. You wouldn’t expect to walk into a bank and buy a Certificate of Deposit or call a stockbroker to purchase a stock without exchanging cash for them. Why would you think you could buy a piece of real estate and have tenants pay you rent on a monthly basis without spending money?

Cash is your first limiting factor. The size of your cash commitment will be the determining factor as to the type, location and condition of the property you can buy.

The next logical thing to consider is your risk tolerance. Just as in the stock market, there is a range from purely speculative purchases through conservative investments. Buying a burnt out building in a depressed area that seems to be “up and coming” is a highly speculative but potentially lucrative investment. You could easily loose everything. Buying a fully tenanted 2 to 4 family home that is in mint condition in an established area would carry very little risk to loss of capital but will generate substantially less profit. Where do you belong on this risk/reward scale? Only you can decide that.

My personal recommendation is to stay on the conservative side. Your first investment needs to be a positive experience. If your first investment is a bad experience, then you will be reluctant to try another, or worse, you’ll no longer have the capital available to try again. Your first investment is also a learning experience for you. There will be mistakes made and you will learn from them. There is more room to make mistakes on a conservative investment than on a speculative one.

I’m not looking to scare you off from the concept of investing in real estate. I personally feel it is the best long term investment that can be made. Armed with the right information and realistic goals you will see how quickly your net worth grows. I’m now going to walk you through the steps you will need to take to accomplish this.

You’ve already taken the first step. You’ve recognized the facts that you will need to dedicate a portion of your free time to run this new business venture and you have accepted the fact that your availability of cash will have a major impact on what you can and cannot do.

In determining the amount of money you’re prepared to commit, you need to remember that what you invest will be tied up for a long period. Once the purchase is made, there is no fast and easy way to get your money out. There are basically 2 ways to free up cash invested in real estate. Either you sell the property or take a mortgage out on the property. Both are time consuming and come with a cost. Basically you need to hold the property for at least as long as it takes for it to appreciate enough to cover these expenses or expect to take a loss. My recommendation is to use only funds you are not planning to touch for 10 years.

Many first time investors look to use the equity they’ve built up in their primary residence as the source of capital. When using this approach you always need to keep in mind that you are committing to an additional monthly expense, the mortgage payment on this money you’re borrowing, that you will need to budget for. Another approach to increase the funds available to invest is to bring a partner to the transaction. Properly structured, this is an excellent approach for individuals to pool their resources and purchase sooner than either partner could on their own.

If you are taking this route, you need to plan on an exit strategy from the beginning. Each partner’s needs and/or goals will evolve over time. This tends to strain the relationship between the partners. The way to minimize this is through planning. From the start you need to formalize the details of the partnership. Specify the amount of money each is investing, guidelines you plan on using in selecting the property, identify the responsibilities of each partner for handling the day to day operations of the business, and most importantly, agree on how long you plan to hold onto the property.

Having an initial focus on a holding period will give partners the ability to work that timeframe into their own personal finances. If you agree to a 5 year holding period, and you need get your money out at year 4, you have 2 options to work with. Either find a way to defer your need for cash for a year or negotiate with your partner to accelerate the sale date. Without the preset holding period you would be totally at the mercy of your partner. Remember, just because you started with a 5 year holding period, doesn’t mean you and your partner can’t mutually agree to extend (or shorten it). It just creates a reference point for both to work from. You cannot put too much detail in this partnership agreement. The more details you address upfront, the less problems you will have along the way.

I have been involved in several partnerships over the years. I can honestly say they all worked out well in the end. I attribute this to the fact that in each case, all the partners entered into the transaction with their eyes open and realistic expectations.

Now that you know how much money there is available to invest, the next step is to see how far it will take you. The investment will need to cover the down payment on the property, transaction costs in acquiring and closing on the property, any initial repairs on the property and cash reserves. No business venture can be successful without having funds available for the unexpected. Things break, tenants vacate or stop paying rent, utility prices jump, etc. When you are financially prepared, issues like this are nothing more than an inconvenience. Without preparation, any one of these problems could escalate into a disaster.

Now your work begins. I suggest you look at a wide geographic area. Use a shotgun approach through the area with a goal to focus down to the one or two areas that you’ve decided warrant an investment. Working this way reinforces your confidence in the area (s) of your concentration. It may even introduce you into an area that you hadn’t previously considered.

In your search for a property, you are also looking for more than just an address. You are looking for neighborhood attributes, price range of the properties in the neighborhood, general condition of the neighborhood, availability of rentals and the going rate of the rentals.

Is the community dependant on cars to get to and from work? If it is, then off street parking is an important amenity. If there is any form of street parking restriction in the community, this amenity becomes a necessity. If the community depends on mass transit, then proximity to a bus stop or a train station becomes critical.

Are neighborhood properties generally well kept? What is it going to cost you to either get your property into shape or to maintain the property? You always need to remember that even though you are going to be an absentee landlord, your property is still part of the community. Your tenants will be part of the community and will be interacting with the neighbors. If the neighbors aren’t happy with you, it is going to affect your cash flow.

When analyzing a potential purchase, your goal is not to find the perfect property, it is to translate each negative issue into a present dollar value. If the property needs renovation, what is it going to cost? Will you need to work around existing tenants or will you have vacancies during construction? What is the finished product going to be worth when you’re done? Is your investment of time and money giving you a proper return?

Is the property in a prime location? If it is, you are going to be paying top dollar for it. If it’s not, does the price reflect the location? How much of a difference in rent is there between the locations?

The real estate market, just like all markets, is priced emotionally, not logically. The way to make money as an investor is to look past the obvious and look for the overlooked. This is how you make your profits. You are looking for what the market missed.

Here’s a typical scenario. You look at a 2 family house where the owner lives on the first floor and rents out the second floor. The tenant has been there for a number of years and because of this his rent is substantially below market. Knowing this, our tenant refuses to let any prospective buyers into the apartment. The current owner is making the two classic errors. First, he has allowed the tenant to fall behind the market (he’s a “good tenant” so the owner didn’t increase his rent over the years). Second, he won’t evict the tenant because he doesn’t want to lose the monthly income. Because of this the owner is having problems attracting offers. You now have the luxury of his undivided attention when you present your offer.

You agree to purchase without seeing the tenant’s apartment. Isn’t this asking for trouble? Not if it’s done properly. You can get a good idea of the size of the apartment just by seeing the first floor apartment. You assume the apartment is a mess and needs to be totally renovated. Now you simply make your offer knowing you have a renovation facing you. Don’t have the money to do the renovation? Then this is may not be the property for you unless you can come up with an alternative to cash. Borrowing additional money outside this purchase could be one solution. Bringing in a partner could be another. Inviting a contractor into the deal with you is another possibility. Your options are only limited by your creativity.

This is my definition of a good deal. The right price for the property at the right time for you. The above example might yield the right price, but if you don’t have the cash to do it, it’s not the right time. Knowing your own limitations is the most efficient way to stay out of trouble.

You’ve decided on a property to buy. You’ve got your contract signed and now it’s time to arrange for financing. The procedure is familiar to you; after all, you already bought your own home. There are going to be some differences this time around. You are no longer financing your primary residence, you are financing a business. From a lender’s standpoint this is a higher risk mortgage. In the mortgage market, higher risk means higher rate and higher down payment. Anything the lender can do to minimize its risk, or increase its rate of return, will be done.

Why is this the case? First, answer this question. If you are obligated to pay 2 mortgages, one on your home and one on an investment, and you only have enough money to pay one, which mortgage would you pay? It’s obvious what you would do and that illustrates the higher risk involved in the investment mortgage.

In understanding the bank’s position, you can arrange your financing in a more professional manner. Your application package will be a concise set of facts proving that there is no unnecessary risk for the lender in approving this mortgage. This will make the approval process much smoother.

This attitude of understanding the position of the “other side” should be present in all discussions. Besides putting yourself in a better negotiating position, it has the additional benefit in that it’s contagious. It pulls the other person into a mindset of trying to find ways to make things work instead of looking for reasons not to do business with you.

If you take the time to understand the needs of the seller, you will be in a much better negotiating posture. You will find there are other issues, other than price, that can make the deal come together.

The time between signing contract and closing on the property is very important. In most cases there is no need to rush to close. Remember, the happiest days for an investor is the time between contract and closing. It’s during that time that the investor enjoys the benefit of any market appreciation without paying for it. The investor’s ties up no more than 10% of the sales price and earns 100% of any appreciation and as an added bonus any problems with the property is still the seller’s responsibility.

During this time you should be fine tuning your plans regarding the property. If you’re taking ownership with any existing tenants, now is the time to decide if you are planning to increase the rent, how much you plan on increasing it. Perhaps you are planning to ask the tenant to vacate. Remember that you will be subject to any existing lease. This will impact when the increase can be effective, possibly the size of the increase and may restrict your ability to remove the tenant. Maybe you are considering buying the tenant out of his lease. Now is the time to decide how much of an offer you are willing to make and when is the best time to approach the tenant.

If you are considering any renovations, now is the time to decide how far you want to go and you may even have the opportunity to get your estimates in place prior to closing. This way your contractors can start immediately after you close.

Decide exactly what work you want to have done before you talk to a contractor. If you are specific in the scope of work you need to get done, understanding that no one is a mind reader, forces the contractor to be specific with his proposal. This makes your job easier in comparing prices since all contractors are then bidding on the same specifications. It also insures that you are getting what you expect as a finished job. 

A common mistake I see is, investors wanting to do the work themselves as a way to save money. Their mistake is not considering all the costs involved in doing it yourself. You decide you want to renovate a kitchen. A contractor will do the job in 5 days at a cost of $15,000. You consider yourself pretty good with tools and you figure your material costs will be $7,000. Why not do it yourself and save $8,000? You plan on doing the work in your “free time”. How much free time do you have? This 5 day project done by a contractor easily turns into 5 weeks of “free time”. Now you have the loss of rent as an additional expense. “Free time” is the most precious time you have. What is the hourly cost of that time to you? Now add that cost into the equation. Suddenly you are no longer savings as much you thought, it could easily cost you more in the end.

Maybe you don’t have $15,000 available, but the work needs to be done. This is now a business decision for you to make. Do you borrow the money to do the work to get it done faster and factor in the financing costs as an additional cost? The decision is yours, just be sure to add in all the costs involved in doing it yourself. Always try to have a complete set of data before making any decision. There is nothing wrong in doing it yourself, as long as you’ve worked out the numbers first.

How much do you “fix up” an apartment? There are several issues that need to be considered in addressing this question. On the one hand you don’t want to invest any more in renovations than you absolutely have to. On the other hand you want to attract quality tenants. Better quality tenants expect to live in a better quality apartment. If you expect to rent an apartment for top dollar to highly qualified tenants then you need to go the extra mile so the apartment gets people excited to want to live there.

You need to know your market. If the area demands basic, clean space at a moderate price, then that’s what you provide. A freshly painted apartment with a clean bathroom (if in doubt, re-grout) and a clean kitchen with working appliances is what you need.

Say the area attracts higher income tenants, that is, tenants who have the financial strength to be owners but have elected to rent. These tenants have made a lifestyle decision. They are looking for a high standard of living without long term financial responsibility. To rent to this profile you need to add polish to the apartment. In renovating the apartment, use ceramic tile in the kitchen instead of vinyl, wood cabinets instead of Formica, consider installing a granite countertop and if space allows add a washer/dryer combo. Remember, here you’re not dealing with a price conscious tenant. You are dealing with someone who likes the comforts of life and is excited by “bells and whistles”.

This is a business; you need to invest money to make money. Once you rent out an apartment you can’t just ignore it. You need to be responsive to any maintenance issues that arise, especially repair issues. A leaking waste line in the kitchen is an inexpensive repair. Left unattended, the problem grows as the damage grows to include cabinet damage, flooring damage and ceiling damage to the space below. It is cheaper to address minor repairs than to allow them to grow to major repairs.

There’s another, even more important reason to be responsive. It encourages the tenant to respect your apartment. You’ve investigated and interviewed the tenant. You’ve concluded that this individual has the financial capabilities to pay the rent, he has the creditworthiness to pay his rent on time and has the character to take care of the apartment. You’re in a business, a service business. The tenant is your client and deserves to be treated as one of your most important customers. He’s more than just a repeat customer, he has signed a document committing himself to be a regular customer for a least a year. He signed this document without any substantial proof that you will maintain his home. If you’re not responsive to the care of your apartment, why should he care about how he treats the space? In the long run you have much more at stake than he has. Protect your investment by staying on top of maintenance issues.

I’d like to tell you that a screening process exists that guarantees that you will only rent to responsible tenants. Unfortunately, there are never any guarantees in business. A tenant may skillfully pass through the screening and have no intention of ever paying the rent. You may have rented to a happily married couple that begin to have marital problems during the term of the lease and the rent stops. Maybe your tenant loses his job. Maybe he just simply looses his mind, or gets involved in drugs or alcohol. Things happen. Remember, even criminals and drug addicts have or have had an apartment and you can be sure that the landlord felt they were responsible at the time they moved in.

Dealing with a problem tenant is a frustrating and expensive situation. The frustration begins with a lack of rent payment followed by not knowing what’s happening inside the apartment and ends with having to deal with Housing Court. Your expenses add up quickly. You’re not collecting your rent, you know you are going to have to do work in the apartment, it’s only a question of magnitude, and aside from all this, you are paying legal fees.

You’ve heard the expression, “The customer is always right”. Remember, the tenant is your customer. The laws governing tenant-landlord disputes always gives the tenant the benefit of the doubt. Where the property is located will determine what degree of trouble you’re in. The first thing you need to do when you are having trouble with a tenant, is contact your attorney. You need to have an expert walk you through the eviction process so you can get possession of the apartment as quickly as possible. Think of it as high stakes board game. As you advance from step 1, to step 2, etc. you need to do everything correctly. One misstep, and you go back to the beginning and start all over. The more time you lose, the more money it costs you in lost rent. The court system will advise the tenant of what steps he needs to take, as well as advise him of his rights through the process. You, on the other hand, are left to fend for yourself. The “consumer” (tenant) has the court to protect him from the “big businessman” (you).

We deal with the vast array of personalities in everything we do. At our jobs, shopping, driving even in our own homes we see the diversity of personalities that make up the human race. Tenants are people. As a real estate investor, your success or failure will depend on this assortment of personalities. You try to do everything you can to weed out the troublesome ones, but you will not have a perfect record. Problems will arise and you will have to learn to deal with them.

As in any investment, you should periodically analyze the investment. You should do this on a 3 to 5 year schedule. You should be reviewing the cash flow. Is the property performing as you expected? Is the rental income increasing, decreasing or is it stagnant? Tenant turnover, is it excessive? Is this becoming a high maintenance property? What’s happening with the neighborhood? Are property values increasing or decreasing? Is this trend unique to this neighborhood or typical for the overall area? How much equity do you now have in the property? Should you be cashing out?

What attracts people to invest in real estate:

1. Historically, real estate is where a family’s real wealth is formed. If you look at all the powerful family names in this country you will see that no matter have much wealth they accumulated through their business interests, the majority of their wealth was derived from real estate. People have always admired the wealth effect of owning real estate.
2. People with a “hands on” approach to life or are “control freaks” will choose real estate over other forms of investing. A real estate investor selects the property, decides on how leveraged he wants to be, directs the improvements that are done, determines the asking rent and chooses his tenants. This is a far cry from reading a prospectus, taking a recommendation from your stockbroker and hope that the management of the company is smart enough to make you money.
3. Real estate investing allows for much higher leverage than any other investment and at a relatively low cost of funds.
4. A typical real estate deal requires that the cash flow of the property be high enough to cover all expenses, including financing, and still turn a profit. If a property doesn’t fit this criteria, it typically isn’t purchased. There is no stock purchase than can be made on margin where the dividend flow is adequate to pay for the interest on the margin account. In the event that the stock price goes down, the investor is responsible to put up additional cash to cover the margin position. The real estate investor, when faced with a decline in market value, may not be happy but he is also not required by his bank to reduce his mortgage amount.

Even with the revised tax laws there are still substantial tax benefits in real estate. For instance, it is the only investment vehicle that the government permits tax-free exchanges. If you are a investor in the stock market and you like the automobile industry but want to sell General Motors and buy Ford, you must pay a capital gains tax on whatever profit you had on GM before you can make the Ford purchase. A real estate investor who wants to move from residential to commercial property can execute a tax-free exchange of one for the other while deferring the capital gains tax.

The driving forces of the investment market are similar to the forces that stimulate the first-time buyer but with some differences. Obviously the shortage of available housing stock and land encourage potential increases in real estate values. The tax benefits of real estate investing aren’t as large as for the owner-occupied purchaser but still positively influence the investment return.

Due to the high transaction costs associated with real estate purchases, investors normally have a long-term time horizon. Over the long haul real estate values have always gone up. Take any 10 year period and compare housing prices. You will see an increase in property values. There may be bumps in the road over the timeline, but the net result will be an increase. So the safety of the real estate market is an important attraction for the investor.

In order to generate higher profits in real estate transactions an investor needs to be creative. Just buying a property at market value and waiting for the market to appreciate will yield a reasonable return on investment. In analyzing a prospective purchase an investor will try to find ways to increase the market value, therefore the rate of return. By addressing weaknesses in the property an investor can greatly enhance his rate of return.

Deferred Maintenance:

This is the most obvious condition than can be addressed. A property is located that, for whatever reason, needs substantial renovations. The property was neglected due to lack of interest, or cash, of the current owner. The investor brings the property up to speed and then either sells the property at full market value or rents it out. If he plans on holding onto the property, he will refinance the property to take his cash out and move on to the next venture. Properties of this type are difficult to finance. The investor will be faced with a higher interest rate, lower loan-to-value ratio, or both. He will probably need to pay for the renovations with his own cash.

Insufficient Rent Roll:

In this case the property is undervalued because the rent roll isn’t up to where it should be. The investor needs to identify why the rent roll is low and come up with a plan of action to correct the problem. His tools here start from not renewing leases through evictions and tenant buy-outs. Estimating the costs involved in doing this is not easy but can be done. Remember here you are dealing with 2 costs: money and time. Once completed this project in now brought up to full value.

Property not being used at its highest and best use:

Through changing the use of the property, its value can be substantially enhanced. Buying a house, tearing it down and building a new home is one possibility. Replacing the house with 2 houses or a multifamily is another variation of the same idea. Converting factory space to residential lofts has become a popular approach inside the city limits. This approach not only has time and money costs but the added expense of dealing with the local building department. Subdivision issues, certificate of occupancy issues, etc. involve additional expenses. Converting a rental property to a co-op or condo will have similar issues.

Assembly of properties:

Acquiring adjoining properties to create enough land to do a large project is another way for investors to work. They may want to assemble enough land to build a shopping center or build an office building. It could be the purchase of air rights to build a higher structure on an existing parcel.

Typically a project will have several of these approaches, working together, in creating a higher value than the property initially had. The profitability of the project will be dependant on the quality of the initial analysis.

We’re going to focus our attention on properties a small investor would be interested in. I think most of us fall into this category right now. Every investor, regardless of weather he is buying his first 2-family home or an office tower in Manhattan he has the desire to accumulate wealth through real estate investing. Obviously the differences in financial capabilities will impact the type of property an investor will be interested in as well as the size of the project.

The profile that most of us fit looks like this. You probably own your own home and are looking to expanding into either a small residential building or a commercial property. Your source of funds for purchasing will be limited to your own cash, savings banks, and mortgage bankers and, in the case of 1 to 4 family homes, the same channels available to the owner-occupied purchase.

In most instances you will be facing higher down payment requirements (sometimes as high as 30%) and a higher cost of funds than the owner-occupied purchaser.

In bidding on a property, you will be competing with other investors as well as individuals interested in occupying the property for their own residence. This is an important issue. The investor looks at the property on a cash flow basis whereas someone looking to live in the property is more concerned about how much he would like to live in the property. A person looking to purchase a property for his own personal use typically is willing to pay more for the property than an investor would.

Fortunately, the state of the current real estate market is scaring away many first time homebuyers as well as many potential investors. This is creating downward pressure on prices creating buying opportunities

Investment Terminology:

Before we analysis a property we need to become familiar with the language of real estate investing. When you develop an understanding of the following 6 terms, you will not only be comfortable in a discussion with a seasoned investor but will also have a blueprint to develop your own procedure to analyze a prospective purchase.

We will be focusing on a cash-flow analysis. Based on the results of this analysis you would then compare them with neighboring properties and other alternatives to invest your money. You are not investing in a vacuum. If you calculate your return on investment is no different that keeping your money in the bank, then why are you considering the purchase? Your final decision needs to be based on your analysis of the cash flow, the anticipated future value of the property and the risk that’s inherit is any investment.

Regardless of the size or type of property you’re considering all these calculations need to be done. Obviously, the more expensive the property is, the more complex the calculations will become. This is due to additional components that need to be addressed in the analysis.

Net Operating Income

The simple definition of the Net Operating Income (NOI) is the amount remaining after total operating expenses (excluding interest payments) are deducted from effective gross income.

Why aren’t we considering debt service? It’s probably the largest expense. We’re beginning by addressing the property as it stands on its own without any mortgage. If the NOI isn’t attractive, there in no reason to go any further unless there are improvements you plan on doing that will improve the NOI. You will then be comparing the NOI before and after the improvements. Of course, the cost of these improvements will need to be considered in the final analysis.

We begin by determining the effective gross income. You start off by using the actual gross rental income and take off a factor for vacancy, usually 5% or the actual vacancy rate if it’s higher. If there is something unusual with the rent roll, then a projected rent roll can be used.

An unusual condition may be a vacant commercial space that the investor wants delivered vacant because he has a tenant for the space. Another possibility would be that the current owner has been warehousing his vacant residential space to make the property more attractive for conversion. Situations like this would warrant using a projected rent roll.

Now that we have a rental figure with a vacancy factor built in we can now add in any ancillary income the property generates. The building may have a laundry room generating income, garage space which has its own income flow or may be the roof is rented out to a cellular phone company for antenna placement. Whatever additional income that’s there now gets added in. This total is called the Effective Gross Income (EGI).

In analyzing a 2-family home you may be working only with the rental income, there may be no other income to consider. You need to consider a vacancy factor for the simple reason that you need to anticipate downtime between tenants. Maybe you can’t, or don’t want to show an apartment with the current tenant in residence. Maybe you want to repaint or do other cosmetic repairs between tenants. Whatever the reason, you need to address the realization that there will be times when both units aren’t rented.

The next step is to look at the expense side of the equation. After totaling up all the fixed expenses, taxes, insurance, utilities, etc. we need to address the variable ones. A management fee factor (even if it’s done in-house there is a cost factor associated to it) depending on the property 5 to 10% should be used. A one tenanted commercial property will have a lower management cost than a 200-unit apartment house although the EGI could easily be similar.

An engineering report on the property will estimate the remaining useful life of all the mechanical systems. A reserve account must be funded out of monthly cash flow to be sure there is money available as systems need to be replaced or up graded. So the last variable expense we will need to use is a Replacement Reserve factor. If the engineering report yields no unusual or immediate issues a factor of 2% of rent roll can be safely used.

Going back to our 2-family house, you need to consider things like roof replacement, hot water heaters, appliances and even the boiler. You can never anticipate everything that will impact your cash flow, but you can do whatever possible to reduce the number of surprises. Overlooking major capital improvements is a common mistake made by novice investors.

All we need to do now is subtract the total of all theses expense from the EGI and we are left with the Net Operating Income (NOI).

Debt Coverage Ratio

Now that we know how the property will perform without any mortgage we can now calculate how much financing the deal can handle and still be a viable purchase. We also need to keep in mind that the lender handling the financing will have a different threshold as to what a viable purchase should look like.

There is good reason for the lender to be more conservative than the investor. The investor has decided to make this purchase based on the cash flow of the property as well as the anticipated appreciation of the property. An investor may be willing to accept a lower profit on a month-to-month basis because he has anticipated a substantial rate of appreciation.

If his calculations are correct, he will have a nice profit when he sells the property. If he’s wrong and has problems meeting ongoing expenses and doesn’t get the appreciation he planned on, he may not be willing to contribute any additional capital to the project. This means the lender is either forced to foreclose, potentially not recouping all that was invested, or to renegotiate the mortgage with the investor. Again not getting the return on their investment that was anticipated or seeing an actual loss.

Essentially the lender is in a partnership with the investor in all the downside exposure of the purchase yet is limited in the profit. All the lender is going to receive is the interest on the mortgage. Any profit on the future sale belongs entirely to the investor. So where an investor may be willing to sacrifice monthly profits for future gain, the lender will not. It has no reason to take on the additional risk since there is no potential reward at he end of the day.

The investor needs to anticipate the calculations the lender will use to approve the financing. One of the most important considerations of any lender is to check to see how close the deal is. In other words, what margin of error in the analysis should there be? After expenses are paid and the mortgage payment is made, what’s left? From the investor’s viewpoint this is his monthly profit, from the lenders standpoint this is the margin of error that allows the venture to absorb bumps in its cash flow without affecting the investor’s ability to make mortgage payments.

The Debt Coverage Ratio (DSCR) is nothing more than a relationship between the annual debt service and the NOI. Take the NOI you calculated and divide it by the monthly debt service. The type of property, the track record of the investor and the comfort level of the lender will determine what Debt Coverage Ratio will be set for the project. This ratio seldom is allowed to drop below 1.25. This actually means for every dollar of annual debt service, there is $1.25 of NOI available to pay it.

The same underwriters that handle primary residences underwrite most mortgages on 2 to 4-family properties. The standards used here are similar to those used in underwriting primary residences. Meaning that the personal income and expenses of the investor are given the majority of the weight in the decision making process.

A commercial mortgage underwriter will be focused on the property, deciding how the property performs on its own. The residential underwriter is assuming that the property isn’t going to perform as anticipated and needs to see that the investor has the personal financial wherewithal to carry the debt.

There is good reason for this. There is a tremendous variation in the rent in apartments in 2 to 4-family homes. Many of these properties have the owners actually living in one of the units and tenants are chosen based more on personalities that maximum potential rent. Also there is a wide variation of apartment condition, layout and services provided.

In an apartment building, on the other hand you have multiple apartments of the same size and same layouts. You have professional management geared to maximizing rents and minimizing expenses. Most importantly, there are similar buildings in the area charging similar rents. There is a substantial pool of data to draw off of in verifying cash flow that simply isn’t available in the 2 to 4-family property category.

Cap Rate

The cap rate is a ratio of the NOI and the listing of purchase price. This rate in then compared to other similar properties in the area to see how it stacks up. If you just try to compare sale prices, as you would with single family homes, you run into the problem of differences in rent roll and operating expenses. These factors can vary greatly from one property to another making a sales comparison difficult or worse inaccurate. Since the cap rate is based off NOI, income and expense variations from property to property are already accounted for.

The Cap Rate is not typically used in the analysis of 1 to 4-family properties that are being purchase for investment. The majority of these properties are owner occupied and market value is more accurately determined through the sales comparison approach. Also there are enough of these property types in a given area to generate a large enough database for sales comparison. This is one more reason supporting the reason that residential underwriting standards are used in the analysis of investor 1 to 4-family properties.

If the NOI of the property our investor is interested in is $50,000 and the cap rate for this type of property in the area is 10% then market value for the property should be $500,000.

The $50,000 NOI divided by the cap rate of 10%. If our investor feels he can work the property and within the year can get his NOI up to $60,000, he can anticipate an increase in value from the $500,000 to $600,000.

Break-Even Ratio

When looking at the financing on a project, both the investor and his lender need to know what the minimum percentage of projected income is needed for the project to break even. The lower the percentage, the stronger the project is.

The calculation is straightforward. First you add your fixed and variable expenses to the debt service. In the variable expense total we had added a factor for replacement for reserves. For this calculation we need to subtract that factor back out. Once we’ve done that we then divide by the gross rental income. This gives us the percentage of income needed to break even.

Cash-on-Cash Return

Any investor, no matter how large or small, will need to know what yield he is getting on his investment. Take the annual NOI, subtract the annual debt service and then divide it by the cash investment of the investor. This is he Return on his Investment (ROI). His lender will also be interested in this number. If the return is not reasonable, the lender will question the investor’s commitment to the project.

Loan-to-Value (LTV)

This is the relationship between the appraised value and the loan amount. The LTV is used in conjunction with the other 5 variables in finalizing the feasibility of the project. If the investor is putting 25% down on the project and the debt coverage ratio or the break-even ratio is too low, than the price is too high. If we have strong ratios, it’s possible to find a source of funds that will consider a higher mortgage amount.

Examples:

Purchasing a 2-family house:

Our subject property is a 2 family home in Queens County. The seller occupies first floor and the 2^nd floor is rented out at $1,800 per month. The asking price is $500,000 and the property tax is $2,400 per year.

The first step will be to develop a sense of the current neighborhood values and how the neighborhood is appreciating in relationship to other areas of interest to the investor. Unless the investor is confident that the area shows good growth potential, there would be no reason for him to go any further with this property. The market analysis shows that within the last 6 months 2 similar homes closed. One sold for $440,000 (5 months ago) and the second one closed at $450,000 (2 months ago).

Next, let’s look at the rental income. There are 2 questions that need to be answered. First, is the $1,800 that’s being paid for the apartment market value and, second, what will the first floor rent for? Research has concluded that the 2^nd floor should be @ $2,000 per month and the first floor should rent for $2,800. So he’s comfortable working with a monthly rent of  $4,600 per month.

The monthly expenses on this property are:

1.  Taxes of $200 per month ($2,400 per year)

2.  Water & Sewer charges of $50.00 per month

3.  Insurance of $100 per month (based on a conversation the investor had with his insurance broker)

4.  Utility costs of $500 per month (based on information supplied by con-ed, the gas and electric utility company servicing Queens County)

5.  Average maintenance cost of  $200 per month (based on the investor’s personal experience)

6.  Management fees of $100 per month (although our investor will be managing the property himself, he does need to factor in expenses such as accounting, legal fees, etc. There will always be outside experts that need to be involved and their costs need to be addressed)

7. The Queens rental market is a very tight one. Rentals are scarce and as quickly as an apartment becomes vacant, tenants are waiting on line to take it. Even in a tight rental market a vacancy factor should be used. Our investor is using a 5% factor, which yields a monthly expense of $230.

The total monthly expense, in this example, comes to $1,380. The monthly income is anticipated to be $4,600. This gives us a monthly cash flow of $3,220 to work with before debt service.

Now that we have the operating expenses regarding the property, we can begin to look at the investor’s personal position. How much capital does he want to commit to this venture? What is the annual rate of return he is looking for on his investment? For the sake of discussion, the investor confirms that the $500,000 list price is reasonable and will look at his options based on paying full price. Should he be able to negotiate a better price, his numbers work out even better. At this point he is looking to find his top end price

Scenario 1:

Our investor starts by looking at financing at the lowest interest rate. This will require him to put 30% down. We will use a factor of 5% of the mortgage amount to cover all the buyer’s expenses. 30% of $500,000 = $150,000. 5% of  $350,000 = $17,500. The total case invested in this case will be $167,500. His mortgage is for $350,000 for 30 years at 7.75% comes to $2,507.44 per month. Our anticipated cash flow was $3,220, leaving $712.56 a month profit. This gives a 5.10% cash-on-cash return before any tax benefits and without considering the amortization of the mortgage. Remember, even a 30-year mortgage has a principal pay down component to it. In this particular case there is $3,071.87 in principal reduction during the first year. Factoring this into our return increase the rate to 6.94.

Scenario 2:

Our investor wants to commit less money into the deal. He now wants to see what happens when he puts 10% down. His down payment reduces to $50,000 and his closing costs increase to $22,500. He now only invests $72,500 but his monthly payment goes up substantially. He now will be paying an interest rate of 9.5% as well as carrying mortgage insurance. His mortgage payment increases to $3,783.84 plus the mortgage insurance of  $131.25 totals to a payment of $3,915.09. With only $3,220 available after expenses, we’re left with a negative cash flow of  $695.09. This would not be an acceptable position to a lender and probably not to the investor.

In order for this deal to work with less money down, it will need to be bought a lower price, financed at better terms or a combination of both. This is where the negotiating skills of the investor come into play. May be he can get the price down or convince the owner to hold the mortgage at an attractive interest rate.

At this point the value of the property, based on its cash flow, will yield a lower value than a comparable market analysis yields. This is almost always the case when analyzing 2 family houses. The potential buyers who are looking to personally occupy one of the apartments are willing to pay more for a home than an investor will.

When an investor buys a property for appreciation, while ignoring its cash flow, he is no longer an investor. He is now a speculator. Equity doesn’t make mortgage payments. An investor is looking for appreciation, without taking money out his pocket each month to meet the bills. A speculator is betting that the rate of appreciation will be high enough that he will be able to sell the property, or refinance the property, before his cash runs out.

Lenders will always look at the cash flow to cover the mortgage payments. They don’t share in the appreciation of the property. They are only there to foreclose when the investment doesn’t work out as planned. The savings banks, back in the Eighties, learned an expensive lesson when they began to back the speculators. They found themselves foreclosing on properties that had a current market value substantially less than the outstanding mortgage. Lenders didn’t learn from their mistakes. Many of the non-performing mortgages that created today’s mortgage crisis were given to investors that were speculating through property flipping where things didn’t go as planned.

A prudent lender wants the investor to share in the risk of the venture. This means they want the investor to have enough of his own money at risk that he will do whatever it takes to protect it. By protecting his own money, he also protects the bank’s investment.

How can the small investor make money if his competition is willing to pay more for the properties than his can? He needs to work his strong points. The person looking to purchase this property for the purpose of moving in needs one of the apartments to be delivered vacant and in a timeframe that fits his needs, the investor doesn’t have these restrictions. From the investor’s prospective he has all these things going for him:

·    Since he’s renting out both apartments, he can accept the property with the existing tenancies.

     ·    Repairs don’t scare the investor away. He just adjusts his offer to reflect the additional costs that will be incurred to make the repairs.

·    Timing is rarely an issue. The investor can close immediately, wait for the seller to be ready or even close and let the previous owner stay on as a tenant.

·    He can be more aggressive in his offer. Having more experience in the purchase process, he is able to go into contract without a mortgage contingency if necessary.

·    The investor can purchase a property with building violations or certificate of occupancy problems. His experience and contacts in the industry will allow him to put a dollar value on the problems instead of being scared off like the owner occupied purchaser might be.

·    The property condition may be such that conventional financing is not available. The investor is capable of being more creative in his financing options.

·    A problem tenant would scare off most people looking to move into the property, but not the investor. He again, can put a dollar cost on evicting the tenant and repairing the apartment. He could even be willing to purchase a property without seeing all the apartments. All he does is reflect this in the sale price.

The investor is in the strongest negotiating position when the property has some issues with it. They could be minor problems or major ones, either way the problems will take the owner/occupied buyer out of the picture. For the small investor to be successful, he needs to be accurate in his analysis of the purchase and creative in his negotiations.

Purchasing a Small Commercial Building:

This is a typical presentation from a current owner:

Monthly Income:

Total                                    $10,000.00 / month

Annual Income:                   $120,000.00

Annual Expenses:

Taxes                                       5,000.00

Insurance                                $2,000.00

Maintenance                             2,400.00

Utilities                                     2,100.00

Total Expenses:                    $11,500.00

Net Operating Income:    $108,500.00

This is how a lender will analyze the same purchase:

So you can see that the amount of cash available for debt service is substantially less when a more thorough analysis of the expenses is done. The next step is to see how large a mortgage this property can support.

Let’s say our lender wants a Debt Service Coverage Ratio of 1.25. That would mean that they would only allow $72,400.00 ($90,500 / 1.25) for annual mortgage payments. It doesn’t matter which mortgage product is used the mortgage payment would need to be $6,033.33 ($72,400 / 12) or less. A 7% interest only mortgage would support a mortgage of $1,034,000.00 but a 15-year self-amortizing mortgage at 6% will support only a $715,000.00 mortgage.

An investment is analyzed based on weighing the size of the perceived profit against the potential loss.

Purchasing a Small Apartment Building:

For our next example we are going to examine the purchase of a small apartment building, located in Queens. A common size building throughout all the boroughs is a 6 Family building. These are typically older building that were built as cold water flats that were upgraded over the years adding central heating systems, etc. The two unique components of a purchase of this type are first, higher maintenance and utility costs. We have an old structure, no idea of the quality of workmanship of the work that was done over the years, poorly insulated and probably an outdated heating system. The second issue is that the tenants are protected under rent stabilization or possibly even rent control.

The Division of Housing and Community Renewal (DHCR) is the State agency, which is responsible for the rules governing rent control and rent stabilization along with the enforcements of those rules.

Rent Control is the older of the two systems of rent regulation. It dates back to the housing shortage immediately following World War II and generally applies to buildings constructed before 1947. In order for an apartment to be under rent control the tenant must have been living there continuously since before July 1, 1971. When a rent controlled apartment is vacated, it either becomes rent stabilized (where the building contains at least 6 units) or is completely removed form regulation. Rent control limits the rent an owner may charge for an apartment and addresses the right of any owner to evict tenants.

Rents charged in controlled apartments are set and adjusted on the basis of registration filed by owners when Federal rent control was imposed in 1943. The rent control law allows DHCR to determine how much rents can be increased based on an assessment of what it costs owners to operate their buildings plus a reasonable profit.

In New York City, apartments are under rent stabilization if they are in buildings of six or more units built between February 1, 1947, and December 31, 1973. Tenants in buildings of six or more units built before February 1, 1947, who moved in after June 30, 1971 are also covered under rent stabilization. A third category of rent stabilized apartments covers buildings with three or more apartments constructed or extensively renovated on or after January 1, 1974 with special tax benefits. Generally, those buildings are only subject to stabilization while the tax benefits continue or, in some cases, until the tenant vacates.

Like rent control, stabilization provides other protections to tenants besides limitations on the amount of rent. Tenants are entitled to receive required services, to have their lease renewed, and may not be evicted except on grounds allowed by law. Leases may be renewed for a term of one or two years, at the tenant’s choice.

Each year the Rent Guideline Board (RGB) of the City of New York decides want the allowable rent increases are for rent stabilized apartments in the city for the upcoming year. They will set the allowable increase for one and two year renewal leases, any vacancy increases, etc. Landlords must comply with these guidelines or face treble damages. If the landlord is found violating any of these guidelines, he must roll back the rent charges to where it is supposed to be and pay the tenant 3 times the overage that was collected during the period in question.

The analysis of this property is similar to what we did with the 2 family house. The main differences are that we need to consider a higher cost factor for maintenance and utility costs and our projections for rent increases need to take on a different slant.

Our subject property has a rent roll that looks like this:

Apt 1        $575.00       (rent stabilized)

Apt 2        $800.00       (rent stabilized)

Apt 3        $950.00       (rent stabilized)

Apt 4        $240.00       (rent controlled)

Apt 5        $900.00       (rent stabilized)

Apt 6     $1,100.00       (rent stabilized)

Total    $4,565.00

This spread of rents is typical for a 6 family house. The rent of an apartment is dependent on the turnover frequency of tenants and the amount of renovation done on the apartment. DHCR permits a landlord to increase the rent by 1/40^th of the cost of improvements in the apartment. If the apartment is occupied, the tenant must agree to the renovations and the increase. If the apartment is vacant, the landlord s free to renovate as extensively as he wishes and therefore increase his rent by that 1/40^th factor.

A building wide renovation can also be done (without tenant permission) and a general increase can be passed through to all your tenants. This is called a Major Capital Improvement (MCI). The catch is that your proposed renovation needs to be submitted to DHCR, they need to approve the job with its associated costs, and upon completion confirm the work was done according to the plans submitted. Although possible to do on a small building, it typically is not cost effective as a means to increasing rent.

The monthly expenses on this property are:

1.     Taxes of  $270.00 per month

2.     Water & Sewer Charges of $150.00 per month

3.     Insurance of $200.00 per month

4.     Utility costs of $800.00 per month

5.     Average maintenance costs of $1,000 per month

6.     Management fees of $150.00 per month

You’ll notice that I’m not factoring in a vacancy component with this example. The reason for that is simple. The main reason for an investor to consider this type of property is that he is purchasing the property based on a rent roll that is substantially below market. When a tenant vacates there is no shortage of potential tenants to take over the apartment. The question is how much of an increase can you get on the unit. The highest rent in this building is still less than 50% of what we were getting in the 2 family example.

The total monthly expenses here come to $2,570 leaving $1,995.00 for debt service and profit. Our investor now needs to arrange for financing. This is a commercial mortgage and a small one at that. His choices for financing are limited and his closing costs are going to be on the high side. Instead of a closing cost factor of 5% we are going to use 7%. Everything is more expensive with a commercial mortgage, the mortgage tax is greater, legal fees and appraisals are more expensive and an environmental study will need to be done. Anticipated down payment requirement will be 25% (maybe 30%).

The asking price on this property is $350,000. 25% down will be $87,500 and the closing costs will add another $18,400 bringing the total cash invested to $105,900. Our mortgage payment at 8.25% will be $1,972.07. Leaving $22.93 as a monthly return on the $105,900 investment. 

Why would an investor consider a property like this?

1.  In our 2 family example our list price worked out to be approximately 9 times the annual rent. This is a pretty normal relation. In this example we are less than 6.5 times the annual rent. This is again a typical relationship. Because of the added problems with rent regulation and maintenance, the market will not support as high a premium on the 6-family as the 2 family.

2.  The rent roll of the 6 family is not at market rent. Any vacancy gives the landlord the ability of a substantial rent increase without needing market prices to rise. The 2 family investor, who bought a property based on rents that are at market or close to market, needs the market price to go up before he can get any sizable rent increase.

1031 Exchanges

Investments are made expressly for the purpose of making a profit. The ultimate goal is that at some point you will sell the asset for more money than you’ve invested. Real estate investing, no matter how large or small, affords several avenues to take your profit out of the deal. The tax consequence of each approach is quite different.

You could simply sell the property and pay tax on the gains. This is the most straightforward method of taking your profits, but is typically the most expensive.

Currently the Federal Capital Gains rate is 15%. If the property has been held for less than 12 months the rate is your ordinary income tax rate, which can be as high as 36%. In the case of depreciable property (such as rental or industrial property) there are additional taxes due. Over the period you have owned the property, you have taken a depreciation deduction each year against your ordinary income. Now that you are selling the property the Federal Government will be recapturing the revenue they didn’t receive from you over the years you had the property in service. This recapture is taxed basically at your ordinary income tax rate. In addition to what you will owe the Federal Government you will also have New York State income taxes to pay.

Depending how long you’ve held the property and the dollar amount of the improvements that have been added to your cost base, you could have a substantial exposure to capital gains tax. Obviously, the first thing that’s done when addressing the issue of taking your profit out of the deal is to have a long talk with your accountant. You should have an idea of your tax bill before considering selling the property.

If you feel this property is still a good investment but need money for other purposes, refinancing the property becomes a viable option. If you’ve owned the property for some time, you probably can net out the same amount of cash through refinancing as you could through selling it. You can safely refinance the property for 70% to 75% of the value of the property, take the proceeds, pay no capital gains tax since you didn’t sell it and still have the property in your portfolio. This is a sensible way of going if your are happy with the investment you’ve made in this property and see it increasing in value going forward. If you’re not happy with the property or have become negative to the prospects of continued appreciation, then refinancing would not be the best course of action.

There is a third option. If you plan on making another real estate investment and don’t want to hold on to this particular piece, you can execute a 1031 tax-deferred exchange. Section 1031 of the Internal Revenue Code allows property owners to exchange their property for other like-kind property.  This makes it possible to transfer the financial gain that is realized from the sale of a property into another property.

There are strict rules that need to be followed in order for the exchange to qualify for this preferential tax treatment. Before considering this approach you should continue your discussion with your accountant. If he agrees that this is the way to go, then work closely with him and your attorney to be sure your execution is properly done.

For a property to qualify for the exchange it first needs to show that it was being held for the productive use in a trade of business or was being held for investment. It can’t be your primary residence or your vacation home. The property you are trading off is called the relinquished property.

Your goal is to take the relinquished property and trade it for the replacement property or properties. The replacement property must be of like kind. All this means is that it must be a property that you will be using for business or investment purposes. You can exchange a residential property for a commercial property, a hotel for a shopping center, etc.

The sale must be executed through the use of a Qualified Intermediary, establishing special trusts or special security and guarantee arrangements. At no point during the transaction can any of the proceeds of sale get into the investor’s hands. The Qualified Intermediary can serve in no other capacity and must be completely independent from you. In other words, a family member would not be eligible to function in this capacity.

Section 1031 requires an actual exchange of properties.  If you simply sell your property and reinvest the money in another property, you will not qualify for exchange treatment, even if it is a simultaneous close.  This type of transaction will result in “Constructive Receipt”. 

Constructive receipt occurs when you have the funds in a position in which you may draw on them, direct their usage, or give notice of intention to withdraw.  In other words, you must not have control of the funds.  If you have any type of control on the funds or control over the person holding the funds, you will be considered to have constructive receipt. When the Qualified Intermediary is holding your funds you are not in constructive receipt because control over this money is subject to a substantial limitation or restriction. You are in constructive receipt at the time such limitations or restrictions lapse, expire, or are waived. The Qualified Intermediary is an independent organization whose only contract with you is to prepare the exchange documents and hold the cash proceeds from the sale of the relinquished property, nothing else. It cannot serve as your attorney, accountant or any other agent of yours.

The proper procedure you need to follow is this. You find a buyer for your property. You then close on the sale, but the proceeds of sale are given to the Qualified Intermediary not to you. You then have 45 days to identify the replacement property to the Intermediary. The Intermediary has 180 days from closing on the relinquished property to close on the replacement property unless the tax return is due for the investor first. Then that date becomes the deadline.

The replacement property must be of equal or greater value than the relinquished property. There can be more than one replacement property. You can:

·    identify up to 3 properties up to any value

·    identify any number of properties as long as the value doesn’t exceed twice the sale price of the relinquished property. (Remember we are talking about the identifying stage; the sale price or prices have not been negotiated yet.)

     ·    identify any number of properties as long as you close and take title to 95% of the value of such properties.

All the proceeds of sale from the relinquished property need to be invested in the replacement property. Remember you are not being relieved of your tax bill, you are just deferring it. When the time comes and you finally sell the replacement property, without doing another 1031 exchange, the capital gains tax is calculated the same as in any other sale. You need to establish the cost basis on the new property at the time of sale.

The basis on the new property starts with the basis transferred from the old property. That is the original purchase price, plus the transaction costs at the time of purchase, plus the cost of any improvements, less any depreciation that was taken over the years. We then add in the difference between the sale price of the old relinquished property and the new replacement property, minus the deprecation on the new replacement property. It is on this number that the capital gains tax is calculated. 

History:

The origins of tax-deferred exchanges go back to The Revenue Act of 1918. This was the first income tax code and it did not specifically allow for any type of tax deferring exchange. To accommodate the needs of farmers, exceptions began to be granted so they could swap parcels of land among themselves to make their farms more productive. The Revenue Act of 1921 was the first time tax-deferred exchanges were formally authorized by the government. This was a much more liberal tax code than we have today. It allowed for exchanges of like-kind as well as non-like-kind assets. Even securities could be exchanged.

The exchange rules were cleaned up with the adoption of the Revenue Act of 1924. This act limited the use of tax-deferred exchanges to like-kind properties. In 1954 the tax code was amended moving the requirements for tax-deferred exchanges to Section 1031 and adopted the framework of our present day structure.

The Deficit Reduction Act of 1984 codified the rules governing a tax-deferred exchange adopting the 45 and 180 calendar day rules. The next significant revision to this section occurred in 1989. The Revenue Reconciliation Act of 1989 made 2 major revisions. First, it eliminated the ability to use a tax-deferred exchange between domestic and foreign properties. Second, it created a 2-year holding period requirement for 1031 exchanges involving related parties.

Major Guidelines:

The property that the owner is selling must qualify as business or investment property. Dealer property or property considered as inventory is not applicable. A property that is being “flipped” would not qualify for a 1031 exchange. Neither would a primary residence or a vacation home meet the requirement.

Only the gain on the net proceeds of sale needs to be reinvested in the replacement property. The net proceeds is defined as the sales price of the property less all transactional expenses paid by the seller at closing. If the replacement property is not of the same or greater value tax will be due on the shortfall. The IRS calls this “boot”.

The mortgage on the replacement property must be equal to or greater than the mortgage that was on the relinquished property at the time of the sale. If the mortgage taken out on the replacement property is greater than the existing mortgage that was on the relinquished property the difference is considered boot and taxes will be owed on that difference. If you are looking to take cash out of the transaction, the way to do it is to place a mortgage on the property after title is transferred from the Intermediary to you.

The same ownership entity that sold the relinquished property must become the owner of the replacement property. Whatever taxpayer id number was used for IRS filings on the relinquished property must be the same id number that is associated with the replacement property. This is why a tax-deferred exchange cannot be used when a partnership is breaking up. In order to take advantage of a 1031 exchange, a partnership would need to convert to a Tenancy in Common form of ownership, wait 2 years to conform with the holding period requirement of related parties, and then execute the 1031 exchange.

Tenancy in Common is defined as an undivided fractional ownership of real estate. Each owner has his own deed and therefore an owner can pass through the exchange since he can now use the same tax id number.

Exchanges can be executed either through a forward exchange or a reverse exchange. Until now we have been addressing forward exchanges, where the relinquished property is sold prior to the purchase of the replacement property. It is possible to acquire the replacement property first. This is called a reverse exchange. In 2000 the IRS published Revenue Procedure 2000-37 in which they set the guidelines to properly execute a reverse exchange. This procedure details the requirements of a “Parking Arrangement”. That is a mechanism by which the Qualified Intermediary acquires the replacement property holding or “parking” it while waiting for the relinquished property transaction to close.

The procedure works like this. First, the Qualified Intermediary either creates an “Accommodation Titleholder” or takes title in its own name. This entity then takes title to the property. Second, a “qualified exchange accommodation agreement” must be entered into within 5 days. This agreement commits the Accommodation Titleholder to report to the IRS that it is the owner of the property and files tax returns reflecting all income and expenses related to the property. It specifies that the property be parked for the purpose of completing a 1031 exchange within 180 days of taking title. Third, the relinquished property must be identified to the Qualified Intermediary within 45 days of the Accommodation Titleholder taking ownership of the replacement property.

The Accommodation Titleholder is an independent entity of the principal in the transaction. This means that the principal can lend money to the Titleholder in order to purchase and or renovate the replacement property. He can lease the property from the Titleholder. He can be paid a management fee for managing the property for the Accommodation Titleholder. He can build on or renovate the property. Whatever the principal does, he needs to make sure that property is transferred to him within the 180 day window or he will not qualify for the exchange.

Construction Exchange:

A 1031 exchange can also be used to construct or substantially rehabilitate a property. The biggest obstacle however is that you need to comply with the 180 day timeframe. The procedure here is similar to the reverse exchange. The property is parked during the construction phase. Proceeds of the sale or the relinquished property is held by the Intermediary and released to the Titleholder to pay the contractors. Once all the proceeds of sale are spent, the property can now be transferred from the Titleholder to the principal completing the exchange.

The 1031 tax-deferred exchange allows the real estate investor the flexibility to modify his real estate holding to best suite his investment objectives without exposing himself to capital gains tax. It also has the effect of keeping real estate values strong. An investor has little incentive to sell off real estate holdings. If he does, he is obligated to share a substantial share of his profits with the IRS. This limits the number of properties that actually come to market. In addition there is another effect. When an investor starts the exchange process in motion, he is forced to move quickly. If he doesn’t complete the transaction within 180 days he loses all the benefits of the exchange. This forces him to be less aggressive in negotiating the purchase price on the replacement property. He will choose to pay a higher price in order to control the timing of the purchase transaction. He’s got too much to loose if he closes on the 181^st day.