Income from Real Estate Property Investments in Illinois

Illinois Real Estate Investments, Foreclosure Seminar and Rehabber Program

Hold on to your wallet, It's time for the Fall Guru Tour

"On news stands everywhere... The Chicago Tribune, Sun-Times, and just about every other area media outlet in town, are already carrying full page advertisements trumpeting the imminent arrival of Donald Trump and his entourage of real estate experts "guaranteed" to reveal the SECRETS of successful real estate investors. Gosh! The auditorium will be chock full of Gurus.

Now, About this Guru Business...

I must say, when I read these advertisements for Trump's mega-events, and Robert Allen's and Carleton Sheets' "free seminars" I get a little weary. Not because of the free seminar "pitch" - indeed, I make the same offers in NDP's run-up to our Boot Camps.

For newcomers to our Urban Rehabber Program such "free events or seminars" provide useful information and an introduction to NDP's educational programs.

And I do believe fully in the value of the Seminar and workshops we've developed since early 2000. We have so many Success Stories, often from folks still involved in our program, that I know we're doing good things.

SECRETS(!) On Tape?

Personally, I don't believe it's possible to learn what's needed to succeed in real estate investing by following a self-study probram based solely on packaged books, or CDs, or tapes – or even boot camps for that matter – sold at premium prices, without ongoing support on a face-to-face basis. I write a lot, and I read a lot, but I don't believe anyone can "learn the business" sitting at home with earphones on, or reading a book - even if I wrote it!

By all means, read the books! It just isn't enough. We all need mentors and networks to really 'make it'.

But that's not what these "mega events" are all about: A featured Celebrity"headliner", with a host of lesser lights who paid for a table at the back of the room, or a "breakout session," in order to sell their products. And then – They all pack up and leave town! At best, they may invite you to "write if you get work." But, not to worry, they'll be in touch shortly. With an even better offer...

A little "food for thought"––

The Chicago Tribune's Lew Sichelman commented on this "Guru business" in an August column (2007), in the Trib's real estate section...

In his article Sichelman notes the recent sentencing of sometimes Guru Wade Cook. Cook is headed off to 88 months in a Federal penitentiary, primarily for tax fraud (Making too much $$ on the seminar circuit to give some of it up in taxes.)

"People such as Cook prey on consumers looking for the secret to make millions in the stock market or in real estate," according to Sichelman. "But there is no route from rags to riches in either field other than hard work."

Sichelman gets at least a part of his inspiration (and documentable information) for this column from John T. Reed who, for years, has made it his mission to unmask charlatans in the "Guru business". I've been recommending Reed's web site for years, both for the pages I'll direct you to and for his published "how to" books which I consider first rate.

That said, I won't be your Guru, but maybe the Urban Rehabber Program will provide the learning and support you need to succeed in this rewarding business.

The Savvy Rehabber

Desiderata– ‘Things to be desired’

~ Live simply; live well. Strive to avoid conspicuous consumption.

~ Practice Thrift in all things; above all, avoid waste.

~ Pay yourself first. In this way you will always be prepared.

~ Be practical. Understand feasibility, what’s

possible, what will work.

~ Be creative, alert for new solutions, techniques, technologies.

~ New is not necessarily better. Seek out the value in the discards of

others; it is a more efficient use of scarce resources.

~ In your work, as in your life: Build simply, but build strong.

~ Quality can be affordable. Quality is inherent in taking care of

what one does–it is not merely a matter of spending more.

~ Craftsmanship is another word for Integrity. The craftsman takes

care in the work of his hands and in the work of life.

~ Value is realized when one believes they’re getting something more

than what they pay for.

~ It is never “just about the money.’ To presume otherwise is

to diminish the Spirit.

~ Marshall the efforts and talents of others, you cannot

do it all yourself!

~ Never cover up or mask a problem. Each problem in turn is an

opportunity for personal growth and a challenge to our integrity.

It is how we deal with the problem that counts.

~ Own your mistakes. It’s how we learn.

~ At all times, be a student as well as a teacher. We all have much to

learn and much to share with others.

~ Be a Mentor. “Each one teach one”– Let the value

of your work multiply.

~ Always seek to be fair–with your Self as well as with others.

~ At the end of the day: You are the responsible party– for your

successes and for your failures.

~ We are all known and ultimately remembered by our Works.

~ Honor what you do, it is who you are.

~ Strive to be a whole person.

~ To be ‘savvy’ is to be wise.

© 2006 Philip Elmes . Inspired by the prose poem “Desiderata” by Max Ehrmann (1872-1945 ), written sometime in the 1920s.

Link to 2 of the Urban Rehabbers "Dirty Little Secrets"

On being ‘rich’ (or maybe we mean ‘wealthy’)

Most ambitious young people set out on their careers determined to do their best, work hard, and enjoy the benefits of diligent pursuit of excellence. This is the American Way. But too soon lifestyle expectations and what we perceive as an ever rising ‘cost of living’ combine to lock us into growing personal debt and, for most, apparently narrowing prospects for financial independence. A financially secure Retirement is becoming an uncertain view of the future.

When we talk about ‘wealth’ and ‘financial independence,’ some of us fantasize about Bill Gates (‘more money than God’) or the late Sam Walton, founder of WalMart, or Donald Trump (‘lots of money,’ and ‘trophy wives with exotic names’). That’s being rich. More interesting to many of us is the notion of Wealth.

Build ‘Passive Income’ for long term wealth

Robert Kiyosaki, in his best selling Rich Dad/Poor Dad (Warner Books, 2000), defines wealth as that moment in time your passive income from investments is sufficient to meet your living expense. The day we recognize that if we were to just stay home, and not go to work, there will be enough investment income coming in to pay the bills and at least ‘get along’–that realization is one’s Declaration of Independence! from the Rat Race, from the stress and dissatisfaction of less than ideal employment. Perhaps, as Joseph Campbell once described it: with this happy turn of events, one is truly freed to ‘follow one’s Bliss,’ to pursue our dreams, to undertake all those other agendas in our lives put aside early on in deference to conformity and the work-a-day world.

It’s assets that count in the long run

If this proves to be a universally accepted definition of Wealth as it should, how might we all achieve such a desirable condition? Kiyosaki, a successful self made millionaire, suggests first of all that we recognize the sometimes subtle difference between assets and liabilities. Assets, he says, are investments that result in real tangible, monetary returns–assets make money. Assets work for us, all the time, rain or shine. Liabilities are items or entertainments that we purchase (homes, cars, wardrobe or vacation cruises) that may contribute to our sense of living the Good Life but nevertheless diminish in value over time and contribute nothing to Passive Income, the true Index of Wealth.

Investing in Real Estate, Securities & Savings

Historically real estate investments have proven comparable to investment in securities (stocks and bonds), “whole life” insurance, and systematic savings programs where interest compounds. The stock and bond market for nearly 75 years, beginning in 1926, yielded a pretax 5-12% annual return where income was left to compound (the difference being the specific investment vehicle).All of these investment vehicles generally increased in value faster–or at a higher rate–than inflation, and will grow even more quickly when additional contributions are made periodically over time. As governmental taxation policies change, advantages sometimes shift from one investment vehicle to another as policy makers seek to encourage one form or another of savings or investment; recent examples include IRA, Roth IRA’s and 401k tax deferred accounts, and changes in capital gains tax rates favorable to investments.

Home Owners enjoy long term Investment Benefits as well.

The real estate market for single family homes has not lagged behind these sometimes sophisticated investment strategies. Indeed popular wisdom has it that the single most important investment one may make is in the purchase of one’s own home. For many, home ownership is their primary estate building opportunity, especially given the likely inadequacy of personal savings as a contributing factor. Across the country, homeowners in particular have enjoyed steady gains in the market value of their homesteads for sixty years or more (since the nation’s recovery from the world wide economic depression of the 1930s). While the midwest may have trailed other more heated regions of the country in recent decades, the statistical gains for the year ending March 2004 are noteworthy.

For Additional Information visit - www.UrbanRehabber.com

Illinois leads neighboring states in real estate appreciation

The East North Central Region, which includes the Chicago metropolitan area, fared somewhat better than neighboring states and metropolitan areas. And Illinois, in particular, fared better than its neighboring states in annual value increase 2003-2004.

The Chicago metropolitan area, including Chicago and its surrounding suburbs, performed in keeping with the statewide housing statistics concerning increases in market value over time. However, it should be noted these statistics do not take in to account increases in median prices due to new construction. That said, it may be useful to plot the increase in value (not adjusted for inflation) of a $100 thousand single family purchased in 1980–

Where is Chicago headed?

A. Beginning in about the year 2000, the Chicago metropolitan area has enjoyed a rapid increase in the median price of housing. This has been due to many factors, including low inflation and low interest rate driven price increases. Federal monetary policies have restrained inflation in recent years to less than 4%. Central to the Federal Reserve Bank’s program has been to reduce interest rates; this policy, in turn, has stimulated new home construction across the country. Improvements in construction technology have contributed to “more house for less money,” further encouraging home buying. In some metropolitan markets – notably including Chicago – central cities are being converted from obsolete commercial and industrial use to high density housing; and long neglected “inner city” residential neighborhoods are being improved (and sometimes “gentrified” to the detriment of long time residents – but that’s another discussion...). To one extent or another, all these factors contribute to increasing median prices.

In the end, Why Real Estate?

B. Liquidity. When compared with other investment and savings opportunities, holding real estate for long term appreciation merely keeps pace with more liquid assets. Assets such as cash savings accounts, Treasury bills, stocks and bonds, may be readily retrieved (by going to the Bank) or sold “over the counter” by calling your broker. Real estate, on the other hand typically takes weeks or months to sell or “liquidate.”

C. (Sophisticated real estate investors, on the other hand, appreciate that where there is “equity” available in a piece of property, it is generally possible to pledge that equity as collateral for a loan and thereby raise needed funds. Other alternatives include: simply refinancing the property, the sale of a partial interest in the property for cash, or the “sale and lease back” of the property to a passive investor, among others.)

D. Security and Long Term Growth. Liquidity is only one attribute looked for by an astute investor. Security and long term growth are also important. The long term growth attributable to real estate equities has already been discussed. To be sure, all investment markets are somewhat cyclical. And in the event of economic catastrophe, such as the Great Depression of the 1930s, which few if any can be full prepared for, all markets will turn “down” for some period of time. Securities analysts suggest the stock market historically has experienced roughly 10-year cycles of “bull” and “bear” markets, sometimes punctuated by sudden and often unpredicted rises and declines (remember “tech. stocks”?).

E. Real estate is arguably cyclical by nature as well. Housing starts (new construction) will increase and decline, often as a function of interest rates. Office building is chronically subject to over building in times of rising rents – due to low vacancy rates – and economic prosperity, only to slow in the face of increased vacancies due to “over building.” Low interest rates beginning in the late 1990s encouraged renters to buy their own homes or condominiums (It became “cheaper to buy than to rent”), resulting in rising vacancy rates in multifamily investment properties and apartment complexes; as interest rates rise in future, this condition too will reverse.

F. In the end, all investment strategies should be long term to be successful. Securities analysts cannot agree on whether those who actively trade – buy and sell frequently based on one “market timing” technique or another – come out ahead in the end. Indeed, the preponderance of evidence suggests simply buying and holding solid “blue chip” stocks works best in the long term, yielding an average of 11-12% annual yield or growth.

G. Leverage. Leverage, or the ability to control a large amount of capital with a lesser amount of cash, is one way to enhance yield on an investment. In the stock market, this is generally referred to as “buying on margin” and is accomplished by borrowing the additional funds from the broker. When one is convinced of the immanent increase in market value of a specific company's stock, using this margin account – in fact borrowing – it is possible to purchase many more shares, which become collateral for the margin account loan. Using this technique, even a small increase in value may equal or even exceed the actual funds initially put at risk (for a 100% or more profit).

For example a 5% increase in value of a thousand shares valued at $100 each would be a gain of $5,000; if purchased using $90 thousand borrowed, this would result in a gross profit of 50% before interest and transaction costs.

I. Speculators in stock options and commodities employ essentially the same arithmetic in their dealings, gambling on both price increases and decreases. The common denominator, once again, is Leverage, the use of limited funds to control substantial assets subject to price fluctuation. The problem is: that while leverage creates opportunity for exceptional gains or profits, the consequences of wrong predictions are proportionately just as great. To have the values go against the investor or speculator is to risk loss of the investment, and liability for additional losses should price declines exceed the “equity” committed.

J. Risk Factors of Leverage. In any event this use of Leverage is inherently high risk and generally left to the realm of speculation rather than investment. In real estate the corollary is (non income earning) vacant land or, possibly, the recent phenomenon of speculators purchasing homes and condominiums in rapidly appreciating markets with the intention to resell in the near term – say, 1-3 years. The vacant land seldom generates income sufficient to cover carrying costs, and gains value only when deemed attractive for development.

K. Similarly, homes purchased in a rising market for speculative purposes rarely enjoy “positive cash flow;” it’s likely one will have to contribute to whatever rental is generated in order to meet all the costs of ownership. Should the market “flatten,” or worse yet decline, the mere transaction costs may seriously compromise profits if sold within the first year or two. Such short term purchases are best understood as speculative real estate plays, rather than investments.

L. Leverage is nevertheless central to understanding the benefits of long term real estate investment in income earning assets. With traditional lenders prepared – if not, indeed, anxious (they’re looking for the business!) – to lend 75-100% of the capital required to purchase and own an investment property, leverage is built into the equation. Like any other form of leveraged investment, increases in the value of the entire asset (appreciation ) magnify the yield on the funds actually invested. Loan reduction paid down over time out of rental receipts also contributes to equity growth and yield.

M. Government ‘Incentives’ make real estate attractive. Governmental incentives, including depreciation, the deductibility of interest and operating expenses, and the availability of long term capital gains tax treatment on the long term profit, all serve to enhance the incentive to invest in real estate.

N. Conclusion

O. This combination of rising demand and increasing market values, and the ready availability of conservatively managed leverage, combine to create an exceptional opportunity for those committed to a long term savings and investment program. For those who “pay themselves first,” practice personal thrift and disciplined investment, real estate offers an accessible path to long term wealth and personal well being.

Analyzing Income Property

P. The Income Statement

Q. The basic analytic tool for evaluating the Investment Quality of any given income producing property is the Income Statement. The Income Statement is a summary of all the critical information concerning the property:

• Purchase Price

• Costs of Acquisition, or Purchase

• Income

• Expenses

Assumptions. The Income Statement presumes a long term commitment to ownership and prudent management. An example of “long term commitment to ownership” is the inclusion of Maintenance and Replacement Reserves, two items often neglected and dealt with ‘as needed,’–another word for Crisis Management by unsophisticated investors.

“Prudent management” is reflected in recognizing the Cost of Management Services, even if the owner/landlord plans to manage his/her own properties. Another example is budgeting for Vacancy and Credit Losses. No one is ever disappointed by better than anticipated investment performance. But such vacancies and credit losses do occur – with the best of management. Lenders and other creditors may be sympathetic with losses due to vacancy, but they seldom forgive or suspend the investor’s obligation to pay while these problems are ‘worked out.’

Net Operating Income. The first objective is to determine Net Operating Income (“NOI”) of the property. This is the foundation, or primary building block, upon which you will build your Income Statement. Net Operating Income is the income remaining after all property related expenses and budgeted Reserves and Vacancy have been deducted. NOI does not take into account mortgage payments (“Debt Service”) or tax consequences; nor will it tell you whether, at the end of the year, you will have any cash left over for other purposes.

Assembling the Information. In evaluating or purchasing a specific property, much of the needed information should be available from the present owner. A conscientious real estate agent will have collected the property’s operating information from the owner at the time the property is listed or offered for sale.

A word of caution is in order here: This is a classic example of the old adage “let the buyer beware!” While lease information should be readily available and verifiable (it’s not unusual to request copies of the actual leases), expense information is frequently understated or omitted entirely. In many cases, the sales agent him/herself may or may not be experienced in selling investment real estate, may not know enough to ‘ask the right questions,’ or may accept misrepresented information as fact. It is extraordinary that maintenance expenses or vacancy reserves are offered up voluntarily by sellers or their brokers. In every instance, the astute investor will take the information provided and test it against his own experience and judgment, collecting vender quotes or ‘comparables’ as needed.

• Operating Income. Where there are leases in place, the seller should provide a schedule of leases in effect and, at the appropriate time (certainly prior to closing), reference copies of all leases. Special note should be taken of expiration dates, security deposits held by the landlord, provision for utility payments (who pays for heat and electricity), and any special clauses relating to lease extensions, options to buy, or any other matters that may effect the value or enforceability of the lease.

With regard to vacant properties, rent comparables must be collected from the marketplace. Rents currently being asked by landlords may be available from the real estate rental classified section of the community’s newspapers. Where properties are characteristically offered subject to government subsidy programs, such as Section 8, then prevailing rents information should be available from the appropriate agency. For example CHAC, the agency responsible for Chicago’s Section 8 “Voucher Program,” provided the following information during 2002.. These “payment standards” were substantially revised during 2004; see note below.

It should be noted the “payment standards” shown, under the protocols observed in 2002, represented the maximum amounts allowable in each category; CHAC staff would then “adjust the allowable rents (on the South Side, invariably downward) for specific neighborhood, condition of the property, etc. Where tenants were to pay their own utilities, a formula amount based on room count, etc., would be deducted to provide for utility payment. To enhance accuracy of pro forma operating statements based on Section 8 rental income, respective landlords should secure current information concerning the voucher program from CHAC.

Income lost due to vacancy or, for example, vacancy due to fire damage and the time needed to repair the damage, is just that: lost income. Lost or uncollected rents are not tax deductible.

Other Income. Security Deposits deposited with the landlord are generally not considered income unless and until such security deposits are seized by the landlord in satisfaction of unpaid rent or damage to the premises. Additional income may be derived from late payment fees collected, parking or garage rental fees, coin operated laundry facilities, utility reimbursements, etc. These “other income” sources may prove difficult to project without operating experience with the particular property but will, nevertheless, be taken into account in preparing year end financial reports for tax purposes.

• Operating Expenses. Operating expenses will fall into two basic categories: Actual expenditures deductible for the tax year, and Reserves for future expenditures and the possibility of lost income due to vacancy or credit losses.

Management Services. If professional management is to be employed to manage the property, there will be a predictable fee to be budgeted based on the Management Agreement. 7-10% of actual rents collected seems to be the prevailing rate for the Chicago market. This is a tax deductible expense.

Maintenance. Ongoing maintenance and upkeep is to be expected in order to preserve the value of the property and assure the comfort and well being of tenants. Minor plumbing repairs, painting and decorating, incidental roof repairs, and yard maintenance are all examples of maintenance. Internal Revenue Service (IRS) guidelines suggest what may be deducted currently as an operating expense.

“Improvements.” Investors and landlords often have difficulty distinguishing just what improvements to their property may; be currently deducted as an operating expense, and what the IRS will deem a non deductible “improvement.” To quote from IRS guidelines (see Footnote above): “An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. ... If you make an improvement to property the cost of improvement must be capitalized. The capitalized cost can generally be depreciated as if the improvement were separate property.” (emphases added) Capitalized expenses and depreciation will be discussed below.

The following examples of “improvements” from IRS Publ. 527 may help:

Insurance. The prior owner’s insurance premiums may or may not be applicable to the property under new ownership and management. One is well advised to secure a new quote for the property from a qualified insurance source.

Utilities: Water & Sewer. The prior owner’s operating information should prove useful here. In the City of Chicago, water and sewer taxes are combined in a single billing from the city. Again, within the City of Chicago, water consumption for single family homes and smaller multifamily properties is seldom separately metered for actual usage. For all practical purposes, the City’s billing amounts to a consumption (water) and usage (sewer) tax. Unlike real estate taxes, water and sewer taxes to not change significantly from year to year and may be predicted with reasonable accuracy.

Utilities: Heat & Electric. Heating and electric bills, on the other hand, can vary widely depending on consumption patterns. Some households are conserving in their use, others less so – particularly when it is the landlord who pays the bills! Multifamily landlords generally have control over gas heating but will, together with everyone else, suffer the consequences of particularly severe winters. Single family landlords, on the other hand, generally insist on the tenants paying their own utility bills as a practical check against excessive usage.

Real Estate Taxes. Real estate taxes for the initial 1-2 years may be determined from information provided by the seller or his agent or, in Cook County, Illinois, by going to the Cook County Assessor’s web site. Real estate taxes are fully deductible as a current operating expense.

It is important to note, however, that the taxes being assessed currently on the property are based on inherently dated information; it is not unusual to find properties that have “flown beneath the radar” for years, enjoying unusually low tax bills. In the event the property is being acquired for substantially more than the value represented in the most recent assessment – which is generally the case in an appreciating market – the purchase itself will trigger an automated adjustment to the valuation. The consequence of this upward adjustment to market value, an increase in the tax to be paid, will not be reflected until the next year’s tax bill or, sometimes, the year after that. In any event, at best the new landlord gets a “stay of execution” – the taxes will go up, but it will take a year or two.

The second major consideration in projecting real estate tax expense, aside from the possible consequence of the purchase itself, is the county’s practice of reassessing all properties within its jurisdiction every three years – the sometimes dreaded “triennial reassessment.” While one cannot with any precision predict the outcome to this periodic reassessment, it is important to recognize this as yet another “unknown” affecting all property owners.

Replacement Reserves. Every property owner recognizes that, even with conscientious maintenance, building components, mechanical equipment and appliances will simply wear out – will need replacement. Some replacements, such as the roof, windows or furnaces, will prove relatively costly. Careful managers will not be caught by surprise by these events. It is the purpose of “replacement reserve” accounts to fund these needed replacements in a timely manner.

Given the fact reserve accounts are funds “set aside” for future use, reserves are not tax deductible. When funds are drawn from such a reserve account, the expenditure will have a tax consequence in that year. Depending on the nature of the replacement or improvement, the expense will be either “expensed” currently – be fully deductible in that year – or “capitalized” as a depreciable building improvement over time. (See “Maintenance” and “Improvements” above for further discussion.)

The arithmetic is straight forward: Make a conservative estimate of the remaining “useful life” of the building component (in years); estimate the cost of the improvement at today’s prices; and divide the cost by the number of years. Do this for each major building element. the total of the annual reserve – in today’s dollars – required for all the elements is the amount that should be set aside each year in a building reserve account ( a savings account or certificate of deposit ).

It is the percentage that counts: This amount – in the example $1318 – should then be calculated against the property’s Annual Gross Income to determine what percentage of the Gross Income should be set aside.

Annual Reserve X 100 ÷ Gross Income = __%

Over time labor and materials required for any project will cost more due to, if nothing else, inflation. If a new roof can be applied today for $4500, in five years that same roof will cost well over $5000. For that reason, it is recommended that the annual amount set aside to fund reserves is indexed to keep up with inflation. This “indexing” is accomplished by making the annual contribution to reserves a percentage of the annual gross income rather than a fixed amount from year to year. As gross income increases due to inflation – rents tend to rise with inflation – the amounts contributed to reserves will increase proportionately. In future, as funds are required to maintain the habitability and value of the property, the investor will be prepared.

Vacancy and Credit Losses. Vacancy and credit losses will occur with any investment property. In today’s market, multifamily landlords routinely estimate vacancy and credit losses at 10-15% of scheduled gross income (the amount to be collected with 100% occupancy and no credit losses). Single family landlords, on the other hand, rent primarily to families who tend to be less transient, less inclined to move, unless prompted by poor maintenance or negligent management. In general, single family rentals are relatively hard to fine; tenants tend to be jealous of their single family housing opportunity and reluctant to leave. Nevertheless, it is prudent to budget for vacancy.

Should a tenant decide to move, it is unusual for a replacement tenant to move in immediately. Generally some weeks will be required to make the property fit to show prospects; and once the new tenant is identified, additional time may be lost due to inspection and lease approval delays. Should there be need to evict a tenant, many weeks may pass before the eviction is accomplished – weeks during which no one may be paying rent. In a word, years may go by with no vacancy but, when a vacancy occurs, it may be several months until occupancy is restored. It comes with the territory.

Recognizing these many “peculiarities” of the business, it is well to budget at least minimally for vacancy or credit losses, recognizing one or more years may pass without such losses. When such losses do occur, however, they often result in a real disruption of Cash Flow. Whether budgeted, as in our example, or set up as a “vacancy reserve” account in the first year or two of ownership, a budgeted allowance for vacancy will prove useful in maintaining an uninterrupted income stream from the property.

For Additional Information visit - www.UrbanRehabber.com

Exercise 1: Determining Net Operating Income

As discussed earlier, Net Operating Income (NOI) is the basis upon which one builds the remaining key analyses of any real estate investment pro forma Operating Statement. NOI does not reveal “cash on cash” returns, after tax income, or the investment quality (or “yield”) of the property. We will find the most interesting analysis, that of the yield – or return on one’s equity – may yield very different answers than the earlier, yet very important, calculations.

Case Study: John & Mary’s Investment. John and Mary are considering the purchase of a 2 flat rental property in a working class neighborhood. Given the purchase price of $125 thousand, and projected mortgage payments of just $650-$770 per month depending on the their financing decisions, John and Mary intuitively feel this is a good deal. Let’s help as they work through their numbers.

First, what’s the Net Operating Income? The property is presently leased to tenants who have lived in the building for several years. The first floor tenant is paying $800 per month for her 2 bedroom apartment; and the 2nd floor tenant is paying $1075 for the 3 bedroom apartment. Both tenants pay their own heating and electrical bills. The leases are guaranteed the the Section 8 “voucher” program.

While the present owner manages the building himself, John and Mary plan to hire a professional management company at a cost to them of 8% of the collected rents. They have secured a new property insurance quote from the agent they’ve known for years; the premium is projected to be about $950 per year. The previous year’s water bills totaled $850 and the real estate taxes were $1520.

The building has been reasonably well cared for, with a number of improvement completed within the last few years. The roof was resurfaced 3 years ago, the third layer on the existing roof. It is anticipated that within the next 12 years the roof will require a “tear off” and replacement at a cost, in today’s market, of $6800, including new gutters and downspouts. New vinyl windows were installed within the last 18 months (at a cost of $3200). The two tenant furnaces and hot water heaters are approximately six years old; it would cost about $3800 to replace them all today. The 2nd floor apartment was carpeted three years ago at a cost of $1000 and appears to be in good condition; the first floor has hardwood and vinyl floors (installed within the last 5 years). The rear porches are enclosed and considered in good condition and protected from the weather. The property is vinyl sided and should require little maintenance in the years ahead (the useful life is not really known).

Determine the projected Net Operating Income for John and Mary’s prospective investment...

Exercise 2: Determining Spendable or ‘Cash on Cash’ Income

Every prudent investor has good reason to be concerned with a prospective investment property’s ability to “carry itself” without need for periodic contributions to maintain the operating expenses of the property. This analysis, built on the NOI analysis completed earlier takes into account “Debt Service,” the payments required to meet the financing commitments of the property. The Spendable Income analysis ignores tax consequences and other yield factors which will be taken up next.

Back to John & Mary – Our investors have tenatively agreed to purchase the Subject Property for $125 thousand. Having excellent credit and good cash reserves, John and Mary have been offered both 80 and 90% loan packages, at very attractive rates ( 6 3/4 & 7 1/4% respectively, for 30 years ). The facts of their purchase may be summarized as follows:

Purchase price $125,000 $125,000

Title Ins. & Costs $550

Recording Fees, etc. $85

Co., State tax stamps $1,300

Financing Costs @2% $2,000 $2,250

Closing Costs $1,935 $1,935

Total Purchase Cost(s) $128,935 $129,185

Financing Options

1st Mtge. 80% LTV / 30 yrs. @ 6 3/4% $100,000

1st Mtge. 90% LTV / 30 yrs. @ 7 1/4% $112,500

Cash to Close (Down Payment) $28,935 $16,685

In order to “solve” for Spendable Income, we now have to determine the amount of annual Debt Service will be required of the two prospective loans. While one might just call up their friendly loan ‘consultant,’ it is possible to figure the amount with a “factor table” or loan calculator–

To use the factor table, determine the number of months of the loan, e.g., 20 years = 240 months. Next find the appropriate interest rate column. Go down the chosen interest rate column to the row denoting the number of months. The resulting “factor” (an 8 digit number) is multiplied by the loan amount. The result is the mortgage payment – principal and interest – to be paid per month; for annual debt service, multiply by 12.

Example: $65,000 at 7% for 20 years, or 240 months

Multiply 65,000 X .00775299 = $503.94 per month

Exercise 3: Determining ‘Taxable’ Income

Unlike (projected) Net Operating Income and Spendable Income, Taxable Income takes into account only actual operating expenses – not Reserve Accounts (which will only be tax deductable when actual expenditures are made). Projected Net Operating Income, then, will be reduced by at least the amount allocated to replacement reserves. For projective purposes estimated Maintenance and Vacancy/Credit losses may be retained.

Two new elements are introduced in determining Taxable Income. The first of these is Interest Expense, a tax deductable line item. While interest may in early years account for the greater part of Debt Service, and be fully deductable, the principal portion will not be deductable. Thus the Interest paid must be calculated for the year.

Step One: Interest. Referring to the last exercise, how much of the total Debt Service for the year is Interest?

The second new element is Depreciation. One of the major benefits of owning investment real estate is the “depreciation” allowed by the Government as a direct subsidy to real property owners. Some authors choose to label depreciation a tax “loop hole”– while it might be fun to call it that, let’s call it what it is: a direct governmental subsidy to the propertied class. (So, too, is the deductability of interest, for that matter, but at least that ‘subsidy’ is available to homeowners as well, as a governmental encouragement of home ownership.) The basic rules governing depreciation are spelled out in the IRS publication 527 referred to earlier –

Exercise 4: Determining ‘Total’ Income & ‘Yield’

Total Income combines the Spendable or Cash Income, with the amount the mortgage was reduced during the year (debt reduction); the Cash Value, if any, of Tax Losses for the year; and the estimated Appreciation in Market Value of the asset that may have occurred. This illustration demonstrates the considerable impact a modest 3% appreciation will accomplish over 10, 15 and 20 years time, particularly when combined with mortgage pay down and systematic reinvestment of spendable income; the second table offers an example at a 6% annual rate of appreciation.

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