Real Estate Investing – Part IV: Commercial Property

This summer I’ve written three “Real Estate Investing” columns covering single family residential properties; duplexes, four-plexes and apartment complexes with fewer than five units; and larger apartment complexes (with up to sixteen units). I recently received a request to write a column on investing in commercial real estate, so here you go.

Commercial property is not for the faint of heart. It’s not too different from the other types of real estate investing, but because of the longer depreciable life there are lower tax benefits and the bigger investment makes it a bigger risk (if you’ve heard of the risk/return trade off, that’s what I’m talking about: bigger risks can lead to bigger returns or profit. Of course, bigger risks can also lead to bigger losses, so it’s best to do your homework to minimize risk where possible.)

When investing in commercial real estate, you’ll want to run a thorough background check of any potential tenant(s), including a credit check and rental history. Don’t give the keys to anyone until the history and credit check come back clean. I’d also screen potential tenant(s) for business experience for the type of lease you’re offering. For example, if the whole reason a potential tenant is opening a restaurant is because his sister-in-law says he’s a great cook, the business plan may not be sound.

Although you may feel uncomfortable asking specific questions about the person’s business plan (especially if you haven’t done this type of lease agreement before), you’d be negligent not to inquire. When turning over an asset worth hundreds of thousands, or even millions of dollars, you want to be certain that the prospective tenant can and will perform the full agreement.

In commercial real estate, you’ll deal primarily with two types of leases: gross leases and triple-net leases. With a gross lease, the landlord is responsible for most expenses, including taxes, insurance, and routine maintenance (the tenant fixes things he breaks). With a triple-net lease, the tenant takes care of virtually all expenses, including taxes, insurance, and all maintenance.

There are pros and cons with both. As a landlord, a primary benefit of the triple-net lease is not having to deal with much property management. You’ll get no calls about a broken window or clogged sewer on a Saturday afternoon. However, if your tenant doesn’t keep up with routine maintenance over the course of several years, the long-term damage can be substantial. And, if the tenant’s business struggles, routine building maintenance is likely to be one of the first expenses to go. Sometimes the ill effects of poor maintenance are not immediately obvious, so trying to recoup expenses years after a lease begins is difficult (bordering on impossible).

As a rule, finding a tenant for a commercial building can take more time than for a residential property, so vacancies can last longer, but because commercial leases are typically multi-year contracts, vacancies are less frequent. As you consider negotiating a commercial lease, it will likely be quite different from the experience you may have had with a residential lease. Commercial tenants may be more along the lines of, “Have attorney; will travel.” If you’re lucky enough to have a major credit tenant (e.g., major grocery store, federal agency, national chain store), you’ll benefit from additional foot traffic and more stable rent. If your building allows for multiple tenants, a major credit tenant will attract other tenants. Because they know they bring these benefits, major credit tenants often play hardball when it comes to lease negotiations. They expect their rents to be lower  than other tenants, and even than operating costs for that space. Depending on how much lower, you’d be smart to play ball.

If you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

Real Estate Investing – Part III

As the headline implies, this is the third column in a series about real estate investing. I started with single-family homes, moved to duplexes and four-plexes, and now I’m on to small apartment complexes (residential real estate with 5-12 units). Before I move on, however, I need to correct last week’s column. I said duplexes and four-plexes have a higher rent-to-income ratio, and I meant a higher rent-to cost ratio. Thanks to my trusty friend Ross Liberty for catching that so I could correct it!

Okay, on to small apartment complexes. These come with advantages and disadvantages; they have a better price-to-income ratio than the smaller investments, but they require different financing, for example.

Five units or more means you cross an invisible threshold where the trusty 30-year fixed rate loan is no longer available to you. You must now delve into commercial financing. With the 30-year fixed loan, many lenders buy and sell these. With a commercial loan on a small apartment complex, it is likely that the lender will not resell the loan. Typically, whoever makes the loan, keeps it in their portfolio. The commercial loan comes with a higher interest rate and a lower loan-to-value ratio, a shorter term, and/or a requirement that the rate be adjustable.

The commercial lender is unlikely to be the same lenders you’ve worked with on standard residential mortgages. A typical commercial loan has a loan-to-value ratio of 70 percent or less and interest rates that are one or two percentage points higher than a home loan. And, the interest rate is often adjustable based on some index. If not, it may have a balloon payment at the end of five or ten years. To make matters worse, when money is tight, even these loans become more difficult to find. This is offset by the economies of scale you get from owning a larger complex.

When you reach complexes of more than 16 units, things change again. First, you are required by law to have an on-site manager. The job description for the on-site manager can be fairly brief, but he or she must live on the premises. Our on-site managers show vacant units, maintain the pool and laundry room, do light yard work, and deal with that noisy tenant at 2:00 a.m.

While bigger complexes can lead to bigger revenues, they can also be harder to sell. Very large complexes, say more than 50 units, are actually easier to finance because different lenders get in the game. Large institutional lenders like insurance companies are not usually interested in $500,000 loans (small apartment complexes), but they are interested in $5 million loans (large apartment complexes).

Most of the pros and cons of investing in residential property apply to large complexes. The 20-year-old resident still thinks he can have a party until 3:00 a.m. and junior next door still wants to have a dog.

On the other hand, vacancies are filled more quickly and there are tax advantages for mulit-family residential real estate (as opposed to commercial real estate like office buildings or retail space). Commercial space usually requires a five-year lease and has more dependable tenants (far fewer 2:00 a.m. parties), but residential properties have a better price-to-income ratio. And, with apartment complexes, you benefit from economies of scale (per unit, your maintenance and management costs are less).

As I’ve said before, real estate investing isn’t for everyone, but if you look at the return on real estate as compared to other investments, it can be quite lucrative.

If you have questions about real estate or property management, feel free to contact me at HYPERLINK “mailto:rselzer@selzerrealty.com”rselzer@selzerrealty.com or visit our website at HYPERLINK “http://www.realtyworldselzer.com”www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at HYPERLINK “http://www.richardselzer.com”www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

Real Estate Investing – Part II

Last week I shared information about investing in real estate, specifically purchasing a single-family home for use as a rental. This week, I’ll share why duplexes and four-plexes can be even better investments, if you have the funds.

I’ll use a four-plex as my example. In Ukiah, you can purchase one for about $450,000 and expect rental income of $3,800 – $4,200 per month. That’s a higher rent-to-income ratio than you can typically find with a single-family home. And duplexes and four-plexes are still easy to finance because they qualify for the same preferred financing as single-family homes, so you can get a 30-year fixed rate loan (not true for most other types of real estate investments).

Because of the lower monthly rent, it is often easier to find tenants for duplexes and four-plexes, but the turnover can be higher. Obviously, you’ll want to fill vacancies as soon as possible, but be aware, having a vacancy is sometimes better than having a bad tenant. Screening tenants thoroughly is essential to your emotional and financial happiness, and your neighbor’s niece and her boyfriend should not be exempt from the same scrutiny all prospective tenants should face. I am biased as the owner of a property management company, but I’d say the work required to find and keep good tenants can be reason enough to consider hiring a property manager.

More living quarters means more people and more maintenance. Four-plexes are ideally suited to small families, adults looking to share expenses, or individuals who want a little extra space. Having all these people living in such close quarters (sharing walls or ceilings/floors) can sometimes lead to disputes, and unless you hire a property manager, it will fall to you, as landlord, to address them.

A four-plex will not require four times as much maintenance as a single-family home, but it will require more. As with a single-family home, you only have one roof to patch, four exterior walls to paint, and one driveway to seal. However, with a four-plex, you have four toilets to unplug, four heating/cooling units to maintain, and four sets of appliances to fix when they break.

As a smart investor you must include these maintenance costs into your planning. Anticipate expenses of about 3-4 percent of the purchase price per year, or $13,500 – $18,000. This includes taxes, insurance, and maintenance costs. While you won’t spend this much every year, you will over time. And when you need the money, you don’t want to dip into junior’s college fund to get it. Create a reserve savings account and pay into it each month.

Happily, you’ll benefit from your property’s depreciation, which helps offset your cash expenses. Depreciation is a bookkeeping expense that allows you to deduct the value of improvements over time. Depreciation is only a taxable expense, not a cash expense. This means, you have the ability to save on your income taxes and this savings should offset the cash expenses noted above.

So, now you own a $450,000 rental property with a break-even cash flow. You invested $95,000 (a 20 percent down payment plus $5,000 in closing costs), and your benefit is the potential appreciation in the value of this property. If values rise at three percent a year, you’d make $13,500 on a $95,000 investment or almost 15 percent. Not too shabby.

In addition, rents will likely increase over time. And while expenses go up with inflation, your mortgage payment won’t. The bottom line is, if you can afford to buy a $450,000 rental today, in 10-15 years, you should have an asset capable of paying for junior’s college tuition (or more rental properties to earn more income).

If you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

How are 1031 Exchanges like musical chairs?

If you’re interested in investing, 1031 Exchanges are a wonderful, legal way to defer tax liability almost indefinitely. Sound good? Read on.

As always, when I write about investing or tax implications of owning real estate, I am simply sharing my opinion. If you are thinking of investing or have questions about taxes with regard to real estate, speak with your financial advisor and/or tax accountant.

The basics of a 1031 Exchange are simply this: you trade the equity (amount you own free and clear) in your property for the equity in a new property. Basic enough? Although it sounds simple, it can get pretty complicated.

To defer taxes, you need to exchange your current property for a property of equal or greater value.  To the extent that you get cash out or reduce the amount you owe (called boot), you will have to pay capital gains taxes. Capital gains taxes are approximately 10-15 percent lower than income taxes, so that’s good, but if you want to defer all your tax liability, you need to trade properties with equal or greater equity and equal or greater debt.

So, what’s the benefit? Well, if you find someone who owns a property you’d prefer, and they prefer your property–and the properties have equal values and equal debt–you are allowed to trade without paying any taxes.

In recent years, a new chapter was added to the 1031 Exchange rulebook: the Starker Exchange. Prior to Starker, you had to either find someone who wanted your property or a number of individuals who all wanted to trade like properties. Think musical chairs except there are enough chairs for everyone: one, two, three, SWITCH.

In the post Starker world, you list a property for sale and sell it to an exchange accommodator, a middle man. The accommodator takes title to the property and sells it to a third party. The accommodator holds all the cash, kind of like an escrow account. You find a property you’d like to own and the accommodator buys it using your money. He or she then transfers the property to you to complete the exchange. You end up with a more desirable property and pay no taxes.

The clock is ticking on these transactions. After selling your property, you must identify the exchange property within 45 days and complete the purchase of the exchange property within 180 days or by the end of the tax year. However, the 1031 Exchange doesn’t have to be a one for one in terms of numbers of properties, just amount of equity and debt.

Let’s say you own an apartment complex. That’s a big investment, and therefore harder to sell than a single-family home. You could use a 1031 Exchange to trade your apartment complex for several single-family homes. Then, if you only need to liquidate (sell for cash) one of the homes, you only pay capital gains taxes on a single-family home, rather than on the value of the whole apartment complex.

The downside of 1031 Exchanges are these: 1. Accommodators charge a fee for their service. It’s a reasonable fee, but it’s a fee. 2. The income tax basis of your original property is carried to the new property. This means lower depreciation for the future, and when the property is ultimately liquidated, the capital gains will be increased by the amount deferred in the first transaction.

Income tax basis is the amount paid for the property plus capital improvements minus depreciation. The real benefit of a 1031 Exchange is that you basically get an interest-free loan from the Internal Revenue Service and State of California — you have more equity to invest in your next property because you’re not paying taxes on each transaction. As long as you have a long-term view of investing, 1031 Exchanges can be a great way to go.

This is a very simplistic summary of a very complex topic. You must have good real estate advice as well as a tax professional to work with you.

Next time I’ll write about disclosures – where there really is no such thing as TMI (too much information). If there’s something you would like me to write about or if you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

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Why Invest in Real Estate?

If you are in the fortunate position of having a little money to invest, or if you are just curious about investing, here’s a bit on real estate as an investment. Before I get started, I’ll remind you that I am neither a financial advisor nor a tax professional. I am not advising any action; rather I am sharing my opinion and my rationale when I invest. This should not be your only education on investing before you go out to buy that 67-unit apartment complex. Take the time to learn about the pros and cons in more detail before you put up Junior’s college fund or your retirement.

Compared to other investment options with similar risk, real estate offers some excellent advantages. Real estate provides cash flow based on rent, and a tax shelter from depreciation. (A quick definition of depreciation is a measure of how much of an asset’s value has aged or has been used up.)

If you are the type to do your own improvements, maintenance, and repairs, you can spend relatively little to increase the market value of your investment property and/or the amount you can charge for rent. Even if you don’t do your own repairs, as long as you keep the investment property in good condition, real estate generally increases in value over time.

When I evaluate an investment property, I expect rents and market value to go up at about the same rate as inflation over the long term; bear in mind that real estate isn’t like trading stocks. Real estate comes with high transactions costs: you won’t find a broker willing to handle a real estate transaction for $39.95 and it also doesn’t happen this afternoon.

When I’m on the purchasing side of a transaction, I generally assume the transactions costs will be about two percent of the purchase price (i.e., loan fees, escrow fees, title insurance, and closing costs). If I’m on the selling side of the transaction, I expect to pay closer to seven percent of the sales price (i.e., brokerage fees and closing costs).

However, even with high transaction costs, I think real estate is a great investment. Once I own a property, I can leverage it (borrow a large percent of the purchase price). Rental income should be sufficient to cover the loan payments and other expenses including taxes, insurance, maintenance, utilities, and management fees. Depending on the property type, with a 20-30 percent down payment, you should be able to at least break even with cash flow.

Then, since depreciation is based on the   purchase price of “improvements” (a real estate term that refers to everything except the land for a given property, so I’m talking about any structures, paving, etc.), you should have a tax loss of about two percent of the purchase price. That taxable loss creates a tax savings that will probably provide at least a four percent after-tax positive cash flow. To put that another way: usually you have to spend money to reduce your taxable income, right? So, with real estate, you don’t have to spend money to reduce your taxable income because depreciation does it for you. No cash outlay, but reduced tax burden. Win/Win.

If you went to the bank and purchased a Certificate of Deposit (CD), your return would likely be a tiny percent of the same money invested for the same period in real estate. However, unlike the CD, the real estate investment provides you with no guarantees. We’re talking about the risk/return tradeoff: the higher the risk, the greater the potential return. There’s also a risk to not investing: the opportunity cost of giving up the potential income.

When it comes to investing, you have to think about lots of factors. Is this a short-term or long-term investment? If you need this money for Junior’s college fund next year, I wouldn’t invest in real estate. Real estate is not a “liquid” investment (you can’t turn it into cash easily).

If you are interested in a long-term investment and real estate appeals to you, talk to your financial advisor and/or tax professional. Every property is unique. Every transaction is unique, and every person’s financial situation is unique. Two investment opportunities that appear similar may have different financial structures, tax structures, maintenance requirements, risk factors, and more. Be a careful shopper.

If you’re interested in acquiring a list of potential investment properties, call your realtor. Trust me, your realtor will be happy to help you.

Next time I’ll write about 1031 Exchanges. If there’s something you would like me to write about or if you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

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