This article continues some of the things a budding investor-in-training should consider before being trusted with a checkbook. Part 1 discussed what an investment is, what an investor does, and the 4% Rule. The concept of learning to invest through stocks was introduced. This was to accustom the new investor to (a) saving regularly for (b) cash-flow and (c) growth.
The accumulation of a small portfolio of blue chip stocks, purchased at favorable prices over time does not replace income properties but provides necessary liquidity to the complete portfolio.
In Part 2 we talked in broad terms about (a) the various streams of income associated with bonds, stocks, and income properties; (b) what drives value and (c) synergism.
Part 3 narrowed our focus to determining (a) the maximum loan a building will support; (b) an appropriate down payment; (c) a reasonable purchase price; (d) monthly cash flow to the borrower and (e) the cash-on-cash yield on the down payment. All of these items were computed with the calculator found in a basic smart-phone, using the estimated Net Operating Income and a common Debt Coverage Ratio.
That brings us to now, when we’re going to take a different approach to the concept of apartment investing. Do you remember hearing, “Income properties have made more people rich by accident than any other investment has on purpose?” That’s the best case scenario. Now, in Part 4, we will consider the worst case possibility.
This is not a disaster scenario where there’s no alternative but to give the building back to the bank. That at least brings closure. We’re going to explore something even worse (from the borrower’s perspective): the zombie building that makes too much money to justify foreclosure, but at the end of the month there’s never any cash for you. It’s the real estate equivalent of being married to a man who never appreciates anything you do for him. He’s employed, so you can’t send him back. But you sure wouldn’t want another one.
We want to estimate the practical base return available to an apartment building investor. Of course, things could go terribly wrong and the investor may lose his entire investment to any of the four risks associated with the ownership of assets (possibly the subject of a future article). Once again, we’re not referring to a total loss situation. Our question is, if the investor buys poorly and has to keep a building that just barely pays for itself for 30 years can he expect any return at all on his original investment?
This is not an irrational consideration. Even now, after eight years of economic recovery, there are homes purchased just before the Great Recession that remain underwater.
It’s not just single family homes. In the income property world, a building under a long term fixed rate triple-net lease, purchased at low capitalization rates (remember the teeter-totter: low caps mean high values; high caps mean low values), might go underwater soon after cap rates begin their normalization process and remain so for longer than we have left to live.
The answer to our question is important because it might isolate where the returns (if any) may come from and it helps to establish the risk profile for apartment investing.
In the process of estimating a practical minimum return, we must discuss the four streams of income normally available to the apartment investor. Some of these streams will be present even in a barely functioning building and some won’t.
There is a combination of advantages unique to income property investing. Unlike bonds (which can provide cash flow) or stocks (appreciation and cash flow), income properties can generate four sources of income. They are (a) appreciation; (b) cash flow; (c) tax advantages, and (d) equity build-up.
Appreciation: There are two forms of appreciation relevant to our discussion: inflation protection and asset growth. Inflation is exposed when things cost more. That means each dollar is losing some of its purchasing power, so it takes more dollars to buy something cute. Most income properties (not all, but most) automatically adjust to keep purchasing power constant. Asset growth comes from repurposing the investment to bring in more income. Asset growth, if it comes, is in addition to inflation protection.
Inflation Protection – The property consists of two elements: land and improvements. The value of the improvements is directly impacted by inflation because wages almost always increase as the costs of living go up. Most of the cost of the improvements is reflected not in materials, but in the chain of labor costs. Somebody has to cut down the tree, somebody else hauls the logs to the mill, and another group of people cut the logs into lumber. Still others transport the lumber to the job site where the trades begin to assemble the planks into something livable. The price of the initial tree, purchased in place, is only a fraction of the final cost of the lumber products generated from that tree. Consequently, as the cost of new construction rises so does the replacement value of existing buildings. The market adjusts the replacement cost of existing improvements to offset inflation. Even zombie buildings benefit from inflation protection.
Asset Growth – Asset growth is when values improve faster than inflation. This can happen when land is re-purposed from one use to another more expensive use.
One example might be when a hungry developer realizes that the lot now occupied by that pre-War II twelve unit building down the street, the one with the large parking area in back, could be developed into twenty condominiums with underground parking.
It’s not just apartment land. Another example might be farm land right in the Corn Belt. We’re not talking about the old farmhouse, or the barn, the irrigation system or any of the other improvements. For the moment we’re focusing exclusively on the land. The value of the fields is directly affected by the net income the fields provide. Corn at $4 a bushel times (blank) bushels per acre means land at (so much) an acre. If a national subdivision developer sees the opportunity to build 700 homes, that land becomes far more valuable.
Asset growth sometimes comes from strange sources. Recently a credible person told me that the widening of the Panama Canal caused apartment land near the port of Houston to appreciate.
The takeaway is that as a general rule the value of well located apartment buildings, both the improvements and the land, adjust for inflation. This tends to keep the owner’s purchasing power intact.
If there is growth in assets, it accrues to equity build-up which we’ll discuss later.
Cash Flow –The numbers in this section will be illustrative only. You’ll probably want to plug in your own figures when thinking about a specific property. Assume the following at purchase:
Gross Scheduled Income $ 200,000
Expense Ratio 40% (80,000)
Net Operating Income 120,000
Debt Service @ 1.20 DCR (100,000)
Cash Flow 20,000
Look at the relationship between the GSI and the final cash flow: in this case cash flow is 10% of GSI. That seems to be a median figure at time of purchase. Some owners get less, of course, and some make more. If these figures are reasonably accurate and if they adjust only by inflation and otherwise remain in constant relationship to each other, the owner can anticipate inflation adjusted cash flow equal to 10% of the GSI. This is an expectation. It is not universal, and over time some owners can’t get enough rent to even make the mortgage payments. But many owners, especially long term owners, have cash flows well over 10% of GSI.
Depreciation – (Disclosure: I am not an accountant. Whatever I write regarding taxes is probably wrong and should not be believed.)
Land may be the source of value, but improvements are the source of write-offs. We can’t depreciate the land: it’s not supposed to wear out. Only the improvements wear out. They have a stipulated effective life, and the owner is permitted to write-off that portion of the purchase price allocated to the improvements over the statutory amount of time. The multi-year period during which the improvements are written off is an accounting item only; it has nothing to do with how long the building remains rentable.
Example: Imagine you just paid $3,000,000 ($1,000,000 down payment) for an apartment building, and your accountant determined that $1,200,000 was the cost of the improvements (meaning $1,800,000 is considered to be the value of the non-depreciable land). Assume you are permitted to write off the $1,200,000 improvement value over 30 years. On a straight line basis, you could write-off $40,000 a year for three decades ($1,200,000 divided by 30 years.)
If your (combined state and federal) ordinary income tax bracket was 35%, your hard dollar (“real”) tax savings would be $14,000 a year (35% of $40,000). That’s because you are “writing off” some of your income, not some of your taxes. In other words, writing off $40,000 on paper would reduce your taxes by $14,000 hard dollars. That comes out to be 1.4% of your million-dollar down payment.
Years go by and your husband, Phred, passes away the exact day the last payment is made, leaving the paid-for apartment building to you. With no mortgage payment, your cash flow multiplies and you now can do things you only dreamed of before. One of them is Raul, your former pool boy and now your new trophy husband. Raul wants to sell the units and retire to Costa Rica. Your broker finds a buyer at the requested $9,750,000 (original purchase price adjusted for 30 years of 4% annual inflation). Oh-oh! The improvements didn’t wear out after all! Now you have to “recapture” (i.e., pay back) a part of the depreciation taken over the years. Here’s the beautiful part: you only have to pay back a part. The money you wrote off was originally taxable at ordinary income rates, for example 35%. In the year it was earned the IRS was considered it “ordinary income” but that was a long time ago. Time has magically turned that ordinary income into “Long Term Capital Gains” taxable at only 20% (or whatever the rate is at the time). Your tax savings are pretty significant.
“The only people who don’t like the way this turns out are the folks who “exchanged” into bigger and bigger properties every couple of years. The provisions of IRS Code Section 1031 permit the exchanger, I think, to defer payment of all depreciation recapture until the final sale. But then the accumulated taxes are due. And seeing that final accumulated tax bill has caused strong men to weep and women to rant, “I told you we should never have bought that apartment! I told you so! Didn’t I tell you?! Didn’t I? ”
Help her to think of it this way: Taxes are the way Government fines successful people. Who knows, it might help.
(In the example above we ignored the effects of stepped up basis as not relevant to the example. Once again, taxes are not my area of expertise. Don’t believe anything I’ve written about taxes until you get your accountant’s blessing.)
Equity Build-up –Equity build-up, a type of forced savings comes, like Appreciation, in two forms. The first is the reduction of the underlying debt as the loan is amortized. As the loan is paid off what used to be the lender’s share of the building becomes yours. That is one form of equity build-up.
The second form is the possibility of increasing land value due to things other than paying down the loan, like rezoning. We discussed this earlier (see Asset Growth, above). Here we are just restating the obvious, that asset growth accrues to equity build-up.
To simplify things, let’s stipulate that there is no asset growth over the next thirty years. Let’s also stipulate that there is never a dime’s worth of cash-flow during that entire time. This is truly a zombie building. Inflation keeps your purchasing power secure, but other than that the only gains you receive are equity build-up from the tenants paying off the mortgage and the depreciation write-offs.
We’ve already determined the “hard” dollar tax savings in our example to be 1.4%. What’s left is to determine the yield from equity build-up. What sort of return might you expect?
Assuming 1/3rd down, you can expect to triple your money. You will have turned (example) $1,000,000 into $3,000,000 (remember, in this example there is no inflation) simply by generously allowing your tenants to pay off the loan on your building. If you turn $1 into $3 over 30 years, you will have made 3.7% compounded annually on your investment . . . again, net of inflation. As a point of reference, on the day this is written the 30 year U.S. Treasury bond closed at a 2.96% yield.
Base Return – Equity build-up can triple your money in three decades (net of inflation), with an annual return of 3.7%. In our example there is an additional tax benefit of 1.4% annually in “hard” tax savings. To generalize, the zombie building you might drive past on your way to Nordstrom’s still gives the owner a 5% basic annual return, adjusted for inflation.
Perspective – Any investment that adjusts automatically for inflation is worthy of consideration. An investment that yields 5% net of inflation would be a strong contender in any long term “Best Investment” list. But now add strong cash flows and it becomes clear why people still say “Income properties have made more people rich by accident than any other investment has on purpose”.
Just think about it. You’re getting your nails done and the officious woman with the awful eggplant-colored hair is bragging about some shaky investment and how they only lost a little. This is your chance to say, “Well, our floor is inflation plus 5%. And we usually do a lot better.” It really is thrilling to be in this industry, isn’t it?
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com. This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com