This article was posted on Sunday, May 01, 2016

The point of the Uncle Sally series has been to introduce the interested novice to some of the elements of income property investing. The hope is that misunderstandings might be avoided by opening a dialogue on at least a few of the elements a newish investor might face. One of these points is when to buy.

Exchanging:   As opposed to newbies, existing investors are much less affected by the market cycle. Many existing-investor sales (not all, but many) are part of an IRS Section 1031 exchange. That section of the Tax Code permits tax deferral if, among other things, one property is sold and another like-kind property purchased within a certain time window.

An exchange is not tax-free, although everybody likes to call it that. You still owe the appropriate taxes, but you can postpone their payment for years into the future. You can even defer payment through a succession of 1031 exchanges. Then all the accumulated taxes are due in a single lump sum, from the taxes postponed on the first “exchanged” building through each subsequent transaction right up to the final sale of the very last building in the chain.

After such a series of trades the cumulative tax bill, when finally it is paid, will become an instant neighborhood legend. “Martha, do you know what Janet’s tax bill is? Do you? You’ve just got to sit down before I tell you!” One of my girlfriends exchanged four times over a fifteen year period, back when the market was soaring. When her CPA emailed her a draft copy of the taxes due, she broke down. She consumed a three-pound box of See’s chocolates before the keening was reduced to whimpers.

The thing is, when she saw the bill in front of her she entirely forgot that the tax was for five transactions (four 1031 exchanges and one final sale). She forgot that she wound up with that last 60 unit property only because she was able to reinvest the tax not paid into larger and larger buildings. If she’d paid the entire tax each time she sold-and-bought-bigger she’d probably have ended her career with 18 or 20 units or something.

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Market Cycles:  A person who exchanges does not have to worry about market cycles because each sale-purchase pair happens so closely together that the properties are essentially bought and sold in the same market. There just isn’t time for the market to change within the statutory sell-buy window. If the person sold low, she will subsequently buy low; if she sells high she will subsequently buy high. An exchange is cycle-resistant.

Purchase:  That is not the case when a newbie is buying her first residential income property.  She’s buying into whatever the market is at that moment in time and there is no statute telling her when she must buy. And it’s an important decision that will have significant impact on how her investment performs. Notwithstanding, it may be a Hobson’s choice, a situation with the appearance of choice but not the reality. She may think she can wait until she finds a market she likes, but the waiting may be more damaging than buying in the wrong market.

NOTE: Buying in the “wrong” market does not mean the investment is “bad”. It does mean that the investor’s expectations must be adjusted. 

Time Value: We know by the Rule of 72 that at an 8% return it takes 9 years for money to double. (72 divided by 8% equals 9 years-to-double.)

As an example, if a person begins investing at age 28 and expects to retire when she’s 64, she will be investing for 36 years. That’s 4 doublings (36 years divided by 9 years-to-double). If she started with $250,000 (example), one doubling would raise it to $500,000. The second doubling would bring it to $1,000,000. The third nine year period would raise her net worth to $2,000,000. And at the end of the last 9 year period the investor’s net worth would double again to $4,000,000.

This is where injury from reducing the investor’s time in the market reaches the gobsmacking level. If the investor wasted the first doubling-period, if she waited until she had 3 doubling-periods (instead of 4) for her investments to mature, her money would only double three times: it would turn into $2,000,000 and not $4,000,000.  The cost of losing that single doubling-period would be two million dollars.

If our hypothetical investor waited to invest until the kids were out of school and she could “afford” it, two doubling-periods would have passed. Her $250,000 would only have time to ripen into $1,000,000.

Early investing is not a frivolous matter. Time is determinative. Money doesn’t start working for you until it’s invested. If you wait . . . and wait . . . and (yawn) wait some more until the time is exactly “right” to enter the market you may exhaust much of the time available for your investment to mature.

Buy or Wait? So there’s a cost to waiting. We’ve come now to a fundamental question: should a new investor wait until the apartment market improves or jump in right now, and how would that decision be defended?

We’ll explore this by capitalizing a specific building at two rates. One rate will be the low cap / low interest rate alternative and the other a high cap / high interest rate option.

Hypothetical Example:  Assume a building generates a monthly Net Operating Income (NOI) of $12,000. Roughly, how much is it worth? The building should be worth the sum of (a) whatever mortgage its NOI will support plus (b) an appropriate down payment.

The mortgage depends, in turn, on the interest rate and the Debt Coverage Ratio (DCR).

Mortgage Loan:  A mortgage rate consists of two sub-parts: the Index (the part subject to change in a variable rate loan) and the Margin (never changes).

IndexA common mortgage index is the 10 year Treasury note. Over the past 50 years it has averaged 6.57%. The range has been from 1.53% (July 2012) to 15.32% (Sept 1981).

Margin. The margin provides for the lender’s business expenses, risk and profit. A typical spread has recently been 2.5%, but varies with the lenders perception of risk.

Low Rate. To represent the final mortgage rate at the low interest entry point, we will add a 2.5% margin to the 50 year low Treasury note index rate of 1.53%. This brings the low interest rate example to 4.03%.

High Rate. We’ll follow the same process to find the high rate: 2.5% margin plus 15.32% index, for a total of 17.82%.

Mortgage Amount: The mortgage payment (principal and interest) must be covered by the NOI, with a bit left over for emergencies. The maximum mortgage payment is determined by dividing NOI by the Debt Coverage Ratio. A typical DCR right now is 1.20.

Loan.  $12,000 NOI divided by a 1.20 Debt Coverage Ratio means the building will support a maximum mortgage payment of $10,000 monthly. (The $2,000 remaining will be the borrower’s monthly cash flow.)

Low Rate. At an annual interest rate of 4.03% that $10,000 monthly payment will service a principal amount of $2,100,000 (rounded). If we add a hypothetical 30% down payment ($1,000,000), the building’s purchase price would be about $3,000,000.

High Rate. At an annual interest rate of 17.82% the building will service a maximum loan amount of $670,000 (rounded). Adjusting for a 30% down payment ($290,000), the building value comes to $960,000 (rounded).

It is important to note that the low interest example provided the highest loan amount . . . and the high interest example yielded the lowest mortgage.

Over the last 50 years then, the mortgage value of a stream of net income of $10,000 monthly (the remaining $2,000 goes to cash flow) has fluctuated between $670,000 (Sept 1981) and $2,100,000 (July 2012). This example reflects only what a $10,000 monthly steam of income would be worth at the high and low interest rate extremes during the past five decades.

End of Period Sale:   The initial purchase price does not affect the future sales price. Nobody cares what the current owner paid for the property. They only care about its value when the owner decides to sell it. A reasonable estimate of the building’s value on that (future) date would be the capitalized value of its projected net income. That requires estimating (a) its future net income and (b) a supportable interest / cap rate.

We’re now at a point where we can, using basic valuation techniques, speculate on what the building’s value might be 30 years from now.

NOI:   Presuming the original $12,000 monthly NOI increases at 5% annually, in 30 years it will reach $52,000 per month (Don’t get excited. Inflation adjusted, $52,000 thirty years from now will only buy as many bananas as $12,000 today.)

Loan:  It is supportable to forecast risk-free interest rates in 2046 at the long term average 10 year Treasury rate (6.57%) plus an appropriate margin (say, 2.5%). In this example, we project mortgage interest rates in 2046 at around the 9.07% level.

Sale:    A $52,000 monthly NOI divided by a 1.20 Debt Coverage Ratio provides $43,000 (rounded) for monthly principal and interest payments.

A payment of $43,000 at 9.07% interest would service a mortgage of $5,300,000 (rounded). A 30% down payment brings the forecast value of this building in 2046 to $7,500,000.

Low Rate: Future sales price ($7,500,000) minus low rate purchase price ($3,000,000) results in a projected gross profit of $4,500,000. Not bad, huh?

High Rate: If purchased when rates were historically high (and values historically low), the completed transaction would generate a gross profit on sale of $6,540,000 ($7,500,000 minus $960,000).

Discussion:  The low rate / high price alternative lost value as interest and capitalization rates increased towards their long term average. With values trending down, the investor’s greatest opportunity for gain was through equity build-up as the tenants paid off the underlying mortgage. In this example, the investor’s $1,000,000 down payment turned into $4,500,000.  She has additionally received 30 years of monthly cash flows.

If she’d elected to keep the building to augment her retirement, she would have an income (the NOI) of $52,000 monthly. Once again, that’s the inflation adjusted value of $12,000 today. The high rate / low price option gained value as rates dropped towards their long term average. In this example, the investor’s $960,000 purchase price turned into a little over $6,500,000 in addition to three decades of monthly cash flows.

An additional benefit under the high rate / low price scenario is that as the property value goes up, the owner might serially refinance and buy (over time) several more buildings. Any number of today’s high net worth people did exactly that during the 30 years following the last rate peak of 1981.

Review & Conclusion: The risk-free 10 year Treasury note has averaged 6.57% over the past 50 years, but there is a cycle in interest rates. The range (Index only) has been from 1.53% (July 2012) to 15.32% (Sept 1981). It should be remembered that both these moments occurred during periods of high economic stress in the market, so don’t take them as predictive: the future is not certain.

Interest rates impact investments in the manner of a teeter-totter. Think of the investment sitting at one end of the teeter-totter and interest rates at the other. If rates are high, values are automatically low. When rates are low, values are high.

A property bought at peak value (and rate bottom) is going to be hard to refinance as rates increase (and values drop). Depending on how quickly rates drop, the new loan might be unlikely to even pay off the old loan. A property purchased at a time like this should not be thought of as a friendly ATM but rather as a debt to be paid off so it can become a source of eventual retirement income. There’s nothing wrong with that: it beats most other investments out there.

Alternatively, the equity of a property bought at bargain prices (high cap / interest rates) can be expected to increase rapidly as rates decline and values appreciate. This permits possibly several refinance-and-buy-another opportunities over time. This is where the single income property becomes the friendly ATM we referred to above. The combination of growing net income and lowering interest rates means that every several years the owner can refinance and buy another building. Many people have accumulated significant private wealth in this manner.

Whether the interest rate environment is low or high, it’s probably important for the new investor to take that first step and buy an appropriate building . . . even if the buyer absolutely knows rates will eventually rise (or fall) and prices will go down (or up). She can be right about eventual price trends, but without knowing when it will happen she could ruin her retirement by doing nothing as the “doubling periods” roll past. The Time Value section, above, has something to say about that.

Investing early is the counterparty to buying low. If you invest early (and have more time for compounding to occur) it might take some of the sting out of watching the eventual deterioration in market values. Even if only one apartment building is purchased during the budding investor’s entire career and even if it is at a historically disadvantagous moment, it must be remembered that after the tenants will have paid off the loan the investor will then have the buildings entire NOI to augment retirement income. As in the earlier example, what other $1,000,000 investment – bought at a cyclically high value – is likely to give you thirty years of monthly cash flows followed by an income of $52,000 a month?

Disclaimer: This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. 

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 [email protected] 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at