If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
Continued from Part 26: William J. Bernstein has written on this. In terms of loss to overall wealth, he identified four sources of risk: (1) inflation; (2) deflation; (3) devastation, and (4) confiscation.
Inflation: Inflation is the loss of purchasing power. It takes more money to buy the same package of goods. A hypothetical example of an investment vulnerable to inflation risk is a perpetual fixed rate bond. As inflation rates increase, the value of such a bond decreases. The benefits of inflation accrue to people who owe money. Governments, life insurance companies, and those with debt (especially income property debt) all benefit from inflation.
Deflation: The opposite of inflation, deflation is when it takes less money to buy the same package of goods. Prices go down. Imagine General Electric stock losing (deflated) 30% in a given year. It takes less money to buy the same number of shares. Deflation benefits people who have cash on hand and can make significant investment purchases when values are deflated.
Devastation: Major earthquakes, floods, the Yellowstone Caldera, biblical plagues of locusts, tsunamis, and Cat 5 hurricanes all cause devastation. Devastation can usually – but not always – be insured around. Properly managed, insurance will return people financially to where they were before the devastation happened. In that sense, devastation is asset neutral.
Confiscation: Confiscation is when the government takes property without full compensation. Examples might include civil asset forfeiture, tax liens, judgments, and eminent domain. Confiscation losses are a net debit, and Emily could think of nothing that would turn them into lemonade. She recognized, however, that total loss by confiscation can be reduced by proper insurance (judgments), good accounting (tax liens), and diversification (eminent domain).
That was enough for one evening. Emily uncurled herself from the sofa, returned the yellow pad to the coffee table, and went for a shower and an early bedtime. The TMC Channel was showing a Humphrey Bogart and Lauren Bacall marathon.
Bernstein’s list identifies important “third-party” risks. These are not things the owner has the power to prevent. The owner can usually insure around the consequences of these risks, but not against their occurrence.
Even as we shift from Bernstein’s risks to the extraordinary benefits that are possible with income properties, it’s important to accept that not everything is puppies and kittens. At least one of the benefits may not happen at all, or happen only intermittently (appreciation). Others are time limited: they last for a defined period and no longer (depreciation and equity build-up). Yet another is management sensitive (cash flow).
It was Sunday afternoon when Emily began studying the Four Benefits, corresponding to Bernstein’s Four Risks that are generally available to owners of income property: (a) appreciation (nee inflation); (b) depreciation (tax advantages); (c) equity build-up, and (d) cash flow.
Appreciation / Inflation
Bernstein listed Inflation as one of his major investment risks. What he did not say was that inflation is only a risk with certain investments. With others, it can be a wonderful benefit.
For example, if a person owns a long term fixed rate security like a bond or a mortgage, inflation can be disastrous. Consider parents lending their just-married only daughter the $200,000 necessary to buy a house. She and her new husband, a machinist, jointly sign a note to repay the loan in 360 equal monthly payments of $954 (including interest at a fixed rate for the entire 30 years).
Assume that suddenly, just as the inked signatures were drying, annual inflation jumped to 10% and stayed there for the next 7 years. And further assume the son-in-law’s income was inflation adjusted. After seven years the machinist’s $20 / hour wage would have clicked up to $40. But the fixed rate mortgage payment on their home would remain at $954. That payment represented 48 hours work when he got the mortgage seven years ago, but now he makes that sum in 24 hours. Appreciation is good for the borrower.
Of course, the other side of the coin is that the purchasing power of the $954 her parents receive has ratcheted down by 50%. When the parents made the loan, they could buy almost one thousand dollars of Dollar Menu hamburgers each month. Now their income has remained the same while hamburgers have doubled in price. Their living standard has been halved. Inflation is bad for the lender.
Memo: what is appreciation to the borrower is inflation to the lender.
Appreciation / Inflation has ranged from a low of -0.4% (2009) to a high of 5.4% (1990) over the last 30 years. The total cumulative inflation since 1987 has been 117%.
Depreciation (tax advantages)
Depreciation is restricted by amount and time. You can only take so much, and it can only be taken over so many years. Just thinking about that gave Emily a headache, but she was smart enough to pay a competent accountant for advice on taxes. She needed the advice because she could only recall a little of how taxes were applied to investment properties. She did remember some things, however. She remembered that “property” consists of both land and the improvements (the buildings, etc.). Land is not supposed to wear out, so she could not expect to depreciate it. But the government says building(s) do wear out, and they’ll wear out over (in this example) 30 years.
She worked an example in her head. If she bought a $1,000,000 property and the land value was $400,000 that meant the improvement value was $600,000. Assuming a 30 year straight line depreciation schedule she should be able to write off $20,000 each year for 30 years. The math is $1,000,000 minus $400,000 land value = $600,000 in improvements divided by 30 years = $20,000 annually.
But that is a soft-dollar estimate, and still needs to be adjusted to reach the actual hard-dollar benefit. How much would $20,000 of depreciation actually save Emily in taxes? It would depend on her tax bracket that year. If she was in the 30% bracket, she would save 30% of the write-off, or in this example about $6,000. If she was in the 40% bracket, she would save (in hard dollars) $8,000. These things change occasionally, so she again promised herself to run all the numbers past her tax advisor.
Each new buyer establishes his own depreciation schedule depending on (a) the purchase price (which will almost certainly change with the new sale); (b) the improvement ratio (which could change), and (c) the depreciation schedule taken (if options are provided).
Equity build-up varies depending on the term of the loan and the rate of interest. An interest-only loan will have no equity build-up. Emily, however, had an amortized loan (meaning the loan will eventually pay itself off).
When she made her monthly loan payments, part of the money went towards interest (interest: the rent on the borrowed money) and the balance went towards paying down the principal (the remaining balance on the loan). Everything else being the same, the velocity of the equity build-up she experienced would be directly related to (a) the amount borrowed; (b) the interest rate charged, and (c) the term of the loan. If she had a 10 year fully amortized loan for $1,000,000 at 5%, she could expect equity build-up to grow quickly. Ten years along and the loan would be paid off. If she had the same loan but amortized over a 30 year period, after 10 years she would still owe about $811, 500. There would be much less equity build-up during the first decade or so, but the term was longer and the payments lower, so she could buy a building she could not otherwise afford.
Many (but not all) astute investors buy with maximum leverage, but limit refinances to 50% of market value. This provides some of the advantages of leverage but still leaves a meaningful cash flow.
Cash flow is what is left over after the mortgage and all the costs of running the building are paid. If expenses are high, cash flow can be iffy. When the mortgage is paid off, cash flow suddenly increases because there is no more monthly loan cost.
Cash Flow usually starts off small, in the case of a 1.20 DCR it is often only 15% of the Net Operating Income, but grows over time. When the loan is paid off, the amount formerly reserved for debt service becomes additional cash flow.
Discussion: These four benefits are not equally important. They do not all have the same financial value, nor do they all happen at the same time.
Inflation / Appreciation: Assuming the investor made a down payment of 33% and further assuming that inflation causes the investment to double over the next 30 years, the EOY 30 value of the investment would be about six times the original down payment.
Depreciation: Interestingly, there is no way to depreciate the owner-occupied property. The government says, “You’ll take care of your home, you’re wife will make pretty sure of that. That house you bought to rent out? Probably not so much. It won’t last more than 30 years, so you can write off the improvements over that period”.
Since you can’t depreciate the home you live in, there are occasional scurrilous rumors of siblings exchanging deeds, so the brother owns the sister’s house and the sister owns her brother’s. Now each still lives in the home they want, but they also have a rental property and can take depreciation on it. Emily made a note to ask her CPA about that.
Equity Build-up: At some point many investors prepare for retirement and begin a plan to pay at least some of their units off. There are few things nicer in one’s declining years than to have two or three mortgage-free buildings. One way to do that is to refinance the remaining balance for a shorter term. For example, if a person still owed $700,000 on the property and had 25 years left on the mortgage (due in 2043), he might wish to refinance (no cash out!) the existing loan for, say, 10 years and make the loan paid off in 2028. The property would be free and clear 15 years sooner.
Cash Flow: A simple way to estimate cash flow on a new loan is to divide Net Operating Income by 3 (if the Debt Coverage Ratio is 1.50). For example, if the NOI was $3,000 monthly, the beginning cash flow (after the mortgage payment) would be about $1,000.
If the DCR was 1.20, you’d divide NOI by 6.
In another example, if an investor anticipated purchasing a building with an annual NOI of $120,000 and a DCR of 1.50, his forecasted cash flow would be $40,000 annually. If the DCR was 1.20, the cash flow would be $20,000.
Emily now had a little clearer understanding of the benefits of small unit investing versus five units and up. She also appreciated Bernstein’s risk paradigm and the four advantages of income property investment. Feeling more secure about investing in larger units, she visited the kitchen and turned on the tea.
She was pretty sure there were other important things, but she’d had enough real estate for one day.
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 – BRE: 00957107 MLO: 249261. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]. This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.