When investors buy any commercial real estate they are acquiring a revenue stream. Admittedly there are a few signature buildings that are so iconic that they are a "pride of ownership" acquisition, but most properties are valued solely for their future economic potential. There are four primary ways in which investors benefit from their acquisitions:
1. Cash Flow
is the sum of: Cash In - Cash Out. The primary source of inflow cash is rent. Pet rent, late fees, laundry and owner contributions are also part of the cash in stream. Cash Outflows include taxes, expenses and distributions to owners.
Owner types vary widely on the importance they place on distributions:
- Residential Multifamily properties (2 to 4 units) and smaller Commercial Multifamily properties cast off little cash. Their owners tend to focus more on equity gained at the time of disposition.
- Investors of larger properties often use cash flows (distributions) as a primary source of spendable income. They certainly expect gains at sale, but they often will use that gain to step up in basis to acquire a larger asset in the hope of increasing the monthly cash-flow.
- The bane of all investors is the much dreaded Cash Call. When cash out ‹ cash in to the extent that operations are impacted, the property owner(s) are forced to add new equity to keep expenses current. Be aware that cash call inputs wreak havoc on IRR Calcs.
Because of their focus on maintaining regular, dependable distributions, the owners of larger properties tend to have lower LTV loans. This doesn't eliminate cash calls, but it does make operations inherently more stable, reducing the likelihood of requiring additional cash.
2. Appreciation
is Future Disposition Price - Original Acquisition Price. A 53 unit complex that is purchased for $3.2 million is 2007 appreciates $700,000 if it is sold for $3.9 million several years down the road.
- Appreciation gains can occur from (external) market forces such as a downward trend in Cap rates, or from increases in rent relative to expenses due to high demand.
- Gains can also be "forced" by internal forces. This occurs when we reposition a property. Renters will pay more for upscale amenities and newer looking accommodations. Success requires having the amortized costs of improvements be exceeded by the increased rents. In some cases we merely seek to raise the rents on the existing renters; other times we are using the upgrades to attract a new tenant profile.
3. Loan Paydown
is determined by subtracting the initial loan amount from the remaining loan balance at any given time. Suppose a $3,200,000 property is acquired with a roughly 65% LTV loan at 6% with a 30-year amortization. Day one the beginning loan balance would be $2,000,000. 42 months later (3-1/2 years) the loan balance would be $1,909,649. The loan paydown amounts to $90,351 for that period. Using interest only loans eliminates loan paydown...but does increase cashflow.
4. Tax Shelters and Tax Avoidance Benefits
The final benefit to investors is the tax sheltering of income. Cost Recovery (Depreciation) is the primary example. Industrial and retail properties are depreciated on a 40-year basis; housing is depreciated using 27.5-years. Note: Land is not depreciable. Using our previous example of a $3,200,000 community, let's assume that land was 25% of the value, leaving a depreciable amount of $2,400,000 to be depreciated over 27.5 years, or $87,27.73 per year. That will act as a tax deduction to reduce profits by that amount for tax basis purposes.
A more rapid depreciation methodology is provided by Cost Segmentation, or familiarly, Cost Seg. This is performed based on findings of a cost engineer during their on-site inspection and review of the property. There is great acceptance of this approach by the IRS, but it is not fully understood by investors and many Tax Accountants. Cost Seg. on Assets under $1 Million is not always cost effective due to the fixed costs of the on-site inspection. Savings on multimillion dollar properties are substantial, and can change a 1.1 DSCR property into a 1.25. That means that Cost Seg utilization can impact approval outcomes.
Duties of Professional Investment Brokers
It is incumbent on the Real Estate Professional assisting a client with a multifamilty acquisition to have an understanding of that client's risk profile, investment horizon plus target cash flow and appreciation rates. It is also beneficial to have an awareness of how important their client deems tax shelter options. Given that 1 in 5 1031 Exchanges fail for one reason or another...it makes sense for a broker to offer information regarding Structured Sales before closing on the inital leg of the exchange. This preserves reinvestment options.
To maximize your options, contact Rose City Commercial Real Estate today at 503.577.1034, or rick@rosecitycre.com.
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