Andrew Carnegie, the wealthiest man in America during the early 20th century, once ruminated that “90 percent of all millionaires become so through owning real estate.” At some point, most of those real estate investors decided to become landlords. They were smart enough to let other people pay off their mortgages.
If you follow the stock market, you know that for the past 75 years stocks historically have returned between 10 percent and 12 percent. Investor and realtor Clifford Hockley of Portland, Ore., calculates that a single-family rental property should yield an 8 percent cash flow, while the home value could appreciate conservatively at 4 percent a year. Add to that the annual tax depreciation of the purchase price divided by 27.5 years (lower on condos), and you can see how your annual rate of return could be above 20 percent.
As an investor, you must acquire certain data from the seller of a building before you can make an informed decision about buying it. Among those data are at least three years’ worth of rent roll income. (Did you know that banks are reluctant to loan on buildings with a vacancy rate of more than 5 percent?) Ask to see operating expenses, an income statement, a balance sheet, and the building’s IRS Schedule E tax return information. You need documentation on any liens, major liabilities, etc., that have yet to be paid off. Get a real estate agent who is an investor and an experienced real estate attorney to help you get all your documents together.
If a building can’t earn its way, don’t buy it. Positive cash flow means the difference between being in business and closing down. My father, Leroi Chapelle, who began investing in San Francisco before I was born, says that to satisfy lenders’ requirements, you’ll need probably 15 percent to 20 percent a month more in income than in fixed expenses. You should not have to subsidize your property with money from your job. A balance sheet with regular liabilities looks terrible when you’re applying for mortgages. At worst, negative cash flow could leave you unable to pay taxes or emergency expenses.
How do you calculate cash flow? To oversimplify it, using the data you got from the seller, figure the taxable income or loss from the property, which is the rent roll minus operating expenses (such as property tax, insurance and repairs), depreciation and mortgage interest expense. If you actively manage the property and your adjusted gross income is less than $100,000, the rental loss (up to a maximum of $25,000) could be deducted from other income such as salary, interest and dividends. Multiply the rental loss by your federal income tax rate. That federal tax amount you would have avoided in this deductible rental loss is added against your rental income, expenses and yearly mortgage. The result is your cash flow.
Nice Rate of Return
Investors should look for property that will generate a healthy internal rate of return (IRR). IRR is a function of your purchase price, loan terms, expenses, taxes, rate of appreciation and other factors. Twenty percent or more is a good target. In her book, Rental Houses for the Successful Small Investor, Suzanne P. Thomas explains that rate of return comprises the potential property appreciation, rental cash flow and paying off the principal, which coincides with your equity building up. Then there’s the tax break the IRS allows you by letting you depreciate rental real estate against your taxes. Several Web sites, such as Financial Calculators Inc. (http://www.fincalc.com/), include free IRR calculators.
Cap Rate and More
The next big factor to consider is the capitalization rate or cap rate, the ratio of the building’s annual net income versus the property’s purchase price. The cap rate helps you calculate how many years of rents it’ll take to recoup your purchase price. If you bought a building for $240,000 and generated $2,000 a month from rents before debt service, the cap rate would be $24,000 divided by $240,000, or 10 percent. That means it would take 10 years of net rental income to make back your investment. A high cap rate is good for buyers, but not for sellers. The cap rate on apartments in the top 50 markets in the U.S. is 7.2 percent, according to a survey conducted for The Wall Street Journal by real estate research firm Reis Inc.
Finally, find out how your prospective building measures up to other buildings in the neighborhood when it comes to rents and vacancy rates, debt coverage ratios, cash-on-cash return and price per unit. And while you’re at it, make sure the neighborhood is good or getting there.
Tony Chapelle can be reached at TonyChapelle@hotmail.com, or 212-534-7195.