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Income Approach to Value of Real Estate ever wondered how that works, see below however there are variables
This is simply the quotient of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. -- contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.
In UK practice, Net Income is capitalized by use of market-derived yields. If the property is rack-rented then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields.
However, capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment. The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0.
The Discounted cash flow model is analogous to net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.
The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental houses, duplexes, and simple commercial properties when used as a supplement to other more well developed methods.
The Short-cut DCF method is based on a model developed by Professor Neil Crosby of the University of Reading (and ultimately based on earlier work by Wood and Greaves). The RICS have encouraged use of the method in appropriate circumstances. The Short-cut DCF is an adaptation to property valuation of the DCF method, which is widely used in finance.
That's not true
In the Short-cut DCF, the passing rent, which is constant (in nominal or real terms) for the duration of the rent period, is discounted at an appropriate rate of return (possibly derived by reference to the risk-free rate of return obtained on government bonds, to which is added an allowance for risk and an allowance for the illiquidity of property assets). The reversion is discounted at the market-derived All Risks Yield (ARY), which correctly implies growth in the reversionary income stream. The reversionary income is the current Estimated Rental Value (ERV) inflated by an appropriate annual growth factor (or CAGR - Compound Annual Growth Rate). The crux of the Crosby-Wood model, and that which sets it apart from the customary DCF, is that the growth factor is derived by means of formula, as a function of the rate of return and the All Risks Yield. For example, if the rate of return is 10% per annum, the ARY is 8% per annum and rent is reviewed annually, then the growth factor will be 2%. (This simple subtraction only works when rent is reviewed annually - in all other situations the growth factor is derived by use of the Crosby formula.) Thus the Short-cut DCF produces a mathematically consistent valuation.
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Home buyers and real estate investors have been in a good mood for years, since around 2007, when the housing crisis began.
And why not? Historic low interest rates and home values that have dropped off anywhere from 30 to 60 percent are a potent combination.
But you know the tide is turning when home owners and sellers are finding something about the real estate market that makes them happy. In this case, rising home prices and still-low mortgage interest rates have meant distressed property is getting sucked up in waves, establishing a floor against which future real estate appreciation will be measured.
In other words, we’re finally at the tipping point, a place where interest in real estate has overwhelmed demand.
But that doesn’t mean there isn’t room for would-be investors to buy and hold real estate for the long run. And, no, you haven’t missed the bottom. Here are five ways to successfully invest in real estate:
1. Look for properties where you can build in value. Ilyce recently published a story on her MoneyWatch blog about properties you can purchase for $40,000 — about the price of a luxury car. These homes aren’t necessarily in move-in condition, but they’re not falling down either.
The goal is to find property that costs less than everything else in the neighborhood, even after you make the required repairs. In other words, let’s say you purchase a home for $100,000, when everything else in the neighborhood that’s not a distressed property (i.e., a foreclosure or short sale) is priced at $200,000. Your property needs, let’s say, $60,000 worth of work. When you add that amount to the purchase price, you still wind up with a property that has some sort of profit margin. You can either flip it or hold for the long run, renting it out to pay expenses and generate positive cash flow.
2. Buy a multi-unit property. We’ve known dozens (maybe hundreds) of folks who have bought multi-unit properties over the years, lived in one of the units and used the remaining units to defray their cost of living and leverage their investment.
How does it work? Let’s say you buy a four-unit building for $500,000. Each unit has two bedrooms and two bathrooms. If you live in one of the units, that allows you to rent out the other three apartments. If each of them brings in $1,500 per month, that’s $4,500 per month in income the property is generating, or $54,000 per year. The property may have $10,000 in real estate taxes, which leaves you with $44,000 to put toward the mortgage. That amount will certainly cover the mortgage and any upkeep the property requires.
Again, the goal is to find real estate that will allow you to maximize the leverage on your investment. If you could only afford to spend $150,000 on a single family property, but can actually afford a $450,000 property that generates some income, you might be better off buying the larger property. On a net basis, you might make more money than with a single family property appreciating at the same rate, and you might have bigger tax deductions and tax benefits over time.
3. Own a small business? Buy your building rather than renting an office. If your business is relatively steady and profitable, you might want to look into buying a building that you can use as an office rather than moving to rent a bigger office.
By purchasing a building, you’ll be able to use your rent to pay down your mortgage and build equity in the property. Your accountant might even suggest that you own the building personally and have the company sign a lease renting it from you to maximize tax opportunities. If you are growing, you can purchase a bigger property than you might need now and rent out the other part of the building until you are ready to move into it. If your business outgrows the entire property, you can then rent it to someone else.
There are plenty of ways to profit from the purchase of investment real estate. But the time to buy may be now, when interest rates are at historic lows and real estate values have come way down off their highs.
Now that the long-debated estate tax rules have finally been settled, let's get real: Despite all the hoopla raised, most people probably would never be impacted whether the lifetime estate tax threshold had stayed at $5.12 million or reverted to $1 million. In the end, it actually went up a bit to $5.25 million for 2013.
Even if your estate will only be a fraction of that amount, it still pays to have a plan for distributing your assets. If your finances are in good shape, there's no reason not to start sharing the wealth while you're still around to enjoy helping others. It also doesn't hurt that you can reap significant tax advantages by distributing a portion of your assets now.
Before you start doling out cash, however, make sure you are on track to fund your own retirement, have adequate health insurance, can pay off your mortgage and are otherwise debt-free. You wouldn't want to deplete your resources and then become a financial burden on others.
If you can check all those boxes, consider these options:
Avoid the gift tax. You can give cash or property worth up to $14,000 per year, per individual, before you'll trigger the federal gift tax. (Married couples filing jointly can give $28,000 per recipient.) You must file IRS Form 709 (Gift Tax Return) for any gifts that exceed these amounts.
This doesn't necessarily mean you'll ever have to pay a gift tax, however. You're allowed to bestow up to $5.25 million in gifts during your lifetime above and beyond the annual $14,000 excluded amounts before the gift tax kicks in -- which for most of us means never. Also not counted toward the lifetime exclusion are:
Read IRS Publication 950 for more details. Note: Some people mistakenly believe that the recipient must pay tax on the gifted amount -- that's not the case.
Pay for education. If college is still far off for your children, grandchildren or others, you might consider funding a 529 State Qualified Tuition Plan for them. Any interest the account earns is not subject to federal (and in most cases, state) income tax; plus, many states offer tax deductions for contributions made to their own 529 Plans. And don't worry: If one child decides not to attend college, you can always transfer the account balance to another without penalty. FinAid.org has an excellent guide that explains how 529 Plans work.
Roth IRAs for kids. If your minor children or grandchildren earn income (allowances and gifts don't count), you may fund a Roth IRA on their behalf. You can contribute up to the lesser of $5,500 or the amount of their taxable earnings for the year. Your contributions are made on an after-tax basis but the earnings grow, tax-free, until the account is tapped at retirement.
For young people, these earnings can build tremendously over time. For example, say you made a one-time $1,000 Roth contribution for your 16-year-old granddaughter. If it earned an average of six percent interest, that one-time contribution would be worth nearly $20,000 -- tax-free -- when she reaches age 66. If you (or she) contributed just $50 a month going forward, it would grow to almost $210,000 by age 66.
Fund someone's benefits. Many people cannot afford health insurance and so forego coverage, putting themselves just one serious illness or accident away from financial disaster. Many also cannot afford to fully fund their 401(k) plan or IRA. Consider applying your tax-exempt gifts mentioned above to help loved ones pay for these critical benefits. You'll not help protect them from catastrophe, but also greatly increase their long-term financial self-sufficiency. Charitable contributions. If you're planning to leave money or property to charities in your will, consider beginning to share those assets now, if you can afford to. You'll be able to enjoy watching your contributions at work -- and be able to deduct them from your income taxes. Read IRS Publication 526 for details.
Here's another good charitable contribution idea: With few exceptions, people over age 70 ½ who have a traditional IRA, regular or Roth 401(k) plan or other tax-deferred retirement plan must take annual required minimum distributions (RMDs) and pay any income taxes owed on the amount. Failure to do so by December 31 each year can result in severe financial penalties.
One approach many seniors take is to transfer up to $100,000 directly from their IRA to an IRS-approved charity. Although the RMD itself isn't tax-deductible, it won't be included in your taxable income, which could reduce taxes on your Social Security benefits and make you eligible for tax breaks tied to Adjusted Gross Income (AGI). It also lowers your overall IRA balance, thereby reducing the size of future RMDs.
Note: Such transfers are not allowed from 401(k) plans; however, it is possible to convert your 401(k) balance into a traditional or Roth IRA. See my previous blog, Deadline Approaches for Mandatory IRA Withdrawals, for more details on RMDs.
Before taking any of these actions, consult your financial advisor to make sure your own bases are covered. If you don't have an advisor, search the Financial Planning Association, the National Association of Personal Financial Advisors or the Certified Financial Planner Board of Standards.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.
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Investing in real estate with no money down
By Justin Pierce
Real estate investor Justin Pierce writes an occasional column about his experiences buying and selling houses in the Washington area.
No money down is one of the most talked about topics in real estate investing.
A lot of folks who are trying to sell real estate education courses often throw the term out to get people’s attention. Buying real estate with nothing out of pocket is very possible. Money is still required but other people’s money is used rather than your own.
But just because you can do it doesn’t mean that you should. A no money down deal in and of itself does not necessarily make a deal good.
There are many creative ways to finance real estate. There are some ways that will get you in trouble but most are completely legal and sometimes very ingenious.
One of the favored methods among real estate investors is to use seller financing. This strategy is most often used when accumulating rental properties or longer-term holds. Usually the seller owns the home “free and clear” (no mortgage) but it is not necessary.
Instead of selling the home outright, the seller becomes the mortgage holder. Title to the home is passed to the buyer but a mortgage or deed of trust is registered on the property with a promissory note where the buyer agrees to whatever terms were negotiated. This is a private transaction so pretty much any interest rate and/or points could be charged as long as both parties agree. Sellers may require a down payment but if they don’t, and then you have yourself a no-money-down deal.
Why would a home seller want to do this? Well, there are a lot of reasons.
First, sellers can sell quickly this way and unload a property that they just may not want to manage anymore. It also defers the tax bill. They only pay taxes on the amount that they collect in that year rather than a big lump sum as they would if the home was sold outright. Also, if they sell the home outright what are they going to do with the cash? They might be able to get a much better return on the money by taking interest payments from their home buyer than they would by putting the money in a bank account. Often there is a payoff requirement within three to five years but the seller may opt to collect payments over a full 30 years, essentially turning the deal into a little annuity of sorts.
Another very common way to achieve a no money down deal is to use private money. This can either be a wealthy friend or family member or it can be a professional private lender or hard money lender. These people are not hard to find if you know where to look.
A private or a hard money lender will usually lend 60 to 70 percent of a home’s end value. So the real estate investor’s task becomes to find homes that they can purchase at 50 cents on the dollar. It’s not easy but it is possible. I make my living doing it.
Let’s say you find a home that will be worth $200,000 after all the fix up and you negotiate a purchase price of $100,000. You could then take that deal to a private lender, which might issue you a loan of around $140,000. That may be enough to pay for the purchase, the closing costs and the fix up. No money is required from the investor. These days many private lenders want down payments from unproven real estate investors but if you have a good enough deal you’ll be able to find someone to finance it.
I do this on occasion. I just recently did a single-family rehab where it just sort of worked out that I didn’t need to bring any of my own money. The deal was good enough and the fix-up budget came in a little under my estimate and I was able to make a decent little profit without dipping into my account. I have to say, these deals are nice if they work out.
The problem with no money down deals is that interest payments can really kill your cash flow and eat up profits. I’ve also seen investors over pay for a property because they’re only concerned with keeping their money out of the deal and didn’t keep their eye on the bigger picture. If you’re using a 100 percent seller financing then no one is going to make you get an appraisal. Then the interest payments strangle cash flow and the investor starts to bleed to death slowly. If the home was purchased at a premium then the investor will not be able to sell the home and he might find himself stuck in an overall bad situation.
I once heard a very prominent real estate guru say, “You can name the price if I can name the terms,” meaning that price doesn’t matter if you can get the interest rate, payoff term and down payment you want. That statement is true to a degree but it certainly has its limitations. The rules of business and economics are like those of physics, and breaking them can end in catastrophe.
Keeping your money out of a deal is great. If you don’t have much money then this allows you to get a foot in the door of a great industry and if you do have money it allows you to hold it in a rainy day reserve or take on additional projects.
However, investors always need to think cash flow first, then ensure overall profitability of the deal and have at least two exit strategies. If these three very important things cannot be reasonably assured then you need to walk away regardless of the size of the down payment.
By Chad Taylor
Question: Have you seen the media coverage about the seller’s market?
If I had a dollar for every time I have been asked this question in the last week and a half, I would at least have 30 bucks! Hey, that’s enough for a great lunch.
For those of you who visit our column weekly, this article was nothing new for you. =If you are new to our column here on the PV Post… stay tuned in every Friday. A goal of our team is to provide relevant and rich real estate information in this column, and in real time. So here we go.
The Star story provided several different perspectives and helps spread the good news. By good news, I mean the news that a home purchase is still a great investment. In our area of the country it always has been. Even after suffering the down market, real estate in our area is a wonderful investment. Real estate, unlike most investments, does not suffer the volatility that most investments are subject to. Sure there are cycles of value, both high and low. But if you look at a long term trend line of values (like the one below) you will see that nationally the volatility is not very high. At the end of 2012 is was predicted that prices were still undervalued by 23.8 percent. If most of us look at our investment portfolios from the last few years of the recession, a 23.8 percent loss of value over time is not much (comparatively speaking).
Remember, I said that prices were undervalued by 23.8 percent at the end of 2012. That is not the case today. Here we are in May of 2013 and values are jumping up for the first time in years. AND interest rates are still incredibly low. If you have ever considered investing in real estate, now is the time. Whether to invest in a personal residence for yourself, or to purchase rental income properties. Money is cheap and the rental market is hot. Most of my clients with rentals are seeing a zero vacancy rate. As soon as a home is advertised for rent, it is rented. And typically with multiple interested parties. kind of sounds like both the re-sale real estate market and the rental market are experiencing the same effects of a housing recovery.
Thank you, we'll be in touch!