A Layman's Guide To Real Estate Investment Terminology
I was recently analyzing a real estate investment with some of our agents and I realized I could produce an informative post about real estate investment terminology.
I am combining a real world example of an apartment complex that is for sale with the structure of a "Real Estate Investing 101" type of post. By doing it this way, I bet even the most experienced of residential property holders will learn a thing or two (if not, I will refund your full investment :)).
In order to begin, we will start at the beginning of all income producing property analysis ... The Real Estate Stack.
Real Estate Investment Terminology Explained
The real estate stack is merely the formula that we use to determine our cash flow expectations for a particular property.
This formula is shown in the image at the right, and the elements of the equation have the following meanings:
- PGI (Potential Gross Income) - Your "expectation" of the gross rental income that property will produce
- -V/C (less vacancy and collections losses) - The money you "expected" that you won't really get
- EGI (Effective Gross Income) - The total amount of money you will collect from your tenants
- -OE (less operating expenses) - What you will pay to own, operate, and sustain your real estate investment
- NOI (Net Operating Income) - What you end up with after all the dust settles
- - ADS (less annual debt service) - What you will pay if you borrow money to buy the investment
- CFBT (Cash Flow Before Tax) - Cash in hand after everybody but the IRS has been paid
- +/- TAX (Tax expense or savings) - The taxation impact on owning the property (could be positive or negative)
- CFAT (Cash Flow After Tax) - The cash on cash return considering all expenses and income taxes
So that is the real estate stack defined. So what do you do with it?
Assumptions Required For Real Estate Analysis
Before you can properly evaluate an income producing property for no single investor in particular, one must make a few assumptions.
For example, the investor's income level will impact the tax rate for the cash flow on the property. The investor's credit rating will impact the availability of and interest rate charged for any monies borrowed to purchase the property.
The table on the left includes both calculations and the assumptions made for the purpose of our analysis.
The yellow highlighted areas shows the interest rate and personal income tax rate we used for the investor in this analysis.
Reading from top to bottom, this investment assumes a $2.4M purchase price with $48K in buyer closing costs, resulting in an acquisition cost of $2.448M. A 20% down payment ($489,600) leaves a loan balance of $1,958,400.
One great benefit of owning real estate is the ability to claim depreciation as a tax write-off. In this example, we calculated 83% of the purchase price as its depreciable amount.
Analyzing The Numbers In A Real Estate Investment
The tax consequence in this case would be the net operating income (less) the allowable write-offs. These include interest paid on the loan and depreciation (depreciable amount divided by 27.5 years). The remaining $39,737.97 is the taxable income, which at 35% income tax rate means a tax liability of $13,908.29. So think about it ...
due to the "write offs" in owning real estate, a net operating income of $199,656 incurs an income tax liability of $13,908.29, which is a super-low effective rate of 7% for somebody in the 35% tax bracket!
Real Estate Return On Investment
In order to determine the overall return on investment (ROI) for a real estate purchase, you have to contemplate a sale in the future.
Most investors rely on "cap rate" as rule of thumb to quickly assess a property, but it is a mistake to make cap rate anything more than the starting point for an analysis. We want to look at all the benefits (return) that we get with real estate, not just the current cash flow. Many investors have bought overpriced real estate investments by focusing solely on the cap rate at time of acquisition.
The graphic above left estimates a first year ROI assuming 3.5% appreciation, but we can do much better if establish a future sales date and price.
While nobody can predict the future accurately, there is a method that we can use to produce an arguable result.
The investment that we used in this example is actually an apartment complex that has been converted to condominiums, so we actually have the ability to sell units individually and at a greater price than it would sell as a multi-family property.
Therefore, for our analysis, we are going to say that the investor will buy it today ($2.4M) and sell it as soon as the units are worth $150K each (total value of $8.4M. The units were worth that before the housing market crashed, and we'll see those values again within the next five to ten years. So, here is how we calculate the return ... we plot a sale for each of years five through ten and thus have an ROI for each year a sale could be consummated.
Year 1 includes the down payment (negative) plus the after-tax cash flow (positive). Each year thereafter includes the cash flow, while the final year only includes the net proceeds from the sale.
Thus, the table above shows an annualized return on investment as high as 108% if the property sells in five years down to 41% if it takes ten more years for the market to recover. Not too shabby, huh?
As you can see, the cash flow on this property is very good, but the bulk of our ROI comes from the leveraged appreciation that accumulates over time. If you focus on a cap rate alone, then you might mistakenly value an optimized property the same as a property with upside potential.
SUCCESSFUL INVESTMENT IS WARFARE!
There are fundamental concepts that apply to the real estate investment industry that have also been found true consistently on the battlefield throughout history.
Prudent investors could strengthen their positions by taking a lesson from our military history and doctrine.
This brief paper, assembled by a West Point-educated US Army combat veteran, attempts to explain how investors can alter their strategic plans by using the same analytical techniques as would be applied by our modern warriors.
So hopefully this quick analysis of an apartment complex in Tallahassee shows how we use real estate investment terminology and some simple math to calculate the value of a property.