Articles by Peter Maclennan

October 31, 2014 by Peter Maclennan Leave a Comment

2014 World Series & Real Estate Investing

Madison Bumgarner “MadBum” 2014 World Series MVP

As you may have heard, the San Francisco Giants won the 2014 World Series in a thrilling Game 7 defeating the Kansas City Royals. What is interesting about the win is that it was built upon skillful pitching and base hits. The Giants did not hit any home runs in Game 7 and had only one double in the deciding game.

What does this have to do with real estate?

Base Hits Matter

The Giants won because they were able to get base hits. They were able to get men on base and put them into scoring position. Base hits allowed the runners to slowly advance around the bases and eventually get to home plate to score runs.

In real estate everyone likes to go for the big score. The home run deal that serves up 10%, 15%, or more in return.

However, sometimes it is the smaller deals, the singles and doubles that end up winning the game.

It is the small portfolio of single family homes acquired over 20-30 years that provide the income and wealth that transfer on to the next generation. It is the small acquisitions made with discipline and prudence that provide for the life and retirement you have only imagined.

A Lifetime of Singles

I met an investor who was purchasing his 8th house. I asked him about it. He said, “It took me a lifetime to accomplish it.” And yet, his 8th property acquired in a good area is worth in excess of $400,000. If all of his properties are worth about the same, he has a portfolio of close to $3,200,000. That isn’t too shabby for a lifetime of work.

To have saved $3,200,000 via the stock market he would have needed to deposit $13,260 per year earning an average of 12% per year over a 30 year time period. If that represents 10% of his savings, he would have needed to average an income of $132,600 over that 30 years.

Ready to get started in real estate? Give me a call at 925.385.8798.

Photo Credit: DSC_4813 by wong1982428 used by creative commons license

July 15, 2014 by Peter Maclennan 1 Comment

Calculating Net Operating Income or NOI

Calculating NOI graphic
It seems like each industry has their own acronyms. The same is true for real estate.

In real estate, the letters NOI stand for Net Operating Income. The net operating income is a number on paper 9 times out of 10. It is not an actual figure that will show up in an investor’s bank account nor is it the number that will be used for tax purposes. NOI is useful in comparing the returns of various properties and for determining if a property is financeable. Think of NOI as the return a property would generate if it was purchased for all cash and regardless of taxes and depreciation.

Actual vs. Pro Forma

NOI can be calculated on an actual basis with the actual rents and the actual expenses. NOI can also be calculated on an expected or pro forma basis based on future estimated rents and estimated expenses. NOI is calculated on an annual basis in most cases.

Start with Income

To begin the calculation of NOI begin with the annual gross rental income for the property. Gross rental income is all the expected income from the property. If the property is a NNN property this will include CAM reimbursements.

Vacancy

Next you will need to deduct vacancy expenses. Vacancy expenses are an estimate of the amount of time that a property will be vacant in any given year due to tenants moving or not paying their rent. Usually this is expressed as a percentage of time. A property in a desirable location may have a low vacancy factor of 5% of the time. Another property in a questionable location may have a much higher vacancy factor and may be empty for 25% of the time or more.

By multiplying the vacancy factor by the gross income you arrive at the vacancy expense. Next you subtract the vacancy expense from the gross income. This will give you the Effective Rental Income.

To the Effective Rental Income you add Other Income. Other Income is usually miscellaneous income from parking fees, laundry, billboards, etc. Now you have arrived at the Gross Operating Income.

Minus Expenses

From the Gross Operating Income you subtract the property’s Operating Expenses to arrive at the Net Operating Income. Operating Expenses include all cash expenses paid to keep the property running at maximum efficiency. They will include property taxes, property insurance, management fees, utilities, advertising costs, accounting fees, legal fees, licenses, and other expenses.

Using NOI

NOI is used to calculate a properties Cap Rate (capitalization rate) for properties. NOI is also the number most lenders use to determine if a property has an adequate debt service coverage ratio (DSCR or DCR) to qualify for a loan.

NOI is a useful tool in helping investors analyze and compare investment properties.

July 1, 2014 by Peter Maclennan Leave a Comment

Financing a Fourplex in California

Fourplex in San Diego by Joe Wolf

As I have mentioned elsewhere, purchasing a duplex, triplex, or fourplex can be a beneficial means of getting started building a real estate portfolio, especially for the young professional.

One of the greatest hurdles in purchasing a fourplex is financing the purchase. Since the real estate bubble and the passage of the Dodd-Frank Act, obtaining a residential mortgage has become a much more rigorous process. It is important that potential investors work with a qualified mortgage professional to obtain prequalification early.

Here are some important items that an investor should know when considering the financing a fourplex in California. For help, I reached out to James Frazier & Robert Sinohue from California Mortgage Advisors.

Loan-to-Value (LTV)

The loan-to-value ratio (LTV) is an important factor in determining a property’s financing. This ratio is calculated by dividing the loan amount by the value of the property. Lenders use this to make sure that there is adequate security in the property should they have to seek repayment through the ownership and sale of the property.

LTV ratios are much more restrictive on investment properties than for owner-occupied properties. The maximum LTV varies by [Read more…]

June 26, 2014 by Peter Maclennan Leave a Comment

Advantages of Buying a Fourplex for Investment

Sometimes in investing it pays to start small. Buying a fourplex or quadplex (4 units), a duplex (2 units), or a triplex (3 units) can be a great way for an investor to get started in the investment game.

Advantages of Buying a Fourplex Property

There are several advantages to purchasing this type of property.

Purchase Price is Smaller

Most duplex, triplex, and fouplex properties are less expensive than comparable commercial or multifamily properties. (This doesn’t ring true everywhere, see Walnut Creek, CA.) A lower purchase price allows the prudent investor to save for a down payment quicker.

Financing a Duplex/Triplex/Fourplex

The federal government classifies 1 to 4 unit properties as residential real estate. The two largest buyers of mortgages on the secondary market, Freddie Mac and Fannie Mae, use the government’s classification system when evaluating a purchase of a mortgage. This means that 2-4 unit properties are given similar underwriting standards that a single-family home is given.

This allows an investor to finance the first 4 investment properties with a lower down payment. A 5% difference in down payment (20% vs. 25%) can be $10,000’s.

An investor can also lock in fixed-rate financing for 30 years! Typical commercial and multifamily loans are refinanced every 3 to 10 years. The need to refinance more frequently subjects an investor to greater interest rate risk.

Fewer Management Issues

One of the elements of property ownership that novice investors forget is that of property management and maintenance. As people use stuff, it tends to break (even if they don’t use it it tends to break). Having a smaller complex to figure out maintenance and repairs of a property will be an easier transition for the newbie investor.

Another factor that makes these properties advantageous for an investor is the concentration of maintenance issues. If you own 4 rental homes or a fourplex you have 4 toilets that may get broken and need repairs. The advantage of owning the fourplex is that the toilets are concentrated in one location and you only have one lawn to mow!

June 18, 2014 by Peter Maclennan Leave a Comment

Two Forms of Real Estate Investment

Real estate investment forms - Monopoly style.

Monopoly got it partially right.

There are two forms of real estate investment, equity (ownership) and debt (lending). Each way offers different benefits and risks for investors. Executing the right strategy at the right time or in the right way, can maximize returns for an investor.

Equity Investment

When most people think about real estate investing they think of ownership of property. There are certain rewards with equity investing and certain risks. There are three major benefits of being an equity investor: control, appreciation, and capital gains tax rates.

Control

The first benefit to being an equity investor is that of control. Because equity investors take ownership of the property, they control what goes on at the property. They can choose paint colors, tenants, repair schedules, contractors, and aspects of day-to-day management. These choices can greatly affect the value of a property over time. Good ownership can add value to a property comparative to other real estate investments around it.

Appreciation

The second benefit equity investors reap is appreciation or growth in value of the property. Imagine a scenario where an investor buys a $350,000 property by putting $70,000 down and borrowing $280,000. In our scenarios the property appreciates to $400,000, their lender does not receive a gain from the increase in value. The owner receives the benefit of that appreciation and has grown their equity from $70,000 to $120,000.

Capital Gains Tax Treatment

The third benefit equity investors enjoy is capital gains tax treatment on appreciation for properties held longer than one year. If the value of the property goes up over time, the IRS has decided to tax this gain differently than earned income. Currently, the capital gains tax rate is lower than the earned income tax rate. As well, capital gains can be deferred by the use of a section 1031 exchange, allowing an equity investor to reap larger rewards over time.

There are risks to being an equity investor.

Equity investors are the first to suffer a loss if the value of the property falls. In our example above, the investor paid $350,000 and the bank loaned her $280,000. If the home decreases in value to $300,000, that loss is felt by the investor and not by her lender. She has suffered the first loss if she is forced to sell after a decline in value.

Variable returns are another risk that equity investors face. Cash flow for equity investors fluctuates with changes in rents, maintenance, and other expenses. An equity investor is not guaranteed a certain rate of return.

Debt Investment

The second way to invest in real estate is through loans or real estate notes.

The second investor in our scenario above is the lender or bank. The bank loaned money to the investor secured by her real estate. The lender takes a different type of risk, repayment risk. The lender is taking a risk that the borrower can and will repay the loan.

The risks and benefits of a debt investor are almost the inverse of the equity investor. The benefits of being a debt investor are a consistent or fixed return and not being the first investor to lose money.

Fixed Return

Most debt investments offer a fixed return with little variation, essentially the interest rate. They lend their funds to the owner who pays them interest (or rent) in return for the use of the funds at a known interest rate. The interest rate is the minimum return that an investor should have on their investment.

Steady and regular income is a comfort to investors living off of the income received from these notes or debt. This is often a solid investment for retirees that need consistent income because they have ceased to earn an income.

Equity Cushion

The second benefit for the debt investor is the “cushion” from the owner’s equity in the purchase of a property. The cushion comes from the fact that most lenders do not lend 100% of the property value, the borrower must put cash down or have equity built up in the property to qualify for the loan. The equity cushion provides the debt investor with a level of comfort that not all of their investment will be lost should the borrower decide to stop repayment.

If the borrower fails to repay the loan, the lender will seek repayment through foreclosure and the sale of the real estate. Hopefully, the equity cushion will allow the debt investor to recoup all of their investment and the expenses of foreclosure. (This did not prove true in the last housing bubble and market crash.)

There are some negatives to being a debt investor in real estate, namely lack of control and being subject to ordinary income tax rates.

Lack of Control

A debt investor is generally not involved in the day-to-day activities of a property and does not have direct control over what happens to the property. They are not allowed to choose the paint color or the tenants at a property. They don’t choose who will do maintenance or how often it is done. This lack of control can mean that a property may suffer from a negligent owner threatening the owners ability to repay the loan.

Ordinary Income Tax

Because debt investors are passive investors by definition, the income they earn is subject to ordinary income tax rates. This can negatively impact after tax returns. However, some of this can be shielded by holding debt investments in tax deferral accounts such as a self-direct IRAs or in a 401k.

A savvy investor can use a combination of equity and debt to maximize their investment returns. Choosing one means of investment over another is dependent on each investors situation in life and their desired outcome.

Interested to know what form of investment might be more advantageous for you, then call or text Peter @ 925.385.8798 for further information.

photo credit: Park Place Expensive Real Estate Monopoly by PT Money

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925.385.8798

2014 World Series & Real Estate Investing

Base Hits Matter

A Lifetime of Singles