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April 17, 2018

9 Factors in Multi-Family and Commercial Real Estate

1.  Objectives: 
    
     A. Cash Flow -- Unless structured with enough down payment, in the California market, most properties will not show positive cash flow. But as time passes,  in the proper market, it will turn into positive cash flow.       
      
     B. Leverage -- Through the use of borrowed money (OPM), combined with a small amount of money of your own, you can control large amounts of property.
   
     C. Appreciation
   
     D. Tax Benefits -- Investors are allowed to write-off all operating expenses, interest on loans secured by the property, depreciate the property, and exchange with little or no immediate tax consequence.
 
     E. Equity Build-up -- This results from the periodic pay down of the principal amount of the loan. Watch out for negative amortization.

II. Requirements
   
    A. Understanding the economy and how it creates investment opportunity niches.
       
       1. Phases of the business cycle -- expansion, prosperity,  recession, depression.  When do people buy and when do they rent. When are office buildings built, when do they fill up? When are new businesses created which require new shopping center frontage?
      
        2. Is the trend toward centralization or decentralization?   
 
     B.  Understanding value of income-producing real property. The difference between a single unit speculation and a multi-unit cash flow investment, or a combination of the two.  The value of a real estate investment is defined as the current or present value of the future cash flow benefits that the property is expected to generate.   
 
    C. Understanding the rental marketplace.
 
    D. Cash -- How much down to break even, if not from me, then from whom?
  
    E. Management Skills.
 
    F. Negotiating skills, understanding the contract and knowing what to ask for.

III. Value

Value- - "Until you know the value, everything is worthless."

The value of income producing property is directly related to the income the property produces.

Four Great Forces that Influence Value

Physical -- This is the quality and convenience of schools, shopping centers, playgrounds, transportation systems, etc. It also includes the climatic conditions.

Social -- Population growth or decline; Marriage, divorce and birth rates; educational and religious standards.

Economic -- Business and real estate cycles, variations in directional growth, natural resources, wage levels, tax levels and insurance schedules.

Political -- Zoning, fire and police protection, government loan and other subsidy programs.

Income

Rent amounts are usually controlled by supply and demand.
 
It is net income that we are most concerned with:
  • Gross Scheduled Income
  • Vacancy and Uncollectible Rent
  • Effective Gross Income
  • Operating Expenses (Fixed and Variable)
  • Net Income
  • Debt Service
  • Cash Flow
  • Added Taxes
  • Net Spendable
Increases and decreases in income increase and decrease value.If you can increase the net income by increasing rents or decreasing expenses, you increase the value.

Value by the Numbers

Gross Multipliers -- Value = GSI X GM

Does not take into consideration expenses.

Income = Rate X Value - You can use this as a comparison without understanding capitalization rate.

Changes in value based on changes in income.

Value by Tire Kicking

Cost per Unit

Unit Composition

Parking

Noise

Type of Roof

Individual Utility Meters

Size of Units

Seller Financing Assistance

Deferred Maintenance

Individual Water Heaters

Modern Kitchen

Orientation, Light or Dark

Price per Square Foot

Put on your tenant's hat

What about assemblage and plotting

Rents and the Rental Market Place

You, as an investor, should be able to determine the dynamics of the rental market and in fact, should not purchase until you thoroughly acquainted with it.

Contract Rent - what is being paid under the existing rental agreements and for how long.

Economic Rent -- what could be charged on the open market if the property were readily available.
 
Consider Rent as to:

Quantity -- how much is collected.

Quality -- financial stability of the tenant. For commercial property, you can ask to see the financial statements of commercial tenants if the lease so provides. For residential income property, review the rental applications of tenants.

Durability -- if the property is residential, you may be concerned if the term of the lease is for a prolonged period. If the property is commercial, industrial or office type, you want the lease term to be at least three to five years.

How do you determine market rents? You call. Do continuous rent surveys. Be up to date in your market area.

Types of Leases:

1. Flat, Fixed, or Straight Lease -- Rent is fixed sum paid periodically throughout the lease period.

2. Graduated Lease -- Contains some escalator clause
    A. Step-up lease - rent is increased in a series of steps over a prescribed period of time.
    B. Index Lease - Rent is tied to an index such as the CPI

3. Percentage Lease -- Landlord becomes a partner; rent is based on a minimum and a percentage of the tenants  GROSS receipts above some minimum. Sometimes referred to as a combination lease.

4. Gross Lease -- Tenant pays a certain amount; landlord pays all the expenses. This provides the landlord with a gross rental income.

5. Net Lease -- Tenant pays the rent and also the expenses. If the tenant pays all the expenses, it is referred to as a "triple net" or "net, net, net" lease. In effect, the landlord's rent is a net income to him.

6. Sandwich Lease -- Lease between the primary lease and the primary lease and the operating lease.

7. Ground Lease -- Lease of the land only. Based on the principle that real estate is too valuable to sell. If you can afford to hold it, you keep it in the family, never selling, only leasing. Usually, the improvements will become the property of the land owner when the lease expires.

Cash Required

If you have cash, the property is easier to purchase. All properties can have a positive cash flow; it depends on the down payment. If you don't have cash, there are plenty of people out there that do, but they don't have time to learn investment techniques and don't have time to learn the market.

Determine the amount of down payment required for slight positive cash flow, add 15% to that, and that's how much you need to raise.

You should put together a "landholding agreement" and a Pro Forma to take to your potential investors.

If you obtain a real estate license, you can use your commissions earned as investment capital.

You must have your investment strategy decided. Are you going to "buy and hold" or "buy and flip"? This will depend on your location and the state of the economy.

As a professional investor, group investing may open up a whole new world of opportunities.

Your objectives for your group should read something like this:
  1. Acquire the right property in the right market at the right time.
  2. Manage effectively to enhance cash flow or fix up to re-market.
  3. Dispose of property at the right time (sell or exchange).
IV. Management Skills -  See Property Management Section

V. Negotiating the Purchase
  • Pro-rated rents
  • Security Deposit Credit
  • Inspections
  • Look at last two years operating statements
VI. Tax Benefits

     A. Schedule E
     B. Depreciation -- Residential: 27.5 Years. Nonresidential: 39 years. Alternative: 40 Years. Straight Line
     C. Passive Loss Limitations -- $25,000 per year maximum, unless in the real estate  business
     D. Exchanges-Section 1031 -- Build Estate With Pre-Tax  Dollars.
  • Up in equity
  • Up in Loan
  • Up in Value
     E. Installment Sales -- Paying Tax on a Prorated Portion of  the Gain
                                 
     F. Refinancing- - Nontaxable event  
            
VII. Rules for Investing
  • SURE is better than MAYBE.
  • MORE is better than LESS.
  • SOONER is better than LATER.
  • NEVER borrower for daily living or luxuries -- "Guns Or Butter."
  • BE as solvent as the situation demands.
Take the time to learn. Invest your time before you invest your money: STUDY / RESEARCH / READ / LEARN / COMPARE / ANALYZE.

VIII. Eternal Truths of Investing
  • Buy near the bottom, sell near the top.
  • Markets always correct.
  • The only constant changes.
  • Uncertainty creates opportunity.
  • Never say never.
IX. Implementation
  • Time Frame
  • Criteria
  • Responsibility
(Saul Klein is CEO of Real Estate Electronic Publishing Company, home of RealTown.)

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