The Complete Guide To Real Estate Finance For Investment Properties

he Complete Guide to

REAL ESTATE

FINANCE for

INVESTMENT

PROPERTIES

How to Analyze Any

Single-Family, Multifamily,

or Commercial Property

STEVE BERGES

John Wiley & Sons, Inc.

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The Complete Guide to

REAL ESTATE

FINANCE

for

INVESTMENT

PROPERTIES

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he Complete Guide to

REAL ESTATE

FINANCE for

INVESTMENT

PROPERTIES

How to Analyze Any

Single-Family, Multifamily,

or Commercial Property

STEVE BERGES

John Wiley & Sons, Inc.

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Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Berges, Steve, 1959–

The complete guide to real estate finance for investment properties : how to analyze any single-

family, multifamily, or commercial property/Steve Berges.

p. cm.

Includes index.

ISBN 0-471-64712-8 (cloth)

1. Real property—Valuation. 2. Real estate investment—Rate of return. 3. Real property—Finance.

4. Residential real estate—Finance. 5. Apartment houses—Finance. 6. Commercial real estate—

Finance. I. Title: Real estate finance for investment properties. II. Title.

HD1387.B397 2004

332.63'24—dc22

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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It has been said that there are angels here among us. This book

is dedicated to my sister, Melanie, who is one of them. Angels

are special messengers of God who have come to minister to the

needs of His children here upon the earth. I have observed my

sister’s unwavering devotion to her family, friends, and faith

throughout her entire life. Not once have I ever heard her com-

plain of the heavy burdens she bears. She has instead chosen to

take the high road by walking in faith and humility. She always

has a smile on her face and uplifting words of encouragement

for my family. I know that the light and joy that radiate from her

countenance are truly that of an angel. My heart cries out in

gratitude to her. My lips praise her name. My spirit is uplifted

because of her. Thank you, Melanie, for your example of love

and charity for all of us who are privileged to be a part of your

life. Thank you for being an angel here among us.

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vii

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CONTENTS

Part 1 Real Estate Finance 1

Chapter 1 Introduction to Real Estate Finance 3

Finance as a Discipline 6

The Relevance of Finance as It Applies to Value 9

Chapter 2 Primary Investment Elements and Their Effect

on Financing Strategies 13

Time Horizon 13

Volume of Investment Activity 18

Type of Property 21

Chapter 3 Secondary Investment Elements and Their Effect

on Financing Strategies 27

Cost of Funds 28

Amortization Period 31

Amount of Funds Borrowed 35

Chapter 4 Additional Investment Elements and Their Effect

on Financing Strategies 43

Loan Duration 43

Loan Fees 46

Prepayment Penalties 54

Chapter 5 Structuring Financial Instruments 61

Leverage 61

Debt 64

Equity 67

Partnerships 69

Blended Financing and the Weighted Average Cost

of Capital 72

Options 76

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Chapter 6 Real Estate Investment Performance Measurements

and Ratios 81

Net Income Return on Investment 84

Cash Return on Investment 85

Total Return on Investment 86

Net Operating Income 87

Capitalization Ratio 89

Debt Service Coverage Ratio 92

Operating Efficiency Ratio 93

Gross Rent Multiplier 98

Operating Ratio 99

Break-Even Ratio 100

Chapter 7 Advanced Real Estate Investment Analysis 103

Future Value Analysis 103

Present Value Analysis 108

Net Present Value Analysis 111

Internal Rate of Return 113

Chapter 8 The Valuation of Real Property 121

Appraisal Defined 121

The Nature of Price and Value 122

Three Primary Appraisal Methods 123

Replacement Cost Method 123

Sales Comparison Method 126

Income Capitalization Method 128

Chapter 9 Financial Statements and Schedules 133

Income Statement 136

Balance Statement 143

Statement of Cash Flows 148

Part 2 Case Study Review: Practical Application

of Valuation Analysis 153

Chapter 10 Case Study 1: Single-Family Rental House 155

Test 1: Comparable Sales Analysis 157

Test 2: Cash Flow Analysis 162

Chapter 11 Case Study 2: Single-Family to Multifamily Conversion 175

Exploring Alternative Possibilities 175

The Relationship between Risk and Reward 180

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Contents

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Chapter 12 Case Study 3: Multifamily Apartment Complex 189

Chapter 13 Case Study 4: Single-Family Conversion

to Commercial Office Building 203

Part 3 Epilogue and Appendixes 229

Chapter 14 Epilogue: Destined for Greatness 231

Prior Works 231

Destined for Greatness 233

Appendix A www.thevalueplay.com 243

Appendix B www.symphony-homes.com 245

Glossary 247

Index 269

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PROPERTIES

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Part 1

Real Estate Finance

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Chapter 1

Introduction to

Real Estate Finance

As investors continue to migrate from the stock market to the real

estate market, the need for sound financial analysis of income-

producing properties is greater than ever. Just as buying high-flying

stocks with no regard to intrinsic values resulted in hundreds of

thousands of investors losing their life savings, so will buying real

estate with reckless disregard to property values result in a similar

outcome. While an abundance of books have been written on how to

buy and sell houses, the market is virtually devoid of any works that

specifically address the topic of the principles of valuation as they

apply to real estate. Notable exceptions include more expensive

titles such as Real Estate Finance and Investments by Brueggeman

and Fisher, with a list price of $125, and Commercial Real Estate

Analysis and Investments by Geltner, boasting a list price of $114.

The Complete Guide to Real Estate Finance for Investment Prop-

erties: How to Analyze Any Single Family, Multifamily, or Commer-

cial Property focuses on the concepts of financial analysis as they

pertain to real estate and is intended to help fill the void that currently

exists regarding this subject. This represents a marked contrast from

the works previously referred to in three primary ways. First of all,

the other works are much more expensive. Second, they have been

written to appeal to a different audience in that they are written in a

textbook format with both the student and the professional in mind.

Finally, the other works deal with advanced theoretical principles of

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finance, which are of little value to the investor who most likely has

no background in finance.

The Complete Guide to Real Estate Finance for Investment

Properties, on the other hand, is designed to appeal to those indi-

viduals who are actively investing in income-producing properties,

as well as to those who desire to invest in them. Furthermore, those

same individuals who are now investors will at some point have a

need to divest themselves of their holdings. Whether an investor is

buying or selling, the basis for all decisions must be founded on the

fundamental principles of finance as they apply to real estate valu-

ations. The failure to understand these key principles will almost

certainly result in the failure of the individual investor. At a mini-

mum, it will place him or her at a competitive disadvantage among

those who do understand them. Recall the myriad of investors who

bought stocks for no other reason than that they received a so-called

hot tip from a friend or coworker—and who later collectively lost

billions of dollars. A similar outcome is almost certain for those

individuals investing in real estate who fail to exercise sound valu-

ation principles and act on nothing more than the advice of some-

one who has no business giving advice, such as a broker with a

supposedly hot tip.

The Complete Guide to Real Estate Finance for Investment Prop-

erties is further intended to take the theories of real estate finance

discussed in other books and demonstrate how they can be used in

real-world situations. In other words, it is the practical application of

these theories that really matters to investors. An in-depth examina-

tion of several case studies will provide the learning platform neces-

sary for investors to make the transition from the theory of real

estate finance to its practical application. Investor comprehension

will be further augmented through the use of several proprietary

financial models developed by me for the sole purpose of making

sound investment decisions.

Now that I have established what this book is about, I’ll take a brief

moment to establish what it is not about. The term finance as used

throughout this book is generally intended to refer to principles of

financial analysis and not to debt instruments such as loans or mort-

gages that are used for financing real estate. This is not a book about

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creative methods of borrowing money or structuring nothing-down

deals. Hundreds of those types of books are already available, includ-

ing a few of my own. My purpose in specifically defining what this

book is not about stems from the misleading titles of some currently

very popular real estate books that contain the word finance in their

titles. Perhaps the phrase “real estate finance” means creative borrow-

ing techniques to the authors who wrote them, but to professionals

schooled in the principles of finance, the phrase encompasses a com-

pletely different body of knowledge. This is not to say, however, that

financing mechanisms are not discussed in this book, for they cer-

tainly are. Debt and equity instruments are discussed out of necessity,

as their respective costs must be properly understood for the purpose

of measuring returns and values, as well as evaluating the implications

of using different types of financial instruments for different types of

transactions.

This book is organized into three parts, beginning with Part 1,

which examines the principles of real estate finance. Chapter 1

introduces the world of financial analysis as it applies to real estate

investments. Chapter 2 focuses on primary investment elements

and their effect on financing. Chapter 3 then centers on secondary

investment elements, and Chapter 4 focuses on still other invest-

ment elements and their impact on financing. Chapter 5 shifts to an

examination of the various types of debt and equity instruments

available and their impact on returns. Chapter 6 includes a discus-

sion on various investment performance measurements and ratios,

including return on investment, capitalization ratio, and debt ser-

vice coverage ratio. Chapter 7 is devoted to a more advanced an-

alysis of real estate investments and includes topics such as

understanding present value and future value concepts, internal rate

of return (IRR), calculations, and modern real estate portfolio the-

ory. Chapter 8 explores the realm of the three most commonly used

valuation methods for the different classes of real estate. Chapter 9

provides a discussion on financial statements, including how to

more fully understand them and how you can use them to make

prudent buy-and-sell decisions.

Part 2 takes most of the information discussed in Part 1 and uses

it in a case study format. Chapter 10 examines real estate finance as

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it applies to the valuation of single-family houses. Chapter 11 pro-

vides an in-depth look at converting property from one use to

another. Chapter 12 is a case study that examines a multifamily

apartment complex and walks the reader through a comprehensive

analysis. Finally, Chapter 13 demonstrates how understanding

finance and the different valuation methods can provide significant

opportunities to create value for the astute investor by converting a

single-family property into a commercial office building.

Part 3 consists of an epilogue containing words of inspiration and

several motivating ideas, appendixes, and an extensive glossary.

FINANCE AS A DISCIPLINE

If you are a business student, the first two years of college for both

accounting and finance majors are nearly identical. Each requires

the basic English, history, math, and general business studies. By the

third year of college, however, the two disciplines begin to chart sep-

arate courses. While both subjects deal with numbers and money,

they are quite different in the way they do so.

The accounting discipline, for example, centers on principles

used primarily for bookkeeping purposes and is based on a body of

rules referred to as the generally accepted accounting principles

(GAAP). Although there is some disagreement by scholars of many

of the more advanced rulings, the principles established in GAAP

are nevertheless to be firmly applied and adhered to when recording

entries. As a general rule, the accounting principles are rigid rules

that must be applied for bookkeeping and tax purposes.

The discipline of finance, on the other hand, centers more on the

valuation and use of money than on record keeping. Finance is an

exploration into the world of micro- and macroeconomic conditions

that impact the value of a business’s assets, liabilities, and invest-

ments. While there are certainly rules and laws that govern the prin-

ciples of finance, it is a subject that remains fluid and dynamic. The

expansion and contraction of businesses live and die by those who

understand these laws and their effect on value.

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Professors Lawrence Schall and Charles Haley, authors of Intro-

duction to Financial Management (New York: McGraw-Hill,

1988, p. 10), further expound on the discipline of finance by

asserting that “Finance is a body of facts, principles, and theories

dealing with the raising (for example, by borrowing) and using of

money by individuals, businesses, and governments.” In part,

finance deals with the raising of funds to be used for investment

purposes to help these various types of entities generate a return on

their capital. In addition, the authors state (ibid., pp. 10–11):

The individual’s financial problem is to maximize his or

her well-being by appropriately using the resources avail-

able. Finance deals with how individuals divide their

income between consumption (food, clothes, etc.) and

investment (stocks, bonds, real estate, etc.), how they

choose from among available investment opportunities,

and how they raise money to provide for increased con-

sumption or investment.

Firms also have the problem of allocating resources and

raising money. Management must determine which invest-

ments to make and how to finance those investments. Just

as the individual seeks to maximize his or her happiness,

the firm seeks to maximize the wealth of its owners (stock-

holders).

Finance also encompasses the study of financial markets

and institutions, and the activities of governments, with

stress on those aspects relating to the financial decisions of

individuals and companies. A familiarity with the limita-

tions and opportunities provided by the institutional envi-

ronment is crucial to the decision-making process of

individuals and firms. In addition, financial institutions and

governments have financial problems comparable to those

of individuals and firms. The study of these problems is an

important part of the field of finance.

There you have it. Professors Schall and Haley have outlined some of

the fundamental issues that financial managers in both private and

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public sectors deal with on an ongoing basis. Raising capital, whether

debt or equity, is essential to the successful operation of a firm. What

is even more essential is the proper management of that capital.

I recall very distinctly during my sophomore year of college

being faced with the decision of choosing the accounting or

finance discipline. At the time, I didn’t know any accountants and

I didn’t know any financial analysts, so I wasn’t quite sure whom

to turn to. What I did know, however, was that most of my col-

leagues were choosing the accounting route and encouraged me to

do so as well. After all, that’s where all the jobs were, according to

them. I didn’t really care if that’s where all the jobs were. All I

cared about was becoming fully engrossed in a field in which I

would be the happiest.

My assessment of accounting was that it was rather dry and bor-

ing. Accounting represented mundane and repetitive tasks governed

by a rigid set of principles. It was the recording of a company’s

income and assets that reflected its value at that specific moment in

time. This is typically referred to in accounting circles as a “snap-

shot in time.” Quite frankly, snapshots bored me. I was more inter-

ested in making movies than in taking pictures. Finance opens up an

entire world of possibilities that accounting can’t even dream of. It

takes the snapshot made by accountants and brings it to life by

exploring the vast universe not of what a company is, but rather, that

of what it can become. Finance scrutinizes every strength and weak-

ness of the photograph to measure its true potential. It exhausts

every possibility to breathe the breath of life into it. Finance is an

exciting field that allows individuals to use all of the creative facul-

ties inherent within them to grow in ways limited only by one’s

imagination.

I can only wonder whether my colleagues who chose the account-

ing field are happy in their profession. As for me, I chose the road

less traveled and haven’t looked back since. Some 20 years or so

later, I can say with all the sincerity of my heart that for me it was

the right choice. I should add that it is not my intent to offend those

of you who may be accountants or to demean your role as a profes-

sional in any way, as reports generated by accountants provide valu-

able information for both internal and external users of financial

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statements. My assessment of the accounting profession represents

exactly that—my assessment.

THE RELEVANCE OF FINANCE AS IT APPLIES TO VALUE

In Chapter 4 of The Complete Guide to Investing in Rental Proper-

ties (New York: McGraw-Hill, 2004), I described my zeal for

finance, along with a portion of my background, as follows:

Let me begin this chapter by emphatically stating that I

thoroughly enjoy the subject of finance, and in particular

as it applies to real estate. Finance and real estate are the

two greatest passions of my professional life. For as long as

I can remember, I have always been fascinated with

money. This fascination eventually helped shape my

course in life as I later majored in finance in both my

undergraduate and graduate studies.

After graduating, I had the opportunity to work as a

financial analyst at one of the largest banks in Texas. As

part of the mergers and acquisitions group, my work there

centered around analyzing potential acquisition targets for

the bank. One way companies grow is by acquiring

smaller companies that do the same thing they do. This is

especially true of banks. Big banks merge with other big

banks, and they buy, or acquire, other banks that are usu-

ally, but not always, smaller than they are. I believe our

bank was at the time about $11 billion strong in total

assets. It was my job to analyze banks which typically

ranged in size from about $25 million up to as much as

about $2 billion. I used a fairly complex and sophisticated

model to properly assess the value of the banks. This expe-

rience provided me with a comprehensive understanding

of cash flow analysis which I later applied to real estate.

Like many of you, in my earlier years, I owned and managed

rental properties and read just about every new real estate book that

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came out. They all seemed to be saying the same thing, with only

slight variations in theme, some delving into nothing-down tech-

niques while others focused on slowly accumulating a portfolio of

properties, gradually building a level of cash flow sufficient to pro-

vide a living, otherwise known as the buy-and-hold approach.

The more I read, the more I discovered that none of these books

focused on what matters most in real estate, that being the accumula-

tion of properties that are properly valued, as well as their subsequent

disposition, with the difference being sufficient enough to allow

investors the opportunity to profit. Proponents of the buy-and-hold

strategy would argue that because the holding period extends over

many years, price doesn’t matter as long as an investor can purchase

real estate with favorable enough terms. Nothing could be further

from the truth. It is precisely this kind of misinformation that led

thousands, if not millions, of investors over the cliff in the collapse of

the stock market in the three-year period that began in the year 2000.

Price didn’t matter as long as it was going up and the terms were

good. Since value is a function of the price paid, and price didn’t

matter, value didn’t matter, either. Investors overextended them-

selves buying on margin and otherwise using borrowed funds with

absolutely no regard for an asset’s value. Most of these investors

probably had no conceptual basis for their purchase decisions to

begin with. In the end, many of those same investors watched in hor-

ror as their life savings evaporated right before their very eyes.

Although I had bought and sold real estate for a number of years

prior to my experience at the bank, it wasn’t until I gained a more

complete understanding of the principles of finance learned during

my graduate studies and my tenure at the bank that I was able to sig-

nificantly accelerate my investment goals. I developed my own pro-

prietary financial models, which enabled me to more fully analyze

an asset’s value based on its cash flows and price relationship to

similar assets. The combination of these financial analysis tools and

a sound understanding of valuation principles has allowed me to

increase my personal real estate investment activities from a meager

$25,000 a year in volume to a projected $8 to $10 million this year

alone. Through duplication and expansion, which are part of a well-

defined plan, I fully expect to increase these projections to buy and

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sell over $100 million in real estate annually within the next three to

five years. This may be a bit aggressive for most investors, but I can

see this level of activity in my mind’s eye just as clearly and vividly

as the sun shining in all its glory on a midsummer’s day. The pieces

are already being put into place to help me achieve this not-too-

distant objective.

Achieving goals of this magnitude exemplifies the difference

between the finance and accounting disciplines. The world of finance

can unlock the doors of commerce in a way that most accounting pro-

fessionals can only dream of. A working knowledge of the principles

of cash flow analysis coupled with a comprehension of valuation

analysis will allow investors to chart their own course in the real

estate industry—or any other industry for that matter.

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Chapter 2

Primary Investment Elements

and Their Effect on

Financing Strategies

To achieve the magnitude of investment activity referred to in my

own personal example in Chapter 1, an investor must have clearly

defined goals. The goals you establish will directly impact your

financing strategies. Three primary financing elements around

which all real estate investment activity centers are time, volume,

and the type of property (see Exhibit 2.1). Once you have deter-

mined your time horizon, the rate at which you intend to buy and

sell, along with the type of real estate you will invest in, the proper

financial instruments may then be put in place.

TIME HORIZON

Most real estate professionals incorporate the element of time into

their investment strategy. The element of time refers to the duration

of the holding period. In other words, it is the length of time a par-

ticular piece of investment property is intended to be held. While

some investors, for example, prefer to adopt a short-term approach

by “flipping” or “rehabbing” houses, other investors prefer to adopt

an intermediate-term approach, which includes buying, managing,

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and holding rental property for three to five years. Still others prefer

to purchase office or industrial buildings and hold them for periods

as long as 10, 20, or even 30 years. Establishing your investment

horizon before obtaining financing is crucial to developing a sound

strategy. You must know beforehand if you are going to hold the

property for just a short time, for many years, or for somewhere in

between, since the variable of time is used to calculate interest rates.

Time will also have an impact on whether you obtain a floating rate

or a fixed-rate loan, as well as any prepayment penalties that may be

associated with the loan.

In The Complete Guide to Flipping Properties (New Jersey: John

Wiley & Sons, 2004), I elaborated on the element of time as follows:

Time can have a significant impact on the growth rate of

your real estate portfolio. Time affects such things as the tax

rate applied to your gain or loss. The long term capital

gains tax rate has historically been more favorable than the

short term tax rate. Time is also the variable in the rate of

inventory turnover. Large retailers are willing to accept

lower profit margins on items they merchandise in

exchange for a higher inventory turnover rate. Would you

rather earn twenty percent on each item, or house, you sell

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Exhibit 2.1

Primary financing elements.

1. Time horizon

2. Volume of investment activity

3. Type of investment property

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and have a turnover rate of one, or would you rather earn

eight percent on each item you sell and have a turnover

rate of three? Let’s do the math.

Turnover ratio = = × 20% = 20% = total return

Turnover ratio = = × 8% = 24% = total return

This simple example clearly illustrates that an investor

can accept a lower rate of return on each property bought

and sold and earn a higher overall rate of return, provided

that the frequency, or turnover rate, is increased. I should

mention that this example does not, of course, take into

consideration transaction costs. These costs may or may not

be significant depending on your specific situation, but they

must be factored in when analyzing a potential purchase.

Investment time horizons typically fall into one of three cate-

gories: short term, intermediate term, and long term. Short-term

investors are defined as those individuals who buy and sell real

estate with a shorter duration. They typically hold their investments

less than one to two years. This class of investor most often seeks

gains by adding value through making improvements to the prop-

erty, or by taking advantage of market price inefficiencies, which

may be caused by any number of factors, including distress sales

from the loss of a job, a family crisis such as divorce, or perhaps a

death in the family. The shorter holding period does not allow

enough time for gains through natural price appreciation caused by

supply and demand issues or inflationary pressures.

The short-term investor may furthermore seek to profit by using

the higher-inventory-turnover strategy and, as a result, may be will-

ing to accept smaller returns, but with greater frequency, thus realiz-

ing an overall rate of return considerably higher than the long-term

ᎏ

turnover

ᎏ

years

ᎏ

turnover

ᎏ

years

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approach, as demonstrated previously. Since current tax codes penal-

ize short-term investors by imposing higher tax rates on short-term

capital gains, they must factor this into their analysis before ever pur-

chasing a property.

The proper financing mechanism is also a key part of an in-

vestor’s analysis. In a short-term strategy, an investor can often take

advantage of a loan with a more favorable floating or adjustable

rate as opposed to a longer-term fixed-rate loan. In addition,

depending on the type of financial instrument procured, principal

payments may not be required. This provision allows an investor to

minimize his or her outgoing cash flow by making interest-only

payments. Cash flow is the name of the game in real estate. Learn

to use it to your benefit. Finally, you should be aware of any pre-

payment penalties that may be imposed on short-term financing.

Banks are especially notorious for assessing this additional type of

fee income on a loan. Their decision to do so is based on the prem-

ise that since the loan is short term in nature, they must charge addi-

tional fees to offset their other costs associated with making the

loan, such as administrative costs. That argument, however, is the

same one lenders use to justify charging a loan-origination fee,

which is typically one point, or 1 percent. If you have a good track

record and are an established investment professional, prepayment

penalties can usually be negotiated down to a minimum, and often-

times will be waived all together.

Intermediate-term investors most often hold their properties for at

least two years but no more than five years. This class of investor

typically seeks gains through a combination of increases in property

values, resulting from price appreciation due to supply and demand

constraints in the local market, and by making modest improve-

ments to the property. Reducing debt to increase cash flow is not as

high a priority for intermediate-term investors as it is for their long-

term counterparts. This class of investor also tends to be more highly

leveraged than do long-term investors. Finally, since intermediate-

term investors hold their investment properties for a minimum of

two years, they are able to take advantage of the lower and more

favorable long-term capital gains tax rate. As the tax laws are cur-

rently written, income derived from the sale of assets with a holding

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period shorter than 18 months will be treated as ordinary income

and therefore subject to a higher tax rate.

Once again, the proper financing mechanism is a key part of an

investor’s analysis. In an intermediate-term strategy, an individual

can, like the short-term investor, take advantage of a more favorable

floating-rate loan. If the time horizon is firmly established as one

that will not exceed five years, I recommend using floating-rate

instruments in most cases, since they almost always carry lower

interest rates than do fixed-rate loans. The exception to this recom-

mendation is, however, that if rates are forecast to rise in the near

future, it may be better to lock in a fixed rate now than to run the risk

of rapidly increasing rates. Similarly to short-term financial instru-

ments, you may be able to obtain a loan in which principal payments

are not required.

Depending on the needs of the seller, you may even be able to

negotiate a deal in which no periodic payments whatsoever are

required. This includes both principal and interest. I’ve used this

technique myself; as a matter of fact, I very recently closed on a land

deal valued at $3.3 million that will not require any periodic princi-

pal or interest payments. The seller agreed to carry the note and

allow the interest to accrue. The interest will become payable at the

time individual lots from the land are released, which occurs when

my company, Symphony Homes, builds a house on it (see Appendix

B). At that time, a construction loan is obtained to pay both the

accrued interest and the principal balance to the seller. Interest-only

payments are then made to the bank over the next four months or so

until the house is completed and sold.

Long-term investors may purchase real estate properties and keep

them in the family for generations. They will typically hold them for

a minimum of five years, but oftentimes much longer. Long-term

investors seek gains through capital appreciation by simply holding

and maintaining their investments while making improvements on an

as-needed basis. They sometimes seek to minimize the associated

debt and maximize the cash flow generated by the property through

an acceleration of both interest and principal payments. Although

in the short term, investors adopting this strategy will decrease the

property’s cash flow by making larger monthly payments, they will

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eventually increase its cash flow by eliminating the debt altogether. As

a result, long-term investors are usually not fully leveraged. They gen-

erally prefer the positive cash flow to being excessively leveraged.

Long-term investors are able to take advantage of the more favorable

long-term capital gains tax rates when they do eventually decide to

sell. In addition, long-term investors may elect to take advantage of

deferring the tax liability indefinitely through a provision outlined in

the Internal Revenue Code referred to as a 1031 exchange.

Investors adopting a long-term strategy will most likely desire to

insulate themselves from variations that occur in a sometimes

volatile interest rate environment by locking in fixed-rate loans at

the time of purchase. However, like short-term investors, they can

take advantage of more favorable floating-rate loans. Depending on

the type of financing instrument used, long-term investors may or

may not be subject to prepayment penalties. Some debt instruments,

such as conduit loans, carry heavy prepayment penalties in the early

years. Conduit loans are reserved for larger income-producing prop-

erties and usually have a minimum loan amount of $1 million, al-

though smaller loans are available. A complex prepayment penalty

is almost always imposed on these types of loans, since the loans are

securitized and then sold to investors. The prepayment penalties are

used to ensure that investors who buy the loans are guaranteed a

minimum yield on their related investment.

VOLUME OF INVESTMENT ACTIVITY

The element of volume is the second significant factor that affects an

investor’s strategy and the type of financing to be used. For example,

increasing the volume of units bought and sold, or flipped, increases

the investor’s opportunity to generate profits. By the same token,

increasing the volume of units bought, managed, and held in a port-

folio increases the investor’s opportunity to generate income.

Increasing the volume, however, can significantly increase your

transaction costs, especially if you’re a short-term investor. If, for

example, the lender charges you one or two points every time you

obtain a loan for a house you’re going to flip, the costs for financing

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can add up quickly and will significantly increase the annualized

rate of interest. Let’s look at an example. Assume you are purchas-

ing a house for $100,000 to rehab and then flip. Let’s also assume

that you’re pretty good at doing this and that the average time it

takes you to buy, rehab, and sell a property is three months.

Purchase price = $100,000

Interest rate = 6.0%

Loan-origination fee = 1.0%

Turnaround time = 3 months

Interest paid = $100,000 × 6.0% ÷ 12 × 3 = $1,500

Loan-origination fee = $100,000 × 1.0% = $1,000

Total interest and fees = $1,500 + $1,000 = $2,500

Effective interest rate = ($2,500 ÷ $100,000) ÷ 3 × 12 = 10.0%

As illustrated in this example, although the stated interest rate of 6.0

percent would be considered a very competitive rate for most

investors, the effective rate of 10.0 percent is not nearly as competi-

tive. In fact, in a 6.0 percent interest rate environment, many

investors would not walk, but would instead run out of the bank if

the lender told them the interest rate would be 10.0 percent.

Okay, so maybe $1,000 isn’t a deal killer for this particular invest-

ment, but now let’s factor in volume. Instead of buying just one

house per year, assume you have assembled a team of individuals to

work with you and have increased your volume to 100 houses per

year. The $1,000 in additional fees has now become $100,000. Who

wants to leave $100,000 on the table for the lender? Nobody, that’s

who (besides the lender).

The best way to eliminate fees of this type is by negotiating with

your lender for a line of credit. A line of credit will provide you with

a predetermined amount of money to draw against to finance not

only the purchase of the houses, but also the repair work that will be

needed as well. A line of credit is just like a credit card, but with a

much higher limit. An investor can borrow as much as needed up to

the predetermined credit limit. Since funds are borrowed only as

they are needed, this helps to reduce the overall carrying costs the

investor otherwise might incur.

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I should add that, as a general rule, lenders will not extend a line

of credit to anyone who does not have a solid financial statement,

which includes strong cash reserves. Lines of credit are most often

unsecured, which means the lender has no collateral. The terms

lender and no collateral mix together about as well as water mixes

with oil. One could arguably draw the conclusion that lenders must

be insecure, since they always want some type of security. I suppose

that might be stretching it a bit, though. In reality, lenders just want

to protect their interests. When they loan money, they like to get

something of value in return to hold as collateral just in case the bor-

rower defaults. With an unsecured line of credit, the lender has no

such protection, and that is exactly why it is difficult to get unse-

cured loans.

Although you may not be able to get an unsecured line of credit,

you may be able to start with a secured line of credit by offering

the lender some type of collateral. Forms of collateral you may be

able to offer include equity in any type of asset you own, such as

the following:

■ Your personal residence

■ Investment property you may own and have equity in

■ Business property such as an office building or equipment

■ Notes payable to you that are secured by an asset (for instance,

from owner-financed sales)

■ Financial instruments such as stocks, bonds, certificates of de-

posit, and annuities

■ Retirement accounts (only if the lender can secure an interest

in them, though)

■ Precious metals such as gold, silver, and platinum

■ Personal assets such as boats, automobiles, jewelry, and fur-

nishings

Once investors have proven to a lender that they are capable of

repaying loans on a timely basis, the lender may gradually become

more comfortable with extending larger lines of credit. This will

depend in large part on an investor’s own personal financial strength.

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If lenders determine that particular investors are tapped out and have

depleted their cash reserves, those lenders may not be willing to lend

them anything. It’s all about building relationships and trust over an

extended period of time. It doesn’t happen overnight, but it will hap-

pen as long as an investor is able to prove that he or she is responsi-

ble and trustworthy.

TYPE OF PROPERTY

The type of property an investor purchases is the third primary ele-

ment that affects an investor’s strategy and the type of financing to be

used. Property types that produce income are most commonly classi-

fied as single-family, multifamily, or commercial. The type of loan

obtained for any real estate property will largely be determined by

the type of property being purchased. Financial institutions provide

an array of products that are suited for particular investment types.

The term single-family property is a bit misleading, as it actually

encompasses all real estate with at least one living unit and not more

than four living units. In other words, a house, as well as a duplex,

triplex, and fourplex, are all classified as single-family properties as

far as lenders are concerned. Because single-family properties are

by far the most common of the three types, mortgages are readily

available for them from most financial institutions.

Loan provisions for single-family properties will of course vary

from lender to lender. By either shopping around yourself or using

the services of a mortgage broker, you can easily compare the alter-

natives available among conventional lenders and select the one that

best meets your needs. In The Complete Guide to Investing in Rental

Properties (New York: McGraw-Hill, 2004), I elaborated in consid-

erable detail on the intricacies of financing for single-family proper-

ties. Following is an excerpt taken from Chapter 5.

Conventional bank financing is often available through

small local banks. These types of banks may operate with

just one or two branches and have a small deposit base of

only $15 to $20 million, or they may be somewhat larger

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with as many as five to ten branches and $200 million in

deposits. One primary advantage to using a local bank is

that they can often provide borrowers with more flexibility

than more conventional sources such as a mortgage com-

pany. Local banks may, for example, loan money to pur-

chase a rental property as well as to make improvements

to it.

Small local banks are also much more likely to be famil-

iar with the local area and would therefore have a greater

degree of confidence in the specific market than a larger

regional or national lender would. A personal relationship

with a local banker is much easier to establish also than

with other types of lenders such as conventional mortgage

companies. In a local bank where decisions are made in

part based upon these relationships, an investor can go

into a bank, introduce himself, and speak directly with the

lender. This affords investors with an opportunity to sell

themselves as well as their project. Once a relationship has

been established and the banker gets to know you and is

comfortable with you, future loan requests will be much

easier and will likely require less documentation, possibly

as little as updating your personal financial statement.

Local banks are one of many sources available to finance single-

family properties. Additional alternatives you may wish to consider

include obtaining a mortgage, using an existing line of credit, or

having the seller carry all or part of the note. You may also want to

consider using an option agreement, which is more fully explained

in Chapter 5.

Financing for multifamily properties typically involves using a

network of institutional lenders or investors different from those

mortgage companies that provide financing for single-family proper-

ties. Remember, the primary criterion that separates the two property

types is the number of units. Single-family housing is considered to

be anything from one to four units, whereas multifamily properties

are those with five or more units. In The Complete Guide to Buying

and Selling Apartments (New Jersey: John Wiley & Sons, 2004), I

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described several of the lending programs available to multifamily

investors. Following is an excerpt from Chapter 7.

Specialty apartment lending programs are designed specif-

ically with the small multifamily investor in mind. They are

the product of listening to feedback from investors such as

yourself and have been streamlined and tailored especially

for borrowers in the apartment business. In addition, since

many lenders focus on the larger-sized loans, these pro-

grams were devised to serve a once overlooked segment of

the apartment lending business. Interest rates for this type

of loan are usually very competitive and typically below

prime. Loan amounts vary according to the underwriting

guidelines established by each lender, but generally range

from approximately $100,000 to $2,000,000.

A variety of terms are offered, including one, three, five,

seven, and ten years. Amortization periods are commonly

20 or 25 years, with some lenders offering 30-year periods.

Other advantages of this type of loan include lender fees,

which are kept to a minimum, and third-party report

requirements, which are often not as stringent. A primary

disadvantage of the specialty apartment lending programs

is that the maximum loan amount is usually around $2 mil-

lion. Since this type of loan was designed with the smaller

investor in mind, the maximum loan amounts are capped

at lower levels.

This excerpt was written when the prime lending rate hovered

around 7

⁄2 percent, which, believe it or not, was not that long ago.

Since the current prime lending rate is a historically low 4 percent,

specialty apartment programs are no longer priced below prime.

They do, however, remain at very competitive rates and provide

attractive terms and conditions designed specifically to meet the

needs of the small multifamily investor.

For larger real estate investments such as office buildings, retail

strip centers, or large-scale apartment complexes, the financial

instruments used become more sophisticated and complex. One

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commonly used financing mechanism is referred to as a conduit

loan. Conduit loans are typically originated by large institutional

firms, such as insurance companies, which usually have hundreds of

millions, or even billions, of dollars in investment capital. Once

again, referring to The Complete Guide to Buying and Selling Apart-

ments, I described in part the nature of conduit loans as they apply to

multifamily unit financing:

Conduit financing differs from conventional bank loans in

several ways. First, conduit loans are pooled together when

a certain dollar amount is reached, say $500 million. They

are then “securitized” or packaged together and sold to

investors who seek to maintain a specific yield or return on

their capital. Since the loans are pooled together, it is very

difficult to pay off a single loan out of the pool prior to the

end of the term, and in many cases, the borrower is

“locked out” or prohibited from prepaying the loan. Con-

ventional bank loans, on the other hand, are not securi-

tized but are instead treated as individual loans and

maintained and serviced directly by the issuing bank.

Another key difference is that unlike conventional bank

loans, which are priced off of the prime lending rate, con-

duit loans are generally priced off of an index such as Trea-

sury notes, which correspond to the term of the loan. A

loan with a 10-year term, for example, may use the 10-year

Treasury as its benchmark. A spread is then factored into

the rate by adding the spread to the 10-year Treasury.

Spreads are stated in “basis points,” so a spread of 215

basis points is equivalent to 2.15 percent. If the 10-year

Treasury is currently priced at 5.30 and the spread is 215

basis points (or “bips” as lenders like to call them), then the

interest rate applied to the loan would be 7.45 percent.

Conduit loans also differ from conventional bank loans in

the degree of personal liability associated with each type.

With conduit loans, there is usually no personal liability

while there is almost always full personal liability for con-

ventional bank financing.

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After completing two or three smaller-scale commercial or multi-

family purchases using a more traditional financing mechanism

such as a conventional bank loan, you should be ready to accept the

challenge of the more sophisticated conduit loans. Remember, too,

that conduit loans are designed for investments with a longer hold-

ing period and therefore would not be suitable for a fix and flip type

of application.

In summary, the three elements of time, volume, and property

type must all be considered collectively rather than individually. For

example, the financing instrument used for an Investor A, who

acquires single-family property to hold on a long-term basis, is very

different than that for Investor B, who purchases single-family prop-

erty to buy and sell on a short-term basis. While Investor A pur-

chases one property each year to hold for many years, Investor B

purchases 50 properties each year and holds them just long enough

to rehab and flip them. Although both investors are purchasing sim-

ilar types of properties, the financing mechanisms for each investor

are very different. Investor A will most likely get a 30-year conven-

tional mortgage to finance his property, and Investor B will most

likely use a line of credit to finance her activities. The same princi-

ples hold true for investors purchasing multifamily and commercial

property. In fact, a change in any one of the three variables will have

a direct effect on the financial instrument used in your investment

activities. The more familiar you become with the interaction that

occurs among these three variables, the better able you will be to use

them to your advantage.

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Chapter 3

Secondary Investment Elements

and Their Effect on Financing

Strategies

In Chapter 2, we examined the three primary financing elements

around which all real estate investment activity centers. They are the

elements of time, volume, and property type. In this chapter, we

discuss the three secondary investment elements that affect real

estate financing activities. They are the cost of funds, the amortiza-

tion period, and the amount of funds borrowed (see Exhibit 3.1). It

is essential for individuals to understand how each of these three

variables affects the profitability of the various types of real estate

investments. A material change of any one of the three elements

would change the cash flow of the property. For income-producing

properties, asset value is derived directly from the net income of

the property, so a change in any one of the three secondary elements

may have an impact on its value, whether negative or positive. With

the proper financial model, an investor can easily assess the impact

of changes in value by experimenting with these three elements, or

variables.

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COST OF FUNDS

The cost of funds is the first of the three secondary financing ele-

ments that affect real estate financing and, consequently, real estate

value. The cost to borrow funds is expressed in terms of an interest

rate and represents the portion of the loan payment that the lender

charges for loaning money. Changes in the interest rate charged to

purchase income-producing property have a direct effect on the

property’s value. In Chapter 8, we explore in great detail the three

primary appraisal methods, one of which is the income capitaliza-

tion method. This appraisal method rests on the premise that a

stream of income can be converted into a single capital value. If

there is a reduction in the stream of income, the capital value must

likewise be reduced. An increase to any degree in the cost of funds

borrowed would have a negative effect on an investment property’s

income stream and would subsequently reduce its capital value.

The cost of funds, or interest rate, varies widely among lenders.

Both banks and mortgage companies tend to be fairly competitive,

as do conduit lenders. Banks typically offer loans for shorter dura-

tions and price their loans using the prime lending rate as the bench-

mark. Mortgage companies, on the other hand, often offer loans for

longer durations and price them using an index such as Treasury

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Exhibit 3.1

Secondary financing elements.

1. Cost of funds

2. Amortization period

3. Amount of funds borrowed

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bills or the London Interbank Offered Rate (LIBOR). Likewise,

conduit loans are also benchmarked off Treasury bills. The loan is

priced according to a spread, which is added to the term of a Trea-

sury note and which corresponds to the term of the loan. In other

words, a loan with a 10-year term is priced by adding a spread to a

10-year Treasury note. Spreads are stated in what is referred to as

basis points. A spread of 185 basis points is equivalent to 1.85 per-

cent. If the 10-year Treasury is currently priced at 4.30 and the

spread is 185 basis points, then the interest rate applied to the loan

would be 6.15 percent.

The interest paid on borrowed money represents the cost of funds,

so the higher the rate, the greater the amount paid. On a smaller loan

of, let’s say, $100,000, a difference of 0.5 percent in the interest rate

will have only minimal impact on the viability of an investment

opportunity. On a larger loan of $1 million, however, the difference

of 0.5 percent is much greater. When applying for a loan, you should

make every effort to negotiate the best possible rate, especially on

larger loans. I recently met with one of the lenders with whom my

company, Symphony Homes, does business to review our financial

statements from the previous fiscal year and to plan for the coming

year. Since I do several million dollars’ worth of business with this

lender each year, I don’t hesitate to ask for better pricing. I reminded

him that our company works with several other lenders who are

eager to earn more of our business. My expectation is that he will

soon be giving me a call with more favorable pricing.

To help better understand the impact of various differences in

changes in the interest rate, take a moment to review Table 3.1.

Using a real estate loan calculator developed for Symphony Homes,

the effect of changes in interest rates can be examined on a base loan

of $2.5 million. The loan spread matrix illustrates how changes in

the rate affect changes in the monthly payments. With a loan amount

of $2.5 million and a rate of 6.25 percent, the monthly payment

would be $15,392.93. By reducing the rate by 0.5 percent, the pay-

ment is reduced to $14,589.32, which represents a monthly savings

of $803.61 and an annual savings of $9,643.32 to the investor. The

matrix allows you to quickly and easily examine the effect of

changes in rate applied to different loan amounts at different rates.

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Table 3.1 Chart of Monthly Payments

Symphony Homes, Inc. www.symphony-homes.com

The Value Play www.thevalueplay.com

Loan Amount: $2,500,000.00 Total Interest Paid: $3,041,454.80

Interest Rate: 6.25% Total Amount Paid: $5,541,454.80

Term: 360 months

Loan Amounts Incremented by $5000 Interest Rates Incremented by

⁄2%

Loan / Rate 4.75% 5.25% 5.75% 6.25% 6.75% 7.25% 7.75%

$2,475,000 $12,910.77 $13,667.04 $14,443.43 $15,239.00 $16,052.80 $16,883.86 $17,731.20

$2,480,000 $12,936.85 $13,694.65 $14,472.61 $15,269.79 $16,085.23 $16,917.97 $17,767.02

$2,485,000 $12,962.94 $13,722.26 $14,501.79 $15,300.57 $16,117.66 $16,952.08 $17,802.84

$2,490,000 $12,989.02 $13,749.87 $14,530.96 $15,331.36 $16,150.09 $16,986.19 $17,838.66

$2,495,000 $13,015.10 $13,777.48 $14,560.14 $15,362.14 $16,182.52 $17,020.30 $17,874.49

$2,500,000 $13,041.18 $13,805.09 $14,589.32 $15,392.93 $16,214.95 $17,054.41 $17,910.31

$2,505,000 $13,067.27 $13,832.70 $14,618.50 $15,423.72 $16,247.38 $17,088.52 $17,946.13

$2,510,000 $13,093.35 $13,860.31 $14,647.68 $15,454.50 $16,279.81 $17,122.62 $17,981.95

$2,515,000 $13,119.43 $13,887.92 $14,676.86 $15,485.29 $16,312.24 $17,156.73 $18,017.77

$2,520,000 $13,145.51 $13,915.53 $14,706.04 $15,516.07 $16,344.67 $17,190.84 $18,053.59

$2,525,000 $13,171.60 $13,943.14 $14,735.21 $15,546.86 $16,377.10 $17,224.95 $18,089.41

Value Play Real Estate Software, 3.0.01 www.thevalueplay.com

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Now let’s take a look at how the reduction in the cost of funds by

0.5 percent has affected the value of the property. We have already

established the owner would save an additional $9,643.32 each year.

This means that the income stream from the property will increase

by that same amount. To capitalize the value of the increase in the

income stream, we simply convert the cash flow to a single capital

value, as follows:

Present value of income stream

===$120,541.50

In this example, a capitalization rate, or cap rate, of 8.0 percent was

assumed. Converting the additional income in this example gives us

a single capital value of $120,541.50, which is a direct result of the

reduction in the cost of funds by only 0.5 percent. Although it may

initially seem that this would increase the value of the property,

because interest payments do not affect NOI, the value of the prop-

erty does not change. It does, however, affect the return on invest-

ment (ROI), since the added cash flow represents a savings to the

investor, which in turn increases the rate of return. When you begin

to understand the relationship between the cost of funds and its

effect on value and returns, you can then begin to take full advantage

of its powerful and dynamic force. Remember that all it takes is a

small change in the interest rate to have a dramatic impact on the

rate of return.

AMORTIZATION PERIOD

The amortization period is the second of the three secondary financ-

ing elements that affect real estate financing. While the interest paid

on a loan refers to the cost of borrowing funds, the amortization

period refers to the length of time used to calculate loan payments if

the loan were fully amortized, or repaid, over the stated loan period.

$9,643.32

ᎏᎏ

.08

income

ᎏᎏ

capitalization rate

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An amortization schedule provides a list, or schedule, of the pay-

ments to be made over the life of the loan. This schedule shows the

portion of each payment that is applied to principal and the portion

of each payment that is applied to interest. This information is use-

ful because it allows investors to see at a glance how much of the

payment is being applied to reduce the balance of the loan at any

given point over the period the loan is amortized. The shorter the

amortization period, the higher the payment; conversely, the longer

the amortization period, the lower the payment. Let’s look at a sim-

ple example.

Loan amount = PV = $500,000

Interest rate = i = 6.50%

Amortization period = n = 180; payment = pmt = $4,355.54

Amortization period = n = 360; payment = pmt = $3,160.34

In this example, the difference between a 15-year loan period and a

30-year loan period is $1,195.20 per month. The question becomes,

is it better to get a 15-year loan with a higher monthly payment or a

30-year loan with a lower monthly payment? I recommend using the

30-year amortization period because it provides greater flexibility.

For example, if a person then wanted to apply more to the loan each

month, let’s say the equivalent difference of the 15-year payment, he

or she would be able to do so, but would not be obligated to do so.

Since cash flow is so important in the real estate business, investors

should do everything possible to minimize the monthly cash out-

flows. This includes the portion paid out each month for principal

and interest.

I’ve known other investors, however, whose intentions were to

buy an investment property and hold it for the long term. Many of

these investors preferred shorter amortization periods so they

could repay an investment property’s loan more quickly. Doing

so would enable them to enjoy a higher cash flow from the prop-

erty once the loan was repaid. Even in situations such as this, I

recommend building flexibility into the loan by using a 30-year

amortization period. The investor can then pay off the loan over a

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shorter period of time if desired. This way the investor has the

option to pay a little extra each month, but doesn’t have to. This

option is especially important when a unit is vacant and no income

is being generated.

Table 3.2 illustrates a monthly loan amortization schedule using

$500,000 as the amount borrowed, an interest rate of 6.5 percent, a

30-year period, and a monthly prepayment of $217. Only the first 39

months are shown for the sake of brevity. Now let’s examine Table

3.3. This schedule illustrates the total amount applied to both inter-

est and principal. Note how paying an additional $217 per month

reduced the repayment period from 30 years to about 25 years. As

has already been established, there is a trade-off when prepaying the

loan since the monthly cash flow from the property is reduced by

exactly the amount of additional principal paid. In this example, five

years is shaved off of the total repayment schedule, but $217 per

month is sacrificed in the process.

Another reason to use a longer amortization period is because,

by doing so, the debt service coverage ratio (DSCR) improves.

This is especially important to lenders. They want to make sure

that the real estate being considered for investment purposes will

generate enough cash to service the debt. In other words, lenders

want and need to be assured that the real estate is throwing off

enough cash on its own to repay the loan. Using a longer amorti-

zation period reduces the monthly cash outflow, which in turn

leaves more cash available for the loan payment. The ratio is cal-

culated as follows:

Debt service coverage ratio ==DSCR

The ratio is a simple measure of the relationship of cash generated

from an investment to the debt required to pay for that investment.

The minimum DSCR varies from lender to lender, but in general it

can be as low as 0.75 or as high as 1.40. Most lenders look for a min-

imum DSCR of 1.00 to 1.20. This concept is more fully explored in

Chapter 6.

net operating income

ᎏᎏᎏ

principal + interest

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Table 3.2 Loan Amortization Schedule—Monthly

Loan Amount: $500,000.00 Interest Rate: 6.500%

Number of Payments: 360 Payment Amount: $3,160.34

Total Total

PMT Month Principal Interest Principal Interest Prepayment BALANCE

PMT Month Principal Interest Total Principal Total Interest Prepayment Balance

1 Jan 2005 $669.01 $2,708.33 $669.01 $2,708.33 $217.00 $499,330.99

2 Feb 2005 $672.63 $2,704.71 $1,341.64 $5,413.04 $217.00 $498,658.36

3 Mar 2005 $676.27 $2,701.07 $2,017.91 $8,114.11 $217.00 $497,982.09

4 Apr 2005 $679.94 $2,697.40 $2,697.85 $10,811.51 $217.00 $497,302.15

5 May 2005 $683.62 $2,693.72 $3,381.47 $13,505.23 $217.00 $496,618.53

6 Jun 2005 $687.32 $2,690.02 $4,068.79 $16,195.25 $217.00 $495,931.21

7 Jul 2005 $691.05 $2,686.29 $4,759.84 $18,881.54 $217.00 $495,240.16

8 Aug 2005 $694.79 $2,682.55 $5,454.63 $21,564.09 $217.00 $494,545.37

9 Sep 2005 $698.55 $2,678.79 $6,153.18 $24,242.88 $217.00 $493,846.82

10 Oct 2005 $702.34 $2,675.00 $6,855.52 $26,917.88 $217.00 $493,144.48

11 Nov 2005 $706.14 $2,671.20 $7,561.66 $29,589.08 $217.00 $492,438.34

12 Dec 2005 $709.97 $2,667.37 $8,271.63 $32,256.45 $217.00 $491,728.37

13 Jan 2006 $713.81 $2,663.53 $8,985.44 $34,919.98 $217.00 $491,014.56

14 Feb 2006 $717.68 $2,659.66 $9,703.12 $37,579.64 $217.00 $490,296.88

15 Mar 2006 $721.57 $2,655.77 $10,424.69 $40,235.41 $217.00 $489,575.31

16 Apr 2006 $725.47 $2,651.87 $11,150.16 $42,887.28 $217.00 $488,849.84

17 May 2006 $729.40 $2,647.94 $11,879.56 $45,535.22 $217.00 $488,120.44

18 Jun 2006 $733.35 $2,643.99 $12,612.91 $48,179.21 $217.00 $487,387.09

19 Jul 2006 $737.33 $2,640.01 $13,350.24 $50,819.22 $217.00 $486,649.76

20 Aug 2006 $741.32 $2,636.02 $14,091.56 $53,455.24 $217.00 $485,908.44

21 Sep 2006 $745.34 $2,632.00 $14,836.90 $56,087.24 $217.00 $485,163.10

22 Oct 2006 $749.37 $2,627.97 $15,586.27 $58,715.21 $217.00 $484,413.73

23 Nov 2006 $753.43 $2,623.91 $16,339.70 $61,339.12 $217.00 $483,660.30

24 Dec 2006 $757.51 $2,619.83 $17,097.21 $63,958.95 $217.00 $482,902.79

25 Jan 2007 $761.62 $2,615.72 $17,858.83 $66,574.67 $217.00 $482,141.17

26 Feb 2007 $765.74 $2,611.60 $18,624.57 $69,186.27 $217.00 $481,375.43

27 Mar 2007 $769.89 $2,607.45 $19,394.46 $71,793.72 $217.00 $480,605.54

28 Apr 2007 $774.06 $2,603.28 $20,168.52 $74,397.00 $217.00 $479,831.48

29 May 2007 $778.25 $2,599.09 $20,946.77 $76,996.09 $217.00 $479,053.23

30 Jun 2007 $782.47 $2,594.87 $21,729.24 $79,590.96 $217.00 $478,270.76

31 Jul 2007 $786.71 $2,590.63 $22,515.95 $82,181.59 $217.00 $477,484.05

32 Aug 2007 $790.97 $2,586.37 $23,306.92 $84,767.96 $217.00 $476,693.08

33 Sep 2007 $795.25 $2,582.09 $24,102.17 $87,350.05 $217.00 $475,897.83

34 Oct 2007 $799.56 $2,577.78 $24,901.73 $89,927.83 $217.00 $475,098.27

35 Nov 2007 $803.89 $2,573.45 $25,705.62 $92,501.28 $217.00 $474,294.38

36 Dec 2007 $808.25 $2,569.09 $26,513.87 $95,070.37 $217.00 $473,486.13

37 Jan 2008 $812.62 $2,564.72 $27,326.49 $97,635.09 $217.00 $472,673.51

38 Feb 2008 $817.03 $2,560.31 $28,143.52 $100,195.40 $217.00 $471,856.48

39 Mar 2008 $821.45 $2,555.89 $28,964.97 $102,751.29 $217.00 $471,035.03

Value Play Real Estate Software, 3.0.01 www.thevalueplay.com

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Table 3.3 Loan Amortization Schedule—Annual

Loan Amount: $500,000.00 Interest Rate: 6.500%

Number of Payments: 360 Payment Amount: $3,160.34

Principal Paid Interest Paid Total Paid

Year Period During Period During Period During Period

Year Period Total Annual Principal Total Annual Interest Total Annual Payment

1 Jan–Dec 2005 $8,271.63 $32,256.45 $40,528.08

2 Jan–Dec 2006 $8,825.58 $31,702.50 $40,528.08

3 Jan–Dec 2007 $9,416.66 $31,111.42 $40,528.08

4 Jan–Dec 2008 $10,047.30 $30,480.78 $40,528.08

5 Jan–Dec 2009 $10,720.18 $29,807.90 $40,528.08

6 Jan–Dec 2010 $11,438.12 $29,089.96 $40,528.08

7 Jan–Dec 2011 $12,204.17 $28,323.91 $40,528.08

8 Jan–Dec 2012 $13,021.51 $27,506.57 $40,528.08

9 Jan–Dec 2013 $13,893.60 $26,634.48 $40,528.08

10 Jan–Dec 2014 $14,824.07 $25,704.01 $40,528.08

11 Jan–Dec 2015 $15,816.85 $24,711.23 $40,528.08

12 Jan–Dec 2016 $16,876.14 $23,651.94 $40,528.08

13 Jan–Dec 2017 $18,006.37 $22,521.71 $40,528.08

14 Jan–Dec 2018 $19,212.30 $21,315.78 $40,528.08

15 Jan–Dec 2019 $20,498.97 $20,029.11 $40,528.08

16 Jan–Dec 2020 $21,871.82 $18,656.26 $40,528.08

17 Jan–Dec 2021 $23,336.63 $17,191.45 $40,528.08

18 Jan–Dec 2022 $24,899.53 $15,628.55 $40,528.08

19 Jan–Dec 2023 $26,567.11 $13,960.97 $40,528.08

20 Jan–Dec 2024 $28,346.32 $12,181.76 $40,528.08

21 Jan–Dec 2025 $30,244.75 $10,283.33 $40,528.08

22 Jan–Dec 2026 $32,270.28 $8,257.80 $40,528.08

23 Jan–Dec 2027 $34,431.48 $6,096.60 $40,528.08

24 Jan–Dec 2028 $36,737.42 $3,790.66 $40,528.08

25 Jan–Dec 2029 $38,221.21 $1,330.26 $39,551.47

Value Play Real Estate Software, 3.0.01 www.thevalueplay.com

AMOUNT OF FUNDS BORROWED

The amount of funds borrowed is the last of the three secondary

financing elements that affect real estate financing. The amount of

funds borrowed, or loan amount, is the amount of money being

borrowed to finance an investment. The relationship between the

loan amount and the down payment is an inverse relationship. As

the amount of money being borrowed for an investment property

increases, the amount applied toward the down payment decreases;

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Cost and Revenue Assumptions

Financing Assumptions

Key Ratios

Rental Increase Projections

Average Monthly Rent

Operating Expense Projections

Operating Revenues

Operating Expenses

Actual Projected

Monthly Year 1 Year 2 Year 3 Year 4 Year 5

Table 3.4 Scenario I: 5 Year Pro Forma Income Statement As of January 1st

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Net Operating Income

Cash Flow From Operations

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Cost and Revenue Assumptions

Financing Assumptions

Key Ratios

Rental Increase Projections

Average Monthly Rent

Operating Expense Projections

Operating Revenues

Operating Expenses

Actual Projected

Monthly Year 1 Year 2 Year 3 Year 4 Year 5

Table 3.5 Scenario II: 5 Year Pro Forma Income Statement As of January 1st

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Net Operating Income

Cash Flow From Operations

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conversely, as the loan amount decreases, the down payment in-

creases. It is logical to assume that the more money borrowed, the

greater the monthly payment will be, and the less money borrowed,

the smaller the monthly payment will be. Although an investor

might conclude from this reasoning that it makes sense to put down

as much money as possible to decrease the monthly payment and

thereby increase the property’s cash flow, that conclusion would be

wrong. According to the other people’s money (OPM) principle,

which deals with the concept of leverage, the greater the percentage

of money borrowed the greater the return on equity will be. Even

though the monthly payment will increase by borrowing more, since

the returns are measured as a ratio of the income generated by the

property to the amount of one’s capital invested in it, the rate of

return is greater due to the increase in leverage. The OPM principle,

along with the principle of leverage, is discussed in greater detail in

the next chapter.

Several years ago, I developed a financial model I use extensively

to analyze and evaluate investment properties, which I call The

Value Play Income Analyzer. In Part 2, “Case Study Review, The

Practical Application of Valuation Analysis,” the model is explained

in much greater detail. For now, however, I’d like to focus on three

key measurements in the model. They are net income return on in-

vestment (net income ROI), cash ROI, and total ROI. Let’s take a

moment to examine the effect of changes in the amount of funds

borrowed on these three ratios by looking at two different scenarios.

In Table 3.4 (Scenario I), Investor A has used the Income Ana-

lyzer to evaluate an apartment building available for sale with a total

purchase price of $3,375,000. Under this scenario, the total amount

of funds borrowed by Investor A is $2,531,250. This leaves a bal-

ance of $843,750, or 25 percent, required for the down payment. In

this scenario, Investor A will realize a net income ROI of 5.53 per-

cent, a cash ROI of 13.51 percent, and a total ROI of 18.46 percent

in Year 1 on the invested capital, or cash down payment. Although

many investors would be satisfied with these returns, let’s see if

there is a way for us to improve them.

In Table 3.5 (Scenario II), all variables within the model are held

constant and are exactly the same as in Table 3.4 with the exception

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of two—the amount of funds borrowed and the down payment,

or owner’s equity. In Scenario II, the down payment has been

decreased to $337,500, which is a 10 percent investment, and the

amount of funds borrowed has been increased to $3,037,500. The

monthly payment required to service the debt in this scenario is

$20,509. This compares unfavorably to the monthly payment of

$17,091 in Scenario I and results in a net decrease of remaining after

tax cash flow (CF) of $3,418 per month.

At first glance, you may be inclined to believe that Investor A in

Scenario I is better off than Investor B in Scenario II, since Investor

A pockets an additional $3,418 per month. In Scenario II, Investor B

will realize a net income ROI of 4.15 percent, a cash ROI of 21.61

percent, and a total ROI of 36.47 percent in Year 1 on the invested

capital. According to our analysis, Investor B will earn almost twice

as much as Investor A. By increasing the amount of funds borrowed

and decreasing the amount of funds invested, you can actually earn

a higher rate of return on your invested capital. While it is true that

there is less cash remaining at the end of each period, the investor in

Scenario II fares much better than the investor in Scenario I. This is

because the returns are measured as a ratio of the remaining cash to

the investor’s equity or invested capital. Once again, by investing

less of your own money, you actually earn a higher rate of return

than you otherwise would, in spite of the fact that the remaining

cash has decreased.

In summary, the three secondary investment elements that affect

real estate financing activities are the cost of funds, the amortization

period, and the amount of funds borrowed. Understanding the inter-

action among these three variables and their relationship to one

another is essential for assessing how changes in any one of the

three can affect the profitability of the various types of real estate

investments. The better you understand these principles, the greater

will be your chances for success in the real estate business.

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Chapter 4

Additional Investment Elements

and Their Effect on

Financing Strategies

In Chapter 2, we examined the three primary financing elements

around which real estate investment activity centers—time, volume,

and property type. In Chapter 3 we learned about the three second-

ary financing elements that affect real estate financing activities—

cost of funds, amortization period, and amount of funds borrowed.

Three additional elements have an effect on real estate financing:

loan duration, lender fees, and prepayment penalties (see Exhibit

4.1). Duration must be considered before obtaining a loan to ensure

the life of it is best suited to an investor’s needs. It is also important

to be familiar with the many types of fees charged by lenders and to

know their effect on the overall cost of an investment. Finally,

investors should also be aware of any type of prepayment penalty

that may be imposed by the lender.

LOAN DURATION

The first additional element that has an effect on real estate financ-

ing is loan duration. Loan duration refers to a loan’s life, or term.

For instance, a loan duration of 10 years means that it will expire at

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the end of the 10-year period and must at its expiration either be

renewed or paid in full. A loan with a duration of 10 years may or

may not have an amortization period equal to its duration period.

Whereas amortization refers to the length of time used to calculate

the amount of payment to be made each period, duration refers to

the length of time the loan will exist. For example, a loan with a 10-

year duration, or term, can have a 15-, 20-, or 30-year amortization

period. At the end of its term, any remaining loan balance will have

to be repaid in full if the lender chooses not to renew or extend it.

Regardless of what type of financing is obtained for an investment

property, investors should be familiar with loan terms and the impact

they will have on their financing of real estate. Using the most appro-

priate term is best determined by the estimated length of time an

investment is intended to be held. For example, investors who intend

to hold a property for a period of 10 or more years would most likely

want to obtain a fixed-rate loan with a term that matches the full

amortization period, which is typically 30 years. Financing the prop-

erty with a shorter term, say five years, would force an investor to

refinance the property at the end of the term, or in five years.

Depending on the current interest rate environment, it may be bet-

ter to lock in a lower rate at the time of initial financing, since rates

can change suddenly and without notice. Investors who plan to hold

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Exhibit 4.1

Additional financing elements.

1. Loan duration

2. Loan fees

3. Prepayment penalties

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a property for 10 years or more will need to procure a loan with a

corresponding time frame. If a decline in market interest rates

occurs at some point in the future, an investor always has the option

to refinance. If prepayment penalties exist, however, they, too, must

be factored into the refinance decision. An increase in market inter-

est rates will not affect the mortgage, because a measure of protec-

tion has been built in to insulate the investment from a higher-rate

environment by choosing the most appropriate financing term to

begin with.

Loans having longer durations can sometimes work to an in-

vestor’s disadvantage, especially if the property being purchased is

intended to be held for only a short while. If, for instance, a rehab

property has been identified and the property will be held for one

year or less before disposing of it, then a loan with a shorter duration

is preferable, because such loans typically have lower rates than

those with longer durations. This is because lenders can more accu-

rately predict interest rates over a shorter time frame than they can

over a longer time frame.

A one-year adjustable rate mortgage, or ARM, is almost certain to

have an interest rate ranging from

⁄2 to 1 percent lower than a loan

with a 30-year term. A one-year ARM typically has a fixed rate for

the first six months or one year, and then adjusts either annually or

semiannually thereafter. A comparable loan from a bank may carry

a rate to match a one-year ARM, but may also have a one-year term,

meaning that instead of adjusting, the loan will expire and have to be

satisfied by either renewing it or repaying it.

When selecting the duration or term that best meets an investor’s

financing needs, the investment objectives must first be determined.

Investors must establish beforehand how long a property is to be

held before committing themselves to a particular debt instrument.

Will the property be purchased and added to a portfolio containing

other rental properties and subsequently held for many years, or will

it instead be held for only a short period of time to capture a gain

created by making improvements to it? Investors should establish

their investment objectives prior to making a commitment to the

lender and then choose a loan with a duration best suited to the

desired opportunity.

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LOAN FEES

The second additional element that has an effect on real estate

financing is the loan fee assessed by the lender. Loan fees come in

all shapes and sizes and in all kinds of disguises. They are masked

by using terms such as application fees, review fees, underwriting

fees, loan-origination fees, mortgage broker fees, and points

charged at closing. Since some lenders are overly aggressive and

assess a fee or charge for just about everything, I suggest asking for

a list of all costs that will be charged by both the lender and the

mortgage broker (if applicable). Although by law lenders and bro-

kers are required to disclose all costs, these issues should be

addressed up front. Even after receiving the schedule of costs, it

pays to be careful, since some charges may show up on the settle-

ment statement at the last moment just prior to the loan closing. This

is especially true when using a mortgage broker.

Lenders are required by the federal Real Estate Settlement Proce-

dures Act to provide borrowers with a good faith estimate (GFE) of

the fees due at closing, and they must do so within three days of the

loan application. These mortgage fees, also called settlement costs,

cover the various expenses associated with mortgage financing.

Since closing costs usually range from between 3 and 5 percent of the

sale price, it’s best to wait until receiving a good faith estimate before

signing any loan. In fact, it’s a good idea to obtain good faith esti-

mates from several lenders and compare their respective costs. Take

just a moment to review the good faith estimate in Exhibit 4.2. The

form lists 15 different lender fees alone, as well as a number of addi-

tional fees by parties that may have an interest in the transaction.

Although the broker is legally obligated to disclose all reasonable

and customary fees, the broker doesn’t always know what fees the

lender will charge. The broker and the lender are not one and the

same. The broker acts as a third party to assist the purchaser in

obtaining the most appropriate type of financing. If brokers use

lenders they have not used before, they may not be aware of the

lender’s complete fee structure. I myself have been surprised on

more than one occasion by unexpected charges that show up at the

time of closing. I was especially surprised on a new build-to-suit

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Mailing Address Property Address

Proposed Loan Amount Estimated Interest Rate

Preparation Date

Loan Type

FHA VA Conventional Loan Number

The information provided below reflects estimates of the charges which you are likely to incur at the settlement of your loan. The fees

listed are estimates - actual charges may be more or less. Your transaction may not involve a fee for every item listed.

The numbers listed beside the estimates generally correspond to the numbered lines contained in the HUD-1 or HUD-1A

settlement statement which you will be receiving at settlement. The HUD-1 or HUD-1A settlement statement will show you

the actual cost for items paid at settlement.

"S"/ designates those costs to be paid by Seller/ . "A" designates those costs affecting APR.

These estimates are provided pursuant to the Real Estate Settlement Procedures Act of 1974, as amended (RESPA). Additional

information can be found in the HUD Special Information Booklet, which is to be provided to you by your mortgage broker or

lender, if your application is to purchase residential property and the Lender will take a first lien on the property.

HUD-1 DESCRIPTION OF CHARGES AMOUNT

GENESIS 2000, INC. * W14.0 * (800) 882-0504 Page 1 of 1 Form GFE (03/95)

This Good Faith Estimate is being provided by

a mortgage broker, and no lender has yet been obtained.

Broker"B" "F" designates financed costs.

Date Date

801 Loan Origination Fee @ % + $

802 Loan Discount Fee @ % + $

803 Appraisal Fee

804 Credit Report

805 Inspection Fee

806 Mortgage Insurance Application Fee

807 Assumption Fee

808 Mortgage Broker Fee @ % + $

809 Tax Related Service Fee

810 Processing Fee

811 Underwriting Fee

812 Wire Transfer Fee

813 Application Fee

814 Commitment Fee

815 Lender's Rate Lock-In Fee

901 Interest @ /day for days

902 Mortgage Insurance Premium

903 Hazard Insurance Premium

904 County Property Taxes

906 Flood Insurance

1001 Hazard Ins. @ /mo. for months

1002 Mortgage Ins. @ /mo. for months

1004 Tax & Assmt. @ /mo. for months

1006 Flood Insurance @ /mo. for months

1008 Aggregate Escrow Adjustment

1101 Settlement or Closing/Escrow Fee

1102 Abstract or Title Search

1103 Title Examination

1105 Document Preparation Fee

1106 Notary Fee

1107 Attorney's Fee

1108 Title Insurance

1201 Recording Fee

1202 City/County Tax/Stamps

1203 State Tax/Stamps

1204 Intangible Tax

1301 Survey

1302 Pest Inspection

Exhibit 4.2 Good Faith Estimate

(not a loan commitment).

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home we sold several months ago that closed just recently. The

mortgage broker charged its client over $6,000 in broker fees for a

loan amount of only a little more than $200,000! That’s equivalent

to about 3 percent of the loan amount. What surprised me even

more, however, was that the homeowner had not even received a

good faith estimate until the day before the closing.

The loan application fee is a charge that some lenders assess at the

time formal application is made. Application fees range anywhere

from no charge at all to as much as $500 on single-family residential

properties. On larger commercial or multifamily loans, the initial

application fee can be as high as $2,500 to $5,000. The fee is charged

to offset costs incurred by the lender or broker for items such as

administrative costs and credit reports. Justification for the charges

results from a need to recover costs as well as the inability of some

applicants to qualify for loans. Charging an application fee serves to

filter out those individuals who may not be capable of qualifying for

a loan. If, for example, the applicant believes he may not be able to

qualify for a loan and knows an application fee of $250 will be

charged regardless of whether he qualifies, chances are he will not

bother with the application. Although lenders who charge an applica-

tion fee will most likely have fewer applicants, the quality of those

applicants is likely to be higher.

Application fees are oftentimes negotiable. If you know you have

good credit and will have no problem qualifying for a loan, be sure

to tell the lender or broker and ask for the application fee to be

waived. Many times the answer will be yes. The party taking the

application, however, may elect to charge the fee up front and agree

to credit it back to you at the time of closing. This helps reduce the

risk to the lender that the borrower will switch to another mortgage

company or bank at some point in the process. If the borrower has

paid a $500 application fee, for example, on a single-family invest-

ment property, or perhaps a $5,000 fee on a multifamily property,

and knows she will receive a credit for it at the time of closing,

there’s a very good chance she will stay with the lender to see the

loan through to the closing.

Underwriting fees have come about over the past few years as yet

another way to tack on additional charges. The justification for this

charge is similar to that of the application fee in that, similarly to

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personnel who are paid for processing the loan application, the

underwriting department must be paid for its job of underwriting the

loan. Using that logic, it seems reasonable to expect that at some

point in the future, we might begin seeing other types of fees show

up, such as a “loan committee fee” for reviewing the loan, or per-

haps a “human resources fee” to cover the cost of hiring all the other

departments that are charging us fees. The list is limited only by

one’s imagination.

Loan-origination fees, still another way of charging the borrower,

are usually equivalent to one point, or 1 percent, of the total amount

of the loan. On a $100,000 loan, for example, the fee would be

$1,000. Justification for this fee is supposedly based on the costs

incurred by the lender to actually make the loan once it has been

approved. Legal documents must be drawn up and processed, the

loan must be funded, and everything must be properly recorded.

Some lenders will waive the loan-origination fee altogether or roll it

into the interest rate on the loan by increasing the rate by 25 basis

points, which is the equivalent of one-fourth of a point.

Mortgage brokers earn the majority of their income from the fees

generated by placing loans. Since they are not direct lenders, bro-

kers do not earn anything from the interest being charged. Interest is

paid to the lender and not to the broker. A mortgage broker is simi-

lar to a real estate broker in that they are both compensated only

when they sell something. Both types of brokers are paid on a per-

centage basis. While the real estate agent is paid a commission, the

mortgage broker is paid points. Brokers typically charge between

1 and 2 percent of the loan amount, sometimes more and sometimes

less. Factors that may affect the fees they charge are items such as

the borrower’s creditworthiness, the size of the loan, and their abil-

ity to receive back-end fees from the lender. Don’t be fooled by bro-

kers who charge 1 percent on a $100,000 loan amount and tell you

they are making only $1,000 on the transaction. Brokers are almost

always compensated by the lender for differences in the spread of

the rate charged. For example, if the base rate a lender charges is

6.00 percent with zero points to the borrower, the broker will likely

be paid a back-end fee of 1 percent by the lender. If the broker is

able to sell the same loan to you at, let’s say 6.25 percent, the broker

can double his or her income on the loan and receive 2 percent from

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the lender. Both front-end and back-end fees are legally required to

be disclosed on the good faith estimate. Borrowers have a right to

know how much they are being charged for the lender’s services. If

you’re an investor with good credit and have a strong personal finan-

cial statement, mortgage brokers are less likely to play such games

with you. You’re probably familiar with the term caveat emptor, but

just in case you’re not, the literal translation means “buyer beware”

or “let the buyer beware.” In the case of loan fees, however, I sup-

pose we could say “let the borrower beware.”

Points are often made available to borrowers to buy down the

interest rate applied to a loan. Since one point is equivalent to 1 per-

cent, an investor paying one point on a $100,000 loan would pay

$1,000 in additional up-front fees. For every point paid, the interest

rate on the loan is decreased by approximately

⁄8 to

⁄4 of a percent.

This is only a general guideline, as rate spreads vary widely among

lenders, but the lender you are working with can usually provide an

exact quote by looking at rate sheets. Since rate spreads are dynamic

and change with minor fluctuations in the market, the rate quoted

may be good for just that particular moment, or it may be good for

the remainder of the day.

Take a moment to review Table 4.1. In this example, six different

rate scenarios are compared. The loan amount of $1 million and the

term of 240 months are held constant, while the interest rate and the

points are changed in each scenario. A base interest rate of 7.00 per-

cent with zero points is applied on the first line. In each subsequent

rate scenario, the interest rate is decreased in quarter-point increments

while simultaneously increasing the amount of discount points paid

by the borrower. In the first example, an investor who borrows $1 mil-

lion and pays no points and holds the loan throughout the duration of

its 20-year life would pay a total of $1,860,717.45, with a monthly

payment of $7,752.99. In the last example, the investor borrows the

same $1 million for the same 20-year period, but instead elects to

pay five discount points to buy the rate down from 7.00 percent to

5.75 percent. The investor in this scenario would pay a total of

$1,735,000.42, which includes the $50,000 for points paid, and would

have a monthly payment of $7,020.84. Buying down the rate in this

example would save the investor $732.15 per month and $125,717.03

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Table 4.1 Loan Comparisons

Symphony Homes, Inc. www.symphony-homes.com

The Value Play www.thevalueplay.com

Loan Amount Interest Rate Payments Points Payment Total Paid Cost of Loan Cost of Points

$1,000,000.00 0.07% 240 0% $7,752.99 $1,860,717.45 $860,717.45 $0.00

$1,000,000.00 0.0675% 240 1% $7,603.64 $1,834,873.62 $824,873.62 $10,000.00

$1,000,000.00 0.065% 240 2% $7,455.73 $1,809,375.53 $789,375.53 $20,000.00

$1,000,000.00 0.0625% 240 3% $7,309.28 $1,784,227.69 $754,227.69 $30,000.00

$1,000,000.00 0.06% 240 4% $7,164.31 $1,759,434.54 $719,434.54 $40,000.00

$1,000,000.00 0.0575% 240 5% $7,020.84 $1,735,000.42 $685,000.42 $50,000.00

Value Play Real Estate Software, 3.0.01 www.thevalueplay.com

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over the life of the loan. What this example assumes, however, is that

the investor will hold the property for the full twenty-year period. If an

investor determines ahead of time that a property is going to be main-

tained in her portfolio for the long term, then it makes sense to pay the

additional points up front. On the other hand, if the property is going

to be held for only five years, then it is better to pay the higher inter-

est rate with zero points. In this example, an investor would need to

hold the property for five years and nine months to realize any benefit

of paying the additional points. The break-even point can be calcu-

lated by dividing the cost of points over the savings per month. In this

example, the break-even point is calculated as follows:

Breakeven =

==68.29 months

One additional factor to consider is what the future value of the

$50,000 applied toward the discount points would be if it were

instead used to purchase another investment property. We have

already established that over a 20-year investment horizon, buying

the interest rate down by applying the $50,000 would save

$125,717.03 over and above all other costs. The question becomes,

can the $50,000 be used to invest in another asset over a 20-year

period to achieve an even greater return? To determine this, we must

solve for i, which is the rate required to earn a return on the invest-

ment of $125,717.03. To set the problem up correctly, we know that

$50,000 is the total amount invested, and $125,717.03 is the total

amount returned. Using a financial calculator, the answer can easily

be solved as follows:

Initial investment = present value = PV = $50,000 (cash flow out)

Total amount returned = future value = FV = $125,717.03 (cash

flow in)

Number of years = n = 20

$50,000

ᎏᎏᎏ

($7,752.99 − $7,020.84)

cost of points

ᎏᎏ

monthly savings

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To solve for the total return, solve for i

Interest rate = i = 4.72%

By solving for i, we discover that an investor would have to earn a

return of 4.72% or greater to come out ahead. If the investor could

not earn at least a 4.72% return, he would be better off paying down

the interest rate with the $50,000, assuming, of course, that the prop-

erty will be held for the 20-year duration.

Now let’s assume the investor has an alternative choice, which is

to invest the $50,000 in a small multifamily apartment building.

Let’s also keep the math very simple by assuming he is able to pur-

chase a building with only 10 percent down, which is not at all an

unreasonable assumption. Using this kind of leverage, the investor is

able to purchase a building valued at $500,000 ($50,000 ÷ 0.10 =

$500,000). Let’s also assume the investor purchased the property at

a 10 cap, which means the capitalization rate is 10 percent. An apart-

ment building with a cost of $500,000 and a cap rate of 10 will yield

a net operating income (NOI) of $50,000, which is the amount of

money left over after vacancy losses and operating expenses have

been deducted from gross revenues. It is the portion of income avail-

able to service, or pay, the debt used to finance an investment. Take

a moment to review the following equations.

Price ===$500,000

PV of apartment building == =$500,000

Cap rate ===10.0%

Now let’s take the analysis a step further by calculating the required

debt service on the $450,000 loan that was required to finance the

building. We’ll also assume the investor will use the same loan pro-

gram as he did with the first investment, as follows:

$50,000

ᎏ

$500,000

net operating income

ᎏᎏᎏ

price

$50,000

ᎏ

.10

NOI

ᎏ

cap rate

$50,000

ᎏ

0.10

net operating income

ᎏᎏᎏ

capitalization rate

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Loan amount = PV = $450,000

Number of years = n = 20

Interest rate = i = 7.0%

Annual debt service = pmt = $42,476.82

Let’s take a moment to recap. We have established that the invest-

ment of $50,000 in a $500,000 apartment building will yield $50,000

of NOI and will be used to pay the annual debt service of $42,476.82.

Where does that leave us? Let’s take a look.

$50,000.00 − $42,476.82 = $7,523.18 = remaining cash

= cash return on investment

$7,523.18/$50,000.00 = 15.05% cash ROI

In this example, the investor would earn a cash ROI of about 15

percent, which compares favorably to the 4.72 percent return if the

same $50,000 were used to buy down the interest rate. It is impor-

tant to note also that the cash ROI does not reflect the added value of

the tax savings resulting from depreciation, nor does it reflect the

added value of a reduction in the principal balance, or loan balance,

that occurs over the life of the loan. In summary, it appears that our

investor will fare much better by investing the $50,000 in an apart-

ment building than by buying down the interest rate on the purchase

of his first investment property.

PREPAYMENT PENALTIES

The third additional element that has an effect on real estate financ-

ing is known as a prepayment penalty. Although you would think a

bank or other lending institution would be happy to have its loan

repaid, believe it or not, many financial institutions charge their cus-

tomers a substantial fee for repaying a loan prematurely. This is

especially true on larger commercial and multifamily loans. You

may think, “Why would anyone want to pay off a loan early?” There

are two primary reasons loans are prepaid. The first is due to

changes in interest rates. If, for example, an investor obtained a large

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loan with a fixed rate of 7 percent, and rates then declined to 6 per-

cent, the investor would most likely want to take advantage of the

favorable change by refinancing. When people refinance, it is often-

times through another institution. This means the existing lender

loses a good loan to a competitor and, as a result, loses the income

associated with that loan. To discourage customers from refinancing

early in the life of the loan, lenders build in a prepayment penalty.

See Exhibit 4.3 for a sample of prepayment penalty disclosures.

The second primary reason loans are prepaid results from a

change in ownership. If, for example, an investor obtained a loan

with a five-year term that had a provision for a prepayment penalty

and decided to sell the property after just one year, the lender would

charge a fee, or penalty, for prepaying the loan. Up until the mid-

1980s or so, most loans were assumable, which meant the buyer

could assume, or transfer, the note into her name without having to

get a new loan. If the loan could be assumed by another party, then

it would not have to be prepaid and no penalty would be assessed.

Although assumable loans still exist, they are not nearly as common

as they used to be. In fact, most single-family mortgage notes have a

“due on sale” clause, which means that the note must be repaid in

full if a sale or transfer in ownership occurs.

Prepayment penalty fees are structured in numerous ways and can

sometimes be substantial. Prepayment fee structures range from a

simple declining penalty structure to a quite complex fee structure

for commercially oriented conduit loans. For example, a loan with a

simple declining prepayment penalty structure having a three-year

term may have a fee structure as follows:

Prepay Loan in Year Prepayment Penalty Fee

15%

24%

33%

40%

In this example, if an investor borrowed money and then decided to

repay the loan in Year 1, a penalty of 5 percent of the outstanding loan

balance would be imposed on her. If she repaid the loan in full in Year

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Exhibit 4.3

Prepayment penalty disclosure (2% penalty—Missouri).

YOU MAY HAVE TO PAY A PENALTY IF YOU SIGN A

PREPAYMENT PENALTY RIDER TO NOTE AND YOU

PREPAY ALL OR A PORTION OF YOUR LOAN AHEAD

OF SCHEDULE SET FORTH IN YOUR NOTE.

WHAT IS A PREPAYMENT?

“Prepay” means to pay more than your scheduled principal and

interest payment. Anything you pay in excess of your scheduled

monthly payment amount of principal and interest, provided you

have no outstanding late charges or other fees due, will be applied

to reduce, or prepay, your outstanding loan balance ahead of the

schedule contemplated in your Note. The most common form of

“prepayment” occurs when you payoff your loan in its entirety by

either refinancing or selling your property and using the sale pro-

ceeds to payoff the loan.

WHAT IS A PREPAYMENT PENALTY AND WHY SHOULD

I ACCEPT IT?

A prepayment penalty is a penalty you must pay if you prepay your

loan. It is your choice whether or not your loan has a prepayment

penalty. Generally speaking, your acceptance of a prepayment

penalty has value to your lender and to you. The lender benefits

because the risk of losing the investment in your loan is diminished

in the early years. You benefit because you are able to get a lower

interest rate and margin, and/or reduce your out-of-pocket closing

costs. In other words, if you want to waive the prepayment penalty,

your rate and margin may be higher, and/or your closing costs may

be increased. Ask us how your rate and margin and/or closing costs

would change without the Prepayment Penalty Rider to Note.

CAN YOU MAKE PREPAYMENTS WITHOUT PAYING A

PENALTY?

Yes. In any 12-month period during the term of the prepayment

penalty, you can prepay up to 20% of your original loan balance

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without penalty. After the term of the prepayment penalty, you can

prepay your loan without penalty.

DOES A PREPAYMENT PENALTY LAST FOR THE LIFE

OF THE LOAN?

No. The prepayment penalty applies only during the early term of

the loan. The most common “Prepayment Penalty Term is three

years, although your prepayment penalty term may be different (see

your prepayment penalty rider to note for your actual prepayment

penalty term). Once this term has expired, you will no longer have

to pay a prepayment penalty if you prepay your loan.

HOW IS THE PREPAYMENT PENALTY CALCULATED?

Your prepayment penalty is equal to 2 percent of the balance of the

Note. Any prepayment is payable at the time of the loan payoff or

upon request from the note holder.

PREPAYMENT PENALTY TERM

I have discussed my prepayment options with my loan officer and

have decided to obtain the following prepayment penalty term:

[ ] First five (5) years of the loan

Initials

[ ] First four (4) years of the loan

Initials

[ ] First three (3) years of the loan

Initials

[ ] First two (2) years of the loan

Initials

[ ] First one (1) year of the loan

Initials

[ ] No prepayment penalty

Initials

Acknowledged by:

_________________________ _________________________

Borrower Date Borrower Date

CS-004 09/99

Missouri

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2, she would incur a prepayment penalty of 4 percent of the remain-

ing loan balance. If the loan were repaid in Year 3, a 3 percent penalty

would be imposed. Finally, if she prepaid the loan at any time during

Year 4 or thereafter, there would be no prepayment penalty.

Let’s look at an example to determine how prepayment penalties

affect a loan transaction. In this example, Investor Green has just

acquired a small multifamily apartment building with a purchase

price of $800,000. While Investor Green has bought and sold many

single-family houses over the years, this transaction represents his

very first apartment deal. Since the loan amount is substantially

more than he is used to borrowing through his traditional financing

sources, Investor Green is forced to locate a new source of funding.

Investor Green is new to the world of high finance and agrees to a

loan with prepayment penalty fees structured as follows:

Prepay Loan in Year Prepayment Penalty Fee

14%

23%

30%

Investor Green closes on the property and is now the proud owner

of his first apartment building. Shortly after purchasing it, Green

happens to come across a book titled The Complete Guide to Buying

and Selling Apartments (New Jersey: John Wiley & Sons, 2004),

and discovers a technique that author Steve Berges refers to as the

value play. The value play strategy advocates a buy-and-sell philos-

ophy rather than a buy-and-hold approach. The idea is to purchase a

property that has upside potential, create value in it by making prop-

erty improvements, increasing revenues, and decreasing expenses,

and subsequently sell it to capture the gain, then move on to the next

deal and start the process over. Investor Green decides to implement

the value play strategy with his recent purchase and, after improving

the property and discovering ways to enhance its revenues, decides

to sell in Year 2. Let’s now take a look at how the prepayment penal-

ties affected his transaction. To keep the calculations simple, we’ll

also assume this is an interest-only loan with no payments made to

the principal balance.

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Purchase price = $800,000

Loan amount = $680,000

Interest rate = 6.25%

Loan origination Fee = 0.0%

Turnaround time = 18 months

Interest paid = $680,000 × 6.25% ÷ 12 × 18 = $63,750

Year 2 prepayment penalty = $680,000 × 3.0% = $20,400

Total interest and fees = $63,750 + $20,400 = $84,150

Effective interest rate = ($84,150 ÷ $680,000) ÷ 18 × 12 = 8.25%

As illustrated in this example, although the stated interest rate of

6.25 percent would be considered a competitive rate for most

investors, the effective rate of 8.25 percent is not nearly as attractive.

If our good friend Investor Green had been told up front that his

interest rate would be 8.25 percent, he probably would have politely

told the lender, “No thank you,” and moved on to the next lender.

Although he left an extra $20,400 on the table, because Green

adopted the value play strategy and applied it to this transaction, he

was able to walk away with a handsome profit. Next time around,

however, he’ll be a little wiser by negotiating with the lender in

advance for the best possible terms, which includes the elimination

of prepayment penalties.

As an investor, you should define your objectives with each and

every property you buy before you buy it. This includes defining your

time investment time horizon as well. If, for example, you intend to

purchase a property and implement the value play strategy, you know

you’re going to be holding the note for only a short period of time. If,

for instance, you obtained a $1 million loan with a 5 percent penalty

in Year 1 and prepaid it in that same year, you would be subject to

paying a penalty of $50,000. Ouch! No one wants to leave that much

money on the table. You can easily avoid getting into a situation like

this by knowing what your investment time horizon is ahead of time.

Understanding the nature of prepayment penalties and how they are

applied can potentially save you tens of thousands of dollars. Mini-

mize your exposure by obtaining a loan that doesn’t have a prepay-

ment penalty to begin with. Then you don’t have to worry about it.

In summary, three additional financing considerations investors

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need to be mindful of are a loan’s duration, any collateral fees that

may be charged by the lender or mortgage broker upon the origina-

tion of the loan, and any penalties which may be imposed as a result

of paying off the loan early. The prudent investor should obtain

financing with shorter durations to take advantage of more favorable

rates and also to lock in rates for longer durations for those invest-

ment opportunities that may have longer life cycles. The careful

investor should also use a cost-benefit analysis to determine whether

it makes sense to buy down the interest rate by paying additional

points up front. Finally, the careful investor will become familiar

with the specifics of any prepayment penalty clauses should they

exist.

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Chapter 5

Structuring Financial

Instruments

In Chapters 2, 3, and 4, we learned about the many different ele-

ments that directly impact financing for investment properties. Fac-

tors such as the time horizon, the volume of transactions, and the

type of property being purchased all influence an investor’s deci-

sion-making process. Furthermore, financing elements such as the

cost of funds, the amortization period, and the amount of funds

being borrowed affect the viability and profitability of a potential

investment opportunity. Finally, elements such as loan duration,

lender fees, and prepayment penalties will also have an impact on

whether an income-producing property can meet an investor’s return

criteria. In this chapter, we not only explore the different ways

investors can structure purchases, but also the advantages and disad-

vantages of each (see Exhibit 5.1). We also analyze the effect these

various financing mechanisms have on returns.

LEVERAGE

A lever is a tool supported by a fulcrum that can be used to lift heavy

objects. Archimedes, an ancient Greek mathematician and physicist,

calculated the law of the lever. He is reported to have said that if he

had a lever long enough and a fulcrum large enough, he could lift the

world. When applied to real estate, the principle of leverage enables

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investors to purchase properties they would otherwise not be capa-

ble of purchasing. Applying the law of leverage to the various

financing mechanisms that are available can potentially allow indi-

viduals to greatly magnify the return on their investments. In fact,

without leverage, many people would not even be able to purchase

real estate since they can barely save enough money to make even a

small down payment.

Investors use the law of leverage to help them lever up the returns

on their holdings. The application of this law suggests that investors

will use a lever to lift something that they would otherwise not be

able to lift. The lever is supported by a fulcrum, which is defined as

the support on which the lever turns. In the case of real estate, the

fulcrum represents the use of other people’s money, commonly

referred to as the OPM principle. On one end of the lever is an

investor’s initial capital outlay, however small it may be, and on the

other end of the lever is the real estate being levered. The fulcrum

enables investors to apply the law of leverage.

The law of leverage as it applies to real estate rests on the prem-

ise that the cost of other people’s money must be less than the return

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Exhibit 5.1

Structural elements.

1. Leverage

2. Debt

3. Equity

4. Partnerships

5. Blended financing and WACC

6. Options

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on the asset being invested in. For example, if an investor borrows

funds from a financial institution in the form of debt, the cost of that

debt must be less than the expected return on the assets it is invested

in. If it is not, then it makes no sense to borrow those funds, because

the investor will lose money.

Let’s look at a simple example. If the interest rate on a loan is

6.0 percent and the expected return on assets (ROA) is 10 percent,

then the leverage is said to be positive and would represent a viable

investment opportunity. On the other hand, if the cost of funds is

8.5 percent and the expected ROA is 5.75 percent, the leverage is

said to be negative and would not represent a viable investment

opportunity. The difference between the cost of funds and the ROA

is referred to as the spread. One of the most common mistakes

novice investors make is based on the false assumption that any

property purchased with nothing down must be a good investment

since they didn’t have to put any money down. What they fail to real-

ize, however, is that if the property has a negative spread and a neg-

ative monthly cash flow because it is highly leveraged, the

investment will not generate a positive return. On the contrary, it

will generate a negative return requiring monthly cash injections

that can literally destroy investors if they have no reserves.

Take a moment to review Table 5.1. It illustrates the effect of price

appreciation using no leverage and an initial investment of

$500,000, which represents 100 percent of the purchase price. The

table applies 5, 10, and 20 percent growth rates over a period of

25 years. An investor in this scenario using an annual growth rate

of 5 percent will enjoy a total return of 238.6 percent over the

25-year period. Not bad.

Now let’s compare the returns in Table 5.1 to those in Table 5.2,

which illustrates the effect of price appreciation on leverage using

an initial investment of $75,000, or 15 percent of the purchase price.

This table also applies 5, 10, and 20 percent growth rates over a

period of 25 years. An investor in this scenario using an annual

growth rate of 5 percent will enjoy a total return of a remarkable

1,590.9 percent over the same 25-year period! The use of leverage

has allowed the investor in the second scenario to enjoy a return

almost seven times greater than the investor in the first scenario.

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Table 5.1 Effect of Leverage on Invested Capital Applying Annual

Appreciation Only

Purchase Price: $500,000

Percent Down: 100.0%

Down Payment: $500,000

Number

Annual Appreciation Rate

of Years 5.0% Ret on Inv 10.0% Ret on Inv 20.0% Ret on Inv

1 525,000 5.0% 550,000 10.0% 600,000 20.0%

2 551,250 10.3% 605,000 21.0% 720,000 44.0%

3 578,813 15.8% 665,500 33.1% 864,000 72.8%

4 607,753 21.6% 732,050 46.4% 1,036,800 107.4%

5 638,141 27.6% 805,255 61.1% 1,244,160 148.8%

6 670,048 34.0% 885,781 77.2% 1,492,992 198.6%

7 703,550 40.7% 974,359 94.9% 1,791,590 258.3%

8 738,728 47.7% 1,071,794 114.4% 2,149,908 330.0%

9 775,664 55.1% 1,178,974 135.8% 2,579,890 416.0%

10 814,447 62.9% 1,296,871 159.4% 3,095,868 519.2%

11 855,170 71.0% 1,426,558 185.3% 3,715,042 643.0%

12 897,928 79.6% 1,569,214 213.8% 4,458,050 791.6%

13 942,825 88.6% 1,726,136 245.2% 5,349,660 969.9%

14 989,966 98.0% 1,898,749 279.7% 6,419,592 1183.9%

15 1,039,464 107.9% 2,088,624 317.7% 7,703,511 1440.7%

16 1,091,437 118.3% 2,297,486 359.5% 9,244,213 1748.8%

17 1,146,009 129.2% 2,527,235 405.4% 11,093,056 2118.6%

18 1,203,310 140.7% 2,779,959 456.0% 13,311,667 2562.3%

19 1,263,475 152.7% 3,057,955 511.6% 15,974,000 3094.8%

20 1,326,649 165.3% 3,363,750 572.7% 19,168,800 3733.8%

21 1,392,981 178.6% 3,700,125 640.0% 23,002,560 4500.5%

22 1,462,630 192.5% 4,070,137 714.0% 27,603,072 5420.6%

23 1,535,762 207.2% 4,477,151 795.4% 33,123,686 6524.7%

24 1,612,550 222.5% 4,924,866 885.0% 39,748,424 7849.7%

25 1,693,177 238.6% 5,417,353 983.5% 47,698,108 9439.6%

This simple example does not even take into consideration the effect

of income generated, tax benefits, or principal reduction.

DEBT

In The Complete Guide to Investing in Rental Properties (New York:

McGraw-Hill, 2004), I described the use of debt in the following

excerpt.

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Other people’s money can be provided to you in one of

two forms—either debt or equity. The most common type

of financing is debt. Debt is most often provided in the

form of some type of loan which can come from any num-

ber of sources including banks, mortgage companies, fam-

ily members, friends, credit cards, and home equity loans

to name a few. Financing with debt typically requires that

you repay a loan with predetermined terms and conditions

such as the repayment term (number of years to repay the

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Table 5.2 Effect of Leverage on Invested Capital Applying Annual

Appreciation Only

Purchase Price: $500,000

Percent Down: 15.0%

Down Payment: $75,000

Number

Annual Appreciation Rate

of Years 5.0% Ret on Inv 10.0% Ret on Inv 20.0% Ret on Inv

1 525,000 33.3% 550,000 66.7% 600,000 133.3%

2 551,250 68.3% 605,000 140.0% 720,000 293.3%

3 578,813 105.1% 665,500 220.7% 864,000 485.3%

4 607,753 143.7% 732,050 309.4% 1,036,800 715.7%

5 638,141 184.2% 805,255 407.0% 1,244,160 992.2%

6 670,048 226.7% 885,781 514.4% 1,492,992 1324.0%

7 703,550 271.4% 974,359 632.5% 1,791,590 1722.1%

8 738,728 318.3% 1,071,794 762.4% 2,149,908 2199.9%

9 775,664 367.6% 1,178,974 905.3% 2,579,890 2773.2%

10 814,447 419.3% 1,296,871 1062.5% 3,095,868 3461.2%

11 855,170 473.6% 1,426,558 1235.4% 3,715,042 4286.7%

12 897,928 530.6% 1,569,214 1425.6% 4,458,050 5277.4%

13 942,825 590.4% 1,726,136 1634.8% 5,349,660 6466.2%

14 989,966 653.3% 1,898,749 1865.0% 6,419,592 7892.8%

15 1,039,464 719.3% 2,088,624 2118.2% 7,703,511 9604.7%

16 1,091,437 788.6% 2,297,486 2396.6% 9,244,213 11659.0%

17 1,146,009 861.3% 2,527,235 2703.0% 11,093,056 14124.1%

18 1,203,310 937.7% 2,779,959 3039.9% 13,311,667 17082.2%

19 1,263,475 1018.0% 3,057,955 3410.6% 15,974,000 20632.0%

20 1,326,649 1102.2% 3,363,750 3818.3% 19,168,800 24891.7%

21 1,392,981 1190.6% 3,700,125 4266.8% 23,002,560 30003.4%

22 1,462,630 1283.5% 4,070,137 4760.2% 27,603,072 36137.4%

23 1,535,762 1381.0% 4,477,151 5302.9% 33,123,686 43498.2%

24 1,612,550 1483.4% 4,924,866 5899.8% 39,748,424 52331.2%

25 1,693,177 1590.9% 5,417,353 6556.5% 47,698,108 62930.8%

11532_Berges_c05.k.qxd 7/6/04 11:36 AM Page 65

loan), the interest rate, and any prepayment penalties

which may be imposed for paying off a loan early.

One primary advantage of using debt is its lower cost of

capital than other forms of financing such as equity. Another

advantage of using debt is that it is typically more readily

available than equity. One key disadvantage of using debt is

that the debt must be serviced. In other words, you have to

make periodic payments on the loan. Using debt as a source

of financing will usually have a direct negative impact on

the cash flow from your rental house since loans usually

require monthly payments. It should be obvious to you that

the more you borrow for a particular investment, the greater

your monthly payment will be, and the greater your monthly

payment, the less the property’s after tax cash flow will be.

As a smart investor, you must be sure that you have struc-

tured the purchase of your rental house in such a manner

that will allow you to service the debt on it, whatever the

source of that debt is, without a negative cash flow. This is

after all expenses have been accounted for. You should have

a minimum of a 1.1 to 1.2 ratio of free cash flow left over

after all expenses have been paid to ensure that you can

adequately meet the debt requirements. Debt is a wonderful

tool, but like any tool, you must exercise caution and

respect when using it. Otherwise you can quickly find your-

self in trouble. You must be in control of your debt. Do not

allow your debt to control you.

From this excerpt, we learn that the primary advantages of using

debt are that it is readily available and that it can typically be

obtained at a lower cost than alternative financing sources such as

equity. In Chapter 3, we examined the effect of different interest

rates on the value and returns of an income-producing property. The

lower the cost of funds, the greater the cash flow, and the greater the

cash flow, the greater an investor’s returns.

We also learned that one key disadvantage is that debt usually

requires that some type of periodic payment be made. This is espe-

cially important because an investor purchasing a non-income-

producing property may have a difficult time making the required

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periodic payments. For example, when I purchase land on which to

build houses, my preference is to defer all interest and tax pay-

ments for as long as I can. If possible, I structure the financing in

such a manner that no payments are due until a lot is released.

When a house is ready to be built on a particular lot, all accrued

interest and taxes are paid on the lot at that time. The payment is

made from the construction loan used to build the house. Structur-

ing the financing in this manner enables me to lever up without

having the burden of making periodic payments on the land.

One additional advantage of using debt is that the interest portion of

the payment is tax deductible, because interest is treated as an expense

for tax purposes. Since the interest portion of a debt payment is tax

deductible, the effective interest rate is lower than it otherwise would

be. This provides investors with an added incentive to use debt rather

than equity, since they are able to further reduce their cost of funds.

Let’s take a moment to look at an example to see how this works.

Loan amount = $100,000

Interest rate = 6.50%

Annual interest paid = $100,000 × 6.50% = $6,500

Investor’s tax rate = 35%

Reduction in taxes = $6,500 × 35% = $2,275

Effective interest rate = ($6,500 − $2,275) = $4,225 ÷ $100,000

= 4.225%

This example assumes a loan amount of $100,000 and cost of funds

of 6.50 percent. An investor in a 35 percent tax bracket would real-

ize $2,275 in savings as a result of the reduction in tax liability. The

annual cost of funds is reduced from $6,500 to $4,225, which in turn

reduces the effective tax rate to 4.225 percent.

EQUITY

Another common method of funding an investment is by raising

capital in the form of equity. Whereas debt represents money that is

borrowed, equity represents money that is invested. Equity financ-

ing can be provided by any number of sources and commonly

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involves the formation of a legal partnership or corporation. Family,

friends, business associates, and private investors can all be good

sources of equity financing. One of the main reasons for using

equity financing is to minimize the cash flowing out of income-

producing properties. The repayment of equity financing can be

structured in any number of ways. For example, you can agree with

the investor to pay a specified percentage of the profits at the end of

each quarter, semiannually, or even annually. You could also agree to

defer all payments until such time as the property is sold. Sharing

profits with an equity investor can be based on income, capital

gains, or any combination of the two. Preserving as much cash as

possible, especially in the earlier years of investing when cash

reserves tend to be smaller, can mean the difference between success

and failure in the real estate business.

Although not as common as lenders who provide financing in the

form of loans, or debt, a number of institutional investors are willing

to fund investment projects in the form of equity. In other words,

instead of lending money to buyers, investors contribute capital in

the form of equity. In essence, they become shareholders. Capital

contributions from equity investors allow the smaller private

investors to leverage up into larger commercial or multifamily prop-

erties that they otherwise would not be capable of purchasing.

Equity investors typically require a minimum return on their

investment that is higher than if the funds had been borrowed. Fur-

thermore, because they are shareholders, equity investors also

expect to share in the profits of a property that result from its sale.

Most of the larger institutional investors are looking to place large

sums of capital and oftentimes will not even consider a project less

than $5 million in size. Since they will fund up to 80 or 90 percent

of the capital required, the private investor will need to be prepared

to invest a minimum of 10 to 20 percent. Let’s look at an example to

see how this might work for a commercial strip center with a pur-

chase price of $5 million.

Purchase price = $5,000,000

Total equity = 20% = $5,000,000 × 20% = $1,000,000

Institutional share = 80% = $1,000,000 × 80% = $800,000

Investor share = 20% = $1,000,000 × 20% = $200,000

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Structuring the financing in this manner allows smaller investors

the opportunity to acquire larger income-producing properties than

would otherwise be possible. In this example, the investor is able to

purchase a $5 million commercial property with only $200,000.

Instead of the normal 15 to 20 percent down, the investor has to

come up with only 4 percent of the total purchase price, as follows:

Investor share of total purchase price ==4%

Institutional firms like partnering with local investors who are

familiar with the market in a specific area. Local investors often-

times have a good idea of which areas are preferable for various rea-

sons. For example, they may have insight into which areas are

enjoying positive, even strong, growth and which areas are deterio-

rating and should likely be avoided. Local investors can also help

with, or even be responsible for, the management of the property.

Don’t assume that institutional firms are standing by with an open

checkbook waiting to invest in the first property that you bring to

them. That isn’t the case. These investors have accumulated large

pools of capital because they are very careful, not because they throw

money at every opportunity presented to them. As a smaller investor

who is familiar with the local market, you will have to carefully select

a property that you believe has potential and represents a sound invest-

ment. Then you need to be prepared to put together a well-thought-out

business plan, which will include data specific to the area and the

property, such as the unemployment rate, average vacancy rates, and

rental rates for similar properties. Institutional investors are very

selective when they purchase properties, so be prepared to sell them

not only on the property and the area, but on yourself as well.

PARTNERSHIPS

Combining your own resources with those of a partner is another

way to raise financing for investment properties. The type of partner

I am referring to in this section is a friend, family member, or busi-

ness acquaintance. This differs from the large institutional investor

$200,000

ᎏᎏ

$5,000,000

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described in the previous equity financing section. Partnerships can

be structured in a variety of ways. For instance, capital infusions by

partners can take the form of debt or equity, partners can play an

active or a passive role, and terms for the repayment provisions can

be defined in any number of creative ways. While bringing in a part-

ner certainly has its advantages, probably one of the most challeng-

ing aspects is finding one you can work with.

If your partner participates simply by loaning money in the form

of debt, then a fixed amount will be repaid to that partner under pre-

defined terms and conditions. Unlike more traditional sources of debt

financing, payments can be structured in any manner the two of you

agree on. For example, you may agree to make both principal and

interest payments, interest-only payments, or perhaps defer all pay-

ments until the property is sold. Regardless of how the payments are

structured, the amount repaid is predetermined as set forth in a fully

executed promissory note and is not based on the profitability of the

property. Furthermore, the two of you may choose to secure the loan

by the property, or you may choose to secure it by some other form

of collateral, or you may choose not to secure the loan at all. At a

minimum, the promissory note should be witnessed and recordable.

The two of you may choose not to record the note for any number of

reasons, but the partner loaning the money should have the right to

record the instrument if he or she so chooses. An alternative to secur-

ing debt financing from a partner is to obtain equity financing. If your

partner agrees to invest in your project using equity, then he or she

will share the risk with you. If your project goes south, your partner’s

investment in the project goes south with you. On the other hand, if

you hit a home run, your partner will score right along with you. Both

you and your partner will enjoy the benefit of sharing in the profits.

Partners may take either an active or passive role in helping you

manage and operate the property. For example, you may decide to

have your partners actively participate by taking advantage of what-

ever skill sets they may have. If they have good management skills,

for instance, you may want them to help manage the property. On the

other hand, you may choose to have your partners play a completely

passive role wherein their only contribution is investment capital. In

summary, allowing partners to participate can be beneficial to you by

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providing additional capital for a project that otherwise may be out of

reach financially. Finally, partners may be able to contribute services

or specific skills that you may be lacking.

We’ve discussed several of the advantages of working with part-

ners. Now let’s take a moment to review some of the challenges.

Perhaps the biggest of them is finding the right partner to work with.

Just as a married couple who are in tune with each other can live and

work and dream together in harmony year after year, so can partners

work together to achieve great financial success. As in a marriage,

success requires give and take in the relationship. The partners must

be able to get along with each other and work together in a spirit of

harmony. There must always be a cooperative effort exerted by each

partner. This doesn’t mean there can’t be any disagreements, for cer-

tainly there will be; however, you need to have the ability to resolve

your differences peaceably.

It also helps to clearly define each partner’s duties and responsi-

bilities and to then allow them to work within the agreed-upon

framework. As with our spouses, we are sometimes too quick to crit-

icize and too slow to compliment. It is tempting to micromanage

other people’s performance and point out that they are “not doing it

the right way.” Working closely together with a partner takes just the

right balance of temperament and respect for each other. Husbands

and wives often search for years to find the right companion; even

then, marriages often result in divorce. Finding the right partner to

work with does not happen overnight. Even when you think you

may have found the right business partner, the relationship can fail

for any number of reasons.

You should consider in advance before ever forming a partnership

how its potential failure may affect the relationship you have with that

individual, especially if it is a family member. I know of one particu-

lar instance where a father-in-law invested much of his savings in his

son-in-law’s residential construction business. Two years later, the

family business went belly-up when the son-in-law declared bank-

ruptcy. I’m sure this failure placed a tremendous strain on the family’s

relationships. On a more successful note, however, I am equal partners

with my brother-in-law, Don Mahoney, in our residential construction

company, Symphony Homes. I respect his role as the master builder

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of our homes, and he in turn respects my role as the master builder of

our company. I don’t try to tell him how to build the houses, and he

doesn’t try to tell me how to build the company. That’s not to say that

we don’t have input for each other. He offers his comments and opin-

ions to me, which I gratefully accept, and I offer my comments and

opinions to him. Although we have our differences from time to time,

it has definitely been a win-win partnership for us. Without Don to

ensure that each and every home is built as it should be, I would not

have been able to enjoy a fraction of the success in our company that

I do today. Likewise, without me to develop our business, Don

wouldn’t have nearly as many houses to build as he does today.

BLENDED FINANCING AND THE

WEIGHTED AVERAGE COST OF CAPITAL

When purchasing income-producing properties, especially larger

ones, investors often combine several sources of financing, including

both debt and equity. For example, an investor may purchase a 450-

unit apartment building using a first mortgage for 70 percent of the

total purchase price plus improvements, then raising another 15 per-

cent of the total purchase price plus improvements through equity

arrangements, then borrowing an additional 10 percent of the total

for capital improvements from another lender, and finally, investing

5 percent of his or her own capital. Since the four different sources

that provide the financing will most likely charge different rates, a

blended rate must be calculated. This blended rate is known as the

weighted average cost of capital (WACC). A company’s WACC is

the average rate of return required by all of its creditors and investors.

Calculating the WACC for a business or company enables its own-

ers to determine the threshold for future projects or investments. If a

real estate firm holding a portfolio of properties, for instance, calcu-

lated its WACC at 7.40 percent, assuming the firm’s cost of capital

was held constant, it would have to be able to earn a minimum of

7.40 percent to justify investing in another property. If the expected

return was less than 7.40 percent, the firm would retain its investment

resources until a more favorable opportunity presented itself.

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An investment firm’s cost of capital is calculated by first deter-

mining the weight of each component of debt or equity and then

multiplying that weight by its respective cost. Take a moment to

study the following formula.

Weighted average cost of capital = (proportion of debt × cost of

debt) + (proportion of equity × cost of equity) = WAC C

The formula can also be written as follows:

Weighted average cost of capital =

冢冣

× bond rate +

冢冣

× securities rate = WAC C

WAC C =

冢冣

× R

冢冣

× R

where

WACC is the firm’s weighted average cost of capital

B is the value of bonds, or debt, used for financing

S is the value of stocks, or equity, used for financing

is the cost of debt, or interest rate

is the cost of equity, or the expected return on equity

Now let’s apply the WACC formula to an example. Assume the fol-

lowing:

Value of real estate portfolio = $25 million

Total outstanding debt = $20 million

Total outstanding equity = $5 million

Average cost of debt = 6.20%

Average cost of equity = 10.40%

ᎏ

B + S

ᎏ

B + S

securities

ᎏᎏ

bonds + securities

bonds

ᎏᎏ

bonds + securities

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WAC C =

冢冣

× 6.20%

冢冣

× 10.40% =

冢冣

× 6.20% +

冢冣

× 10.40% = (.80 × .0620)

+ (.20 × .1040) = .0496 + .0208 = .0704 = 7.04% = WAC C

In this example, the weighted average cost of capital for the real

estate portfolio is 7.04 percent. If the investment firm that owned the

portfolio decided to purchase another property, its managers would

carefully examine the firm’s cost structure. Assuming a similar cost

structure was required to purchase the property, then the manager’s

threshold would be a minimum of 7.04 percent. That means the total

return from the property must yield an income stream of at least 7.04

percent to increase the total return to the firm. Anything less than

that means that the cost of financing the property would be greater

than the income earned from it and would therefore have a negative

impact on earnings.

Although the WACC calculation is a useful tool for individuals or

businesses investing on a larger scale, it is just as useful for those

individuals or businesses investing on a smaller scale. As an exam-

ple, an investor buying a $1 million commercial building must pull

$200,000 out of her mutual fund, which has been averaging a 12.0

percent rate of return. She will borrow the remaining $800,000 at an

interest rate of 6.0 percent. The WACC in this example would be as

follows:

WAC C =

冢冣

× 6.00%

冢冣

× 12.00% =

冢冣

$800,000

ᎏᎏ

$1,000,000

$200,000

ᎏᎏᎏ

$800,000 + $200,000

$800,000

ᎏᎏᎏ

$800,000 + $200,000

$5,000,000

ᎏᎏ

$25,000,000

$20,000,000

ᎏᎏ

$25,000,000

$5,000,000

ᎏᎏᎏ

$20,000,000 + $5,000,000

$20,000,000

ᎏᎏᎏ

$20,000,000 + $5,000,000

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× 6.00% +

冢冣

× 12.00% = (.80 × .0600)

+ (.20 × .1200) = .0480 + .0240 = .0720 = 7.20% = WAC C

At first glance, it appears that because the WACC is 7.20 percent,

our investor is better off leaving her money in the mutual fund so it

can continue to earn 12.00 percent rather the 7.20 percent shown in

the calculation; however, because financial leverage was introduced,

this may or may not be the case. If the property was purchased at a

capitalization rate of 8.50 percent, that means its net operating

income would be $85,000 annually before interest. Applying a sim-

ple interest-only calculation would require annual debt service as

follows:

Net operating income = $85,000

Debt service = $800,000 × 6.00% = $48,000

Net income before taxes = $37,000

Now let’s compare the earnings of $37,000 to the yield on our

investor’s savings if left in her mutual fund.

Mutual fund savings = $200,000

Expected rate of return = 12.00%

Earnings before taxes = $24,000

Difference between investments = $37,000 − $24,000 = $13,000

Yield on investor’s equity = $37,000/$200,000 = 18.50%

In this simple example, by introducing the concept of financial

leverage, the investor would be able to earn an 18.50 percent rate of

return by purchasing the commercial building versus a 12.00 per-

cent rate of return by leaving her money invested in a mutual fund.

Calculating the weighted average cost of capital enables the investor

to better understand her true cost of capital. Although she is borrow-

ing funds at an interest rate of 6.00 percent, because she is investing

funds that would otherwise earn 12.00 percent, her true WACC is

7.20 percent.

$200,000

ᎏᎏ

$1,000,000

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OPTIONS

Option agreements are used by investors to gain control of an asset

without having to take legal title to it. Options give investors the

legal right to purchase an asset at a predetermined price. The use of

options is used by investors every day in the stock market to gain

control of the rights to either buy or sell various types of securities.

An investor could purchase, for instance, a put option for 1,000

shares of Intel with a strike price of $35. This gives the investor the

right to sell shares of Intel at $35. The Black-Scholes model is the

standard by which options are valued. As with all options, time t is

one of the variables that determine its value. Investors have the

right to exercise an option at their discretion within a specified

period of time. While it is possible that an investor will buy or sell

at precisely the right time to lock in a gain, it is also possible that

the option will expire worthless and that the investor will lose the

money invested to purchase it. In the case of the investor who pur-

chased a put option for 1,000 shares of Intel, it is hoped that the

price of the stock will fall so that the investor can sell it at the

higher strike price of $35 after having purchased it at any price less

than its strike price.

An option works essentially the same way with real estate as it

does with a stock. Some sellers may require the purchaser to meet

additional obligations, such as assuming responsibility for interest

and taxes; however, these items are negotiable. When an option is

used with real estate, investors have the legal right to purchase a

specified piece of property at a predetermined price within a given

time frame. As with stocks, t will eventually expire worthless if the

option is not exercised. At some point before the expiration of the

option agreement, the investor may exercise her right to purchase

the property at whatever price was established. In addition, since a

legal interest is held in the property, that interest is usually trans-

ferable. This gives the investor the right to sell the property with-

out ever taking title to it. Options are a terrific tool investors can

use to purchase property with very little cash of their own. This is

especially true if another buyer is found before actually having to

take title to it. Another benefit of using options is that they provide

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investors with the ability to limit their risk exposure in a particular

property to only the premium paid for the option. If the investor

decides not to exercise the right to purchase, the option expires

worthless, and only the premium paid for the option is lost.

Depending on the value of the subject property, an option may

potentially cost tens of thousands of dollars. While this may repre-

sent a substantial amount of money, keep in mind that the price

paid for an option is relative to the value of the property being

sought. Although the Black-Scholes model is the standard used to

price options for stocks, option premiums for real estate are typi-

cally based on whatever price is negotiated by the parties that have

an interest in it. I personally have paid anywhere from about 1 per-

cent of the total purchase price to as much as 5 percent for an

option.

Some of the real estate investment activities employed by Sym-

phony Homes include the use of options for the development and con-

struction of single-family houses. Options are used to acquire rights to

property to build on without ever taking legal title until we are ready to

begin construction. The company does, however, have a recordable

interest in the property. In Chapter 2, I referred to a recent real estate

transaction that was worth $3.3 million.An option agreement was used

to acquire the rights to that property, which gives Symphony Homes

the ability to build on any one of the lots in an entire community at a

predetermined price. When our company has a purchase agreement to

build a new home for a client on one of those lots, we then exercise the

option on that lot and take legal title to it. Although we do have a pre-

determined strike price, or purchase price, on all of the lots, interest

and taxes begin accruing from the date the agreement is signed. The

advantage to us in this case is that even though we do eventually have

to pay those costs, we are able to defer them until we are actually ready

to begin construction on a lot. This provision allows us to minimize our

outgoing cash flow and thereby retain as much working capital as pos-

sible to take advantage of other potential opportunities.

Let’s take a moment to compare the use of an option agreement

on this transaction to the use of traditional bank financing. By using

an option, we were able to gain control of the lots in an entire

community with only 1 percent down. By comparison, purchasing

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developed land through more traditional means such as bank financ-

ing typically requires at least a 20 percent down payment.

Scenario 1: Option Agreement Scenario 2: Traditional Bank Financing

Purchase price $3,300,000 $3,300,000

Option fee 1% 20%

Total cash required $3,300,000 × 1% = $33,000 $3,300,000 × 20% = $666,000

Difference = $660,000 − $33,000 = $627,000

In this example, using an option agreement allowed me to gain

control of an entire community with only $33,000. If I had

approached a bank to finance the project, it would have required

$660,000 in total cash. Using an option agreement provided me with

a net favorable reduction in the amount of cash required of

$627,000. I think you would agree with me that this is a significant

sum of money. The use of an option here allowed me to take full

advantage of the law of leverage by gaining control of real estate

valued in excess of $3 million for a meager 1 percent of the purchase

price. Now that’s what I call leverage!

The advantages of using an option in this case are twofold. The

first advantage is that if we have difficulty selling new homes to

prospective buyers in this particular community, we are not stuck

with the ongoing burden and cost of owning the lots. The only thing

we have at risk is our option money. The second advantage is that if

we were to actually purchase the lots, the sale would trigger an

increase in taxes due to a new and much higher assessed value,

because the value of finished lots is much higher than when the

developer first starts improving the land. This is because in the state

of Michigan, property values are not reassessed until a transfer of

ownership has occurred. They are instead capped at a maximum

increase by a change in prices similar to that of the Consumer Price

Index (CPI). As the new owners, Symphony Homes would then be

obligated to assume the new, higher tax liability.

In summary, the use of options can be an incredibly effective tool

for real estate investors who are interested in gaining control of

investment property without having to take title to it. Options enable

investors to gain control of property with very little money down,

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which thereby allows them to maximize the use of leverage. I rec-

ommend, however, that options agreements be used prudently.

Remember that time is one of the variables of an option agreement,

and when t expires, so does the option. Carefully study the market as

it applies to your particular investment opportunity before commit-

ting any capital to it to determine whether the probability of the out-

come is favorable. This will help minimize the risk of any loss of

capital.

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Chapter 6

Real Estate Investment

Performance Measurements

and Ratios

Investors use a variety of methods to help them evaluate potential

investment opportunities. These range from as unscientific an

approach as a hot tip from a real estate broker who supposedly has

inside connections, to general rules of thumb, to advanced mathe-

matical models that analyze every facet of a property’s income and

expenses. My experience has been that the majority of less experi-

enced investors really have no idea how to go about properly ana-

lyzing real estate, especially when it comes to multifamily and

commercial properties. Most of them rely on using comparable

sales of similar properties to help assess value. Although this is a

good place to start, it should by no means be considered exhaustive.

A more comprehensive approach requires the use of all or part of

the 10 essential performance measurements outlined in Exhibit 6.1.

A thorough mastery of these measurements is crucial to your suc-

cess in this business. Without understanding them, how can you

possibly know whether you’re paying too much for a property?

Likewise, how can you know if you’re getting a good deal? The

answer is you can’t.

One primary method of measuring relationships that exist between

the variables of an investment’s income components is through the

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use of ratios. A ratio is a mathematical equation used to express the

relationship between sets or groups of numbers. The use of ratios for

analyzing income-producing properties is essential to properly and

fully understand their respective values. Furthermore, ratios provide

a gauge or general rule of thumb so that a specific property’s value

can quickly be determined relative to similar properties that may be

for sale.

Two precepts must be remembered when applying ratio analysis.

The first is the notion that value is relative. In The Complete Guide

to Investing in Rental Properties (New York: McGraw-Hill, 2004),

I described this precept as follows:

The smart investor knows that perhaps more important

than any other part of the investment process is having a

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Exhibit 6.1

Ten essential performance

measurements.

1. Net income return on investment

2. Cash return on investment

3. Total return on investment

4. Net operating income

5. Capitalization ratio

6. Debt service coverage ratio

7. Turnover ratio

8. Gross rent multiplier

9. Operating ratio

10. Break-even ratio

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thorough understanding of the concept of real estate

values. I like to compare the process of purchasing rental

houses to that of shopping for a new car. If you’re any-

thing at all like most people, before you buy a new car

you’re likely to look at all of the newspaper ads related to

the type of car you want. Then you’ll probably call several

of the local dealers to gather some general information

and determine which models they have in stock. After

that, you’ll begin comparison shopping by going around

to several dealerships to see which one is offering the best

deal. Somewhere along the way, you will have narrowed

your selection of cars down to one or two models. Finally,

you’ll begin the arduous task of negotiating price and

terms with the salesperson. Since you’ve shopped around

quite a bit already, you are already familiar with the car’s

price and what represents a good value. A good value in

this case means that the price is equal to or less than fair

market value relative to all other cars that are similar in

design and features. If you can’t reach an agreement with

the salesperson, then it’s on to the next dealer to try again

until finally, you’ve found just the right car at just the right

price.

Since purchasing a rental house for investment purposes

costs anywhere from five to ten times more than a new car,

don’t you think it would be in your best interests to spend

at least as much time shopping for a house as you do a car?

Yes, of course it would. The more houses you look at in a

particular market, the greater you understand their relative

values. The fact that a 1200-square-foot house with three

bedrooms, two baths, and a two-car garage is priced at

$125,000 in a particular neighborhood means absolutely

nothing by itself. It is only when you compare the price of

that house to the price of all other similar houses in the

same area that its price becomes meaningful.

Using the logic described here, we have established the precept

that indeed, value is relative. This logic leads us to the second

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precept, which is that performance measurements are relative. The

notion that value is relative leads us to conclude that the perfor-

mance measurements that capture those values must also be relative.

For example, what might be considered a good cap rate in one area

might very well be considered poor in another area. These areas

do not have to be in different parts of the country, either. They can

quite easily be in the same metropolitan area. Since cap rates are a

function of property values, and property values are in part deter-

mined by the location of the property, an investment property in a

less than desirable neighborhood would command a higher cap

rate (and lower price) to attract buyers who prefer a higher yield.

Conversely, an investment property in a highly desirable neighbor-

hood would command a lower cap rate (and higher price) to attract

buyers who prefer a higher-quality asset.

The notion that value and performance measurements are relative

is essential for investors to both understand and apply. Without this

knowledge, it would be very easy to overpay for a property. Be sure

to factor these precepts in when analyzing potential investment

opportunities.

NET INCOME RETURN ON INVESTMENT

One thing almost all investors have in common is a desire to know

the answer to the question, “How much will I make on my invest-

ment?” Put another way, investors want to know what the return on

their invested dollars will be, or what their return on investment

(ROI) will be. The ROI performance measurement can be applied to

measure the effectiveness of all types of assets and is especially use-

ful in real estate. The ROI measurement captures the relationship

between net income and invested capital, cash flow and invested

capital, and the asset’s total return and invested capital.

The first of these measurements, net income return on invest-

ment, captures the relationship between net income and invested

capital. This is helpful to financial managers who focus primarily

on the traditional income statement. Net income is derived by

subtracting all items that are classified as expenses for reporting

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purposes from gross revenues. Net income is calculated both

before and after taxes. It gets a little tricky in that whenever a pay-

ment is applied to a mortgage, not all of the payment is treated as

an expense. For example, the interest, taxes, and insurance portion

of a payment are treated as expenses. The principal portion of the

payment, however, is treated as a balance sheet item and has no

effect on the income statement. When a payment is applied to prin-

cipal, two things happen. First, cash is reduced, and second, the

loan balance is reduced. The balance sheet remains precisely in

balance, as one asset is used to reduce a liability by an equivalent

amount.

The net income ROI performance measurement is calculated as

follows:

Net income ROI

We explore this performance measurement more fully by study-

ing a detailed example in Part 2, “Case Study Reviews.”

CASH RETURN ON INVESTMENT

The second performance measurement is referred to as the cash

return on investment, also known as the cash-on-cash return. It is the

ratio between the remaining cash after debt service and invested

capital, also known as owner’s equity. This ratio differs from the net

income ROI in that it excludes all noncash items, such as deprecia-

tion expense, and includes the nonincome portion of loan payments

that are made to principal loan balances. As a general rule, investors

tend to focus more on this performance measurement than they do

on the net income ROI measurement since it represents the cash

return on their investment.

The cash ROI performance measurement is calculated as follows:

gross income − operating expenses − interest − depreciation

ᎏᎏᎏᎏᎏᎏᎏ

owner’s equity

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Cash ROI =

The cash ROI, then, is the ratio between the remaining cash after

debt service and invested capital, or owner’s equity. This perfor-

mance ratio is important to investors because it measures the

monthly and annual cash returns on the cash they have invested.

TOTAL RETURN ON INVESTMENT

The third performance measurement is referred to as the total return

on investment. The total return on investment is similar to the cash

ROI with one important distinction—it accounts for that portion of

return that is not cash, namely, the reduction in principal. In other

words, it takes into account the portion of the loan that is reduced

each period by the payments that are applied to the remaining loan

balance, or the principal portion of the loan payment. The total ROI

is the ratio between the remaining cash after debt service plus prin-

cipal payments and invested capital. The total ROI is calculated as

follows:

Total ROI

The total ROI performance ratio does exactly as its name implies.

It provides a measurement of the total return of an investor’s capital

by capturing both the cash and noncash portions of the return. The

noncash portion is similar to making a house payment amortized

over a period of years. The value is there in the form of a buildup of

equity and a decrease in the liability, or mortgage, as the loan balance

is reduced a little at a time over several years. The gain is realized in

the form of cash at the time of sale. The total ROI can be calculated

as both before-tax and after-tax performance measurements.

remaining cash after debt service + principal reduction

ᎏᎏᎏᎏᎏᎏ

cash investment

remaining cash after debt service

ᎏᎏᎏᎏ

cash investment

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NET OPERATING INCOME

The fourth performance measurement is known as net operating

income (NOI). Net operating income is the income that remains

after all operating expenses have been paid. It is also the amount of

income available to service the property’s debt—in other words, to

pay on any outstanding loan balances such as a mortgage or seller-

financed note. Net operating income is also the numerator in the

quotient used to calculate the capitalization rate. NOI is calculated

as follows:

Gross income − total operating expenses = net operating income

The net operating income is a key figure to understand because it

is needed to calculate a property’s cap rate. It can also be used to

estimate the approximate sales price of an income-producing prop-

erty. For example, if you know that office buildings in a given mar-

ket are selling for an estimated cap rate of eight (8 percent), and the

NOI from a particular building is $240,000, then the estimated sell-

ing price for the building should be approximately $3 million. The

calculation is made as follows:

= sales price

= $3,000,000

Now take a moment to review Table 6.1. The table provides a

detailed example of how NOI is derived in a typical apartment build-

ing. These figures will vary widely, of course, among apartment

buildings depending on factors such as whether the tenant or the

management is paying for utilities, local tax rates, labor costs, and

other factors.

$240,000

ᎏ

.08

Net operating income

ᎏᎏᎏ

Cap rate

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Table 6.1 Net Operating Income

Operating Revenues Annual

Gross Scheduled Income 700,489

Less Vacancy 24,340

Net Rental Income 676,149

Utility Income 71,877

Other Income—Laundry, Misc. 16,760

Gross Income 764,786

Operating Expenses

Gener

al & Administrative

Management Fees 26,767

Office Supplies 4,691

Legal and Accounting 1,404

Advertising 1,938

Total General & Administrative 34,801

Repairs and Maintenance

Repairs, Maintenance, Make Readies 69,664

Contract Services 5,088

Patrol Services 4,831

Grounds and Landscaping 4,751

Total Repairs and Maintenance 84,334

Salaries and Payroll

Office 33,780

Maintenance 21,920

Payroll Taxes 9,176

Total Salaries and Payroll 64,876

Utilities

Electric 82,459

Gas 20,056

Water and Sewer 54,548

Trash 8,387

Telephone 1,378

Total Utilities 166,827

Other

Real Estate Taxes 38,536

Insurance 19,447

Total Other 57,982

Total Operating Expenses 408,821

Net Operating Income 355,965

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CAPITALIZATION RATIO

The fifth performance measurement is referred to as the capitaliza-

tion ratio, or cap rate, which is the ratio between net operating

income and sales price. Like the other performance measurements,

the cap rate is a relevant measurement, which means that a favorable

cap rate in one market may be considered unfavorable in another

market. The cap rate is calculated as follows:

= capitalization rate

The cap rate is an indicator of value that measures the conver-

sion a single payment or a series of payments, such as in a perpe-

tuity, into a single value. The process of converting income into

a single value then is what we refer to as capitalization. The cap

rate captures this measurement in a single value. It is very similar

to the yield on a financial instrument such as a certificate of

deposit. In The Complete Guide to Buying and Selling Apartments

(New Jersey: John Wiley & Sons, 2004), I discussed this crucial

performance measurement at length. Following is an excerpt from

Chapter 4.

As you can see, this ratio is really a very simple calculation

used to measure the relationship between the income gen-

erated by the property and the price it is being sold for. To

help put this in a better perspective for you, let’s refer back

to the beginning of this chapter when we discussed certifi-

cates of deposits. We knew the value of a CD was calcu-

lated by its respective yield. The cap rate measures that

exact same relationship!

Present value of CD == =$200,000

Or to look at it another way . . .

$10,000

ᎏ

.05

income

ᎏ

rate

Net operating income

ᎏᎏᎏ

Sales price

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Rate == =.05 = 5%

Buying an apartment building as related to this equation

is really no different than buying a CD from your local

bank. As an investor, you are willing to pay or invest a cer-

tain amount of capital in order to achieve a desired return.

You know that the rates paid by banks for CDs will vary

within a given range, let’s say 4%–6%, so you will most

likely shop around a little bit to find the most favorable

rate. The same is true of apartment complexes. The rate

paid, or yield on your investment, will vary within a given

range, generally 8%–12%, depending on a variety of mar-

ket conditions including supply and demand issues, the

current interest rate environment, and tax implications

imposed by local, state, and federal authorities.

Let’s look at an example. We know that NOI is derived

by subtracting total operating expenses from gross in-

come. If you were to pay all cash for an apartment build-

ing, then NOI represents the portion of income that is

yours to keep (before taxes and capital improvements), or

the yield on your investment. If you were considering

purchasing an apartment building that yielded $50,000

annually and the seller had an asking price of $800,000,

should you buy it? Let’s plug in the numbers to our equa-

tion and find out.

Net operating income = $50,000

Sales price = $800,000

Cap rate == =.0625 = 6.25%

In this example, you can see that the asking price of

$800,000 provides us with a yield of only 6.25%. Let’s

$50,000

ᎏᎏ

$800,000

NOI

ᎏ

price

$10,000

ᎏᎏ

$200,000

income

ᎏ

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assume that comparable properties in this particular mar-

ket are selling for cap rates of 10%. Armed with that

knowledge, we can easily determine a more reasonable

value for the property by solving for sales price as follows:

Cap rate =

Price == =$500,000

So in this example, based on the limited information we

have, we know the apartment is overpriced by $300,000.

Understanding this simple, yet powerful equation is funda-

mental to properly assessing value. Armed with this knowl-

edge, you can quickly determine if the asking price of an

apartment building is reasonable.

The cap rate is one of the most important performance measure-

ments available to investors. You can see by the example illustrated

here that an investor who is unfamiliar with this key ratio could have

potentially overpaid for the apartment building by an astonishing

$300,000. I should add that you can’t always rely on the advice or

opinion of a real estate agent when it comes to analyzing income-

producing properties such as apartment buildings. Many well-

meaning agents don’t understand value any better than the average

person. Unless agents specialize in multifamily or commercial prop-

erty, they will most likely not truly understand the value of an

income-producing asset. I’ve also met my share of agents who do

work in this industry and who still don’t understand value. My

advice to you is to familiarize yourself with cap rates by looking at

and analyzing as many income-producing properties as you can. By

doing so, you will be able to rely on your own judgment and not the

opinions of others.

The cap rate is an important performance measurement to be

used not only with apartment buildings, but with any kind of

$50,000

ᎏ

.10

NOI

ᎏ

cap rate

NOI

ᎏ

price

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income-producing real estate. The cap rate is so important, in fact,

that it is the premise on which one of three traditional appraisals

methods are based. The income capitalization method, as it is

referred to, is discussed in greater detail in Chapter 8, “The Valua-

tion of Real Property.”

DEBT SERVICE COVERAGE RATIO

The sixth performance measurement is known as the debt service

coverage ratio (DSCR). The DSCR is a ratio that measures the rela-

tionship between available cash after operating expenses have been

paid and the cash required to make the required debt payments. This

ratio is especially important to lenders, as they want to ensure that

the property being considered for investment purposes will generate

enough cash to cover any and all debt obligations. In other words,

they want and need to be assured that the real estate is throwing off

enough cash to repay the loan. The debt service coverage ratio is cal-

culated as follows:

Debt service coverage ratio ==DSCR

The ratio is a simple measure of the relationship of cash generated

from an investment to the debt required to pay for that investment.

The minimum DSCR varies from lender to lender, but in general it

can be as low as 0.75 or as high as 1.40. Most lenders look for a min-

imum DSCR of 1.00 to 1.20.

Several factors can impact the DSCR. For example, if an investor

increases the amortization period from 20 years to 30 years, the

monthly payment will decrease. Since NOI isn’t affected by a

change in the amortization period, the DSCR will increase. Take a

moment to review Tables 6.2 and 6.3. The two tables are identical

except for the amortization period, which is 20 years in Table 6.2

and 30 years in Table 6.3.

Using a 20-year amortization period in Table 6.2 results in a

DSCR of 116.03 percent. If the lender’s minimum required DSCR

net operating income

ᎏᎏᎏ

principal + interest

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was 120.00 percent, this property would fail, because it falls below

the minimum. That doesn’t necessarily mean the lender would reject

the loan, however, as compensating factors may be taken into con-

sideration. Now take a moment to study Table 6.3.

In this example, a 30-year loan amortization period is used, which

results in a decrease in the amount of cash required to service the

debt each month. The DSCR in this example is 138.65 percent,

which compares favorably to the DSCR of 116.03 percent in Table

6.3. Since the lender’s minimum required DSCR is 120.00 percent,

the property structured with the longer amortization period of 30

years meets the lender’s minimum requirement.

OPERATING EFFICIENCY RATIO

The next performance measurement is referred to as the operating

efficiency ratio (OER). The OER is a computation that measures the

operating expenses of an investment property relative to its size. The

ratio is useful for both multifamily and commercial real estate prop-

erties. It is calculated as the ratio of total operating expenses to total

square feet. The result provides a measure of how efficiently the

property can be operated. The lower the number, the less it costs to

manage and operate the property. The calculation is made as fol-

lows:

Operating efficiency ratio ==OER

In the examples illustrated in Tables 6.2 and 6.3, the total operating

expenses in Year 1 are $120,000 and the total square feet are 38,200.

The resulting OER is 3.14, calculated as follows:

OER ==3.14

This calculation tells us is that it costs $3.14 per square foot on aver-

age to operate the property. The operating efficiency ratio captures

$120,000

ᎏ

38,200

total operating expenses

ᎏᎏᎏ

square feet

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Table 6.2 Debt Service Coverage Ratio

Rental Increase Projections

Average Monthly Rent

Operating Expense Projections

Operating Revenues

Operating Expenses

Actual Projected

Monthly Year 1 Year 2 Year 3 Year 4 Year 5

Cost and Revenue Assumptions

Key Rent RatiosFinancing Assumptions

Financing and Income Analysis

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Net Operating Income

Cash Flow From Operations

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Table 6.3 Debt Service Coverage Ratio

Rental Increase Projections

Average Monthly Rent

Operating Expense Projections

Operating Revenues

Operating Expenses

Actual Projected

Monthly Year 1 Year 2 Year 3 Year 4 Year 5

Key Rent Ratios

Cost and Revenue Assumptions

Financing Assumptions

Financing and Income Analysis

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Net Operating Income

Cash Flow From Operations

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the relationship between operating expenses and size and can there-

fore be a useful measurement in evaluating similar properties. If the

average OER in a specific market is 3.00, or $3.00 per square foot,

then this property would be considered to be within range, but

slightly above average.

GROSS RENT MULTIPLIER

The next performance measurement is referred to as the gross rent

multiplier (GRM). The gross rent multiplier measures the relation-

ship between the total purchase price of a property and its gross

scheduled income. It is the ratio of price to income. The GRM cal-

culation is made as follows:

Gross rent multiplier ==GRM

The GRM is similar to the cap rate in that it captures the relation-

ship between revenues and price; however, there are two primary

differences. The first is that while the GRM measures the relation-

ship between gross revenues and price, the cap rate measures the

relationship between net revenues, or NOI, and price. The second

difference is that one ratio is inverted compared to the other. For

example, purchase price is the numerator in the GRM quotient, but

it’s the denominator in the cap rate. While a higher cap rate is pre-

ferred to a lower cap rate, a lower GRM is preferred to a higher

GRM. This is true because the ratio will decrease the lower the pur-

chase price is relative to income. It will also decrease the higher the

income is relative to the purchase price.

In the examples illustrated in Tables 6.2 and 6.3, the GRM of 5.09

measures the relationship between the total purchase price and the

gross scheduled income in Year 1.

GRM ==5.09

$1,002,000

ᎏᎏ

$196,800

purchase price

ᎏᎏᎏ

gross scheduled income

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In the model used to make the calculation, both improvements

and closing costs have been factored into the analysis. Although

there are no improvements in this example, they are typically

included if major capital expenditures are expected. If the

improvements are expected to increase the gross revenues, that,

too, should be taken into consideration. The GRM can be cal-

culated on either an as-is basis with no changes or improvements

to the property, or on a pro forma basis, which includes both

improvements and the expected increase in revenues that would

result from the improvements.

OPERATING RATIO

The next performance measurement used to analyze income pro-

ducing properties is the operating ratio (OR), which is the ratio

between total operating expenses and gross income. Like the oper-

ating efficiency ratio, it provides a gauge of how efficiently a given

property is being operated. Whereas the OER measures efficiency

relative to a property’s total square footage, the OR measures effi-

ciency relative to a property’s income. The calculation is made as

follows:

Operating ratio ==OR

Depending on the type of income property, an OR can range from

about 30 percent to as high as 70 percent or even more. Commercial

properties tend to have a lower OR since most of the expenses are

passed through to the tenant. Multifamily properties, on the other

hand, tend to have a somewhat higher OR since the expenses that are

passed through vary. For example, an apartment building being

operated as an “all bills paid” property will certainly have higher

expenses relative to its income compared to a similar property in

which the utilities are paid by the tenants.

In the examples illustrated in Tables 6.2 and 6.3, the OR of

total operating expenses

ᎏᎏᎏ

gross income

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58.5 percent measures the relationship between total operating

expenses and gross income and is calculated as follows:

OR ==58.5%

The result in this example of 58.5 percent is somewhat on the high

side, but does not fall outside the range of normal ratios. An investor

looking to create value in an income-producing property would

carefully examine each factor that contributes to the operating

expenses. In other words, a high OR may signal that repairs and

maintenance are abnormally high, or perhaps that management

expenses could be trimmed. Conversely, an unusually low OR could

signal that not all of the operating expenses are being reported. If

repairs and maintenance, for example, are known to average 10 to

15 percent of gross income but are being reported as only 3 or 4 per-

cent, then either the property is in exceptionally good condition or

not everything is being reported.

BREAK-EVEN RATIO

The final investment performance measure we examine is known as

the break-even ratio (BER), which measures the relationship

between total cash inflows and total cash outflows. The BER is sim-

ilar to the OR in that both ratios use total operating expenses as part

or all of the numerator and gross income as the denominator. The

difference between the two is that the BER includes as part of the

numerator the debt service. The BER serves as a performance meas-

urement of cash flows from a property, and the OR serves as a per-

formance measurement of income and expenses.

As the break-even ratio’s name implies, the break-even point is

the point at which the total cash inflows are exactly equal to the total

cash outflows. A property with a negative cash flow has a ratio

greater than 1.0, which means that its cash outflows exceed its cash

inflows; conversely, a property with a positive cash flow has a ratio

$120,000

ᎏ

$204,960

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less than 1.0, which means that its cash inflows exceed its cash out-

flows. The break-even ratio is calculated as follows:

Break-even ratio =

= BER

In the examples illustrated in Tables 6.2 and 6.3, the BER would be

calculated by adding the total operating expenses of $120,000 to the

debt service of $61,276 and then dividing this sum by the property’s

gross income of $204,960. Take a moment to review the calculation.

BER ==88.4%

The property in this example has a positive cash flow since

the BER is 88.4 percent, which is less than 1.0, or 100 percent. I

strongly recommend to investors who have adopted a buy-and-hold

strategy to invest in only those properties that have a positive cash

flow and a BER of less than 1.0. To do otherwise means that addi-

tional cash must be invested each month. A property with a negative

cash flow is just like my three growing sons. They are constantly

hungry and have to be fed all the time! Unless you have deep pock-

ets, a hungry property will eat your lunch if you’re not careful! If

you’re buying a property for the purpose of a quick rehab or flip,

then a positive cash flow isn’t as important, because you don’t need

as much cash to sustain the project. The negative cash flow, along

with the building improvements, is factored into the analysis to

determine whether the project represents a viable opportunity.

In summary, each of the 10 real estate investment performance

measurements discussed in this chapter can be used by investors to

assist in properly analyzing potential investment opportunities. Wise

investors who elect to master these principles will no doubt gain

greater insight into property values and their worth relative to alter-

native opportunities.

$120,000 + $61,276

ᎏᎏᎏ

$204,960

total operating expenses + debt service

ᎏᎏᎏᎏ

gross income

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Chapter 7

Advanced Real Estate

Investment Analysis

In the previous chapter, we examined 10 different real estate invest-

ment performance measurements, which enabled us to better under-

stand how an income-producing property was performing at a given

point in time. These measurements are considered to be static mea-

surements, meaning that they do not take into account a property’s

performance over more than one time period. Instead, performance

is measured at either a specific point in time or over one period of

time, for example, one month or one year. This chapter focuses on

advanced methods of real estate investment analysis by measuring

performance over multiple periods of time. These financial concepts

deal with the time value of money and are especially helpful to indi-

viduals investing in real estate over a prolonged period of time.

FUTURE VALUE ANALYSIS

The first of these financial measurements is referred to as future

value (FV). The future value concept seeks to determine the value of

an investment over multiple periods of time by using the principle of

compounding. This principle is used to attribute the interest earned

on interest. For example, interest as it applies to money is simply the

cost of money to the borrower and the income to the lender. Com-

pound interest is the interest paid on the interest to the borrower and

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the interest earned on the interest by the lender. The future value

concept helps investors to know what a particular property will be

worth over a given period of time.

Let’s look at a simple example to better understand the concept of

future value and compounding. Banker Smith has offered to pay

Investor Jones 5 percent annually for a certificate of deposit held for

three years. How much will Investor Jones’s initial investment of

$1,000 be worth at the end of the three-year period? To find the solu-

tion, we start by introducing the following terms.

PV = present value = the value of an investment today

FV = future value = the value of an investment at some point in

the future

i = the interest rate

n = the number of periods

In this example, our terms are applied as follows:

PV = $1,000

FV = ?

i = 5.00%

n = 3 years

FV in Year 1 = $1,000.00 (1 + .05) = $1,000.00 × 1.05 = $1,050.00

FV in Year 2 = $1,050.00 (1 + .05) = $1,050.00 × 1.05 = $1,102.50

FV in Year 3 = $1,102.50 (1 + .05) = $1,102.50 × 1.05 = $1,157.63

In this example, at the end of Year 3, Investor Jones would receive a

total of $1,157.63 from Banker Smith. Now let’s look at solving the

same problem another way.

FV = PV (1 + i)

FV = $1,000 (1 + .05)

FV = $1,000 (1.1576)

FV = $1,157.63

Applying future value principles to real estate helps investors

determine the value of their invested capital at some distant point in

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the future. A working knowledge of the principle of compounding is

essential to understanding the effects of returns which are generated

over multiple periods of time. It is this compounding component

that allows the growth of an investment to accelerate over time. Take

a moment to review Exhibit 7.1.

Exhibit 7.1 illustrates the difference between growth rates in an

initial investment of $1,000 earning 10 percent per year over a 25-

year period. The line that curves up sharply is earning interest at a

compounded rate, and the line that is linear is earning interest at a

simple rate. The future value of a $1,000 investment earning 10 per-

cent interest and compounded annually over 25 years is $9,850. By

comparison, the future value of a $1,000 investment earning 10 per-

cent simple interest annually over 25 years is only $3,400. In this

example, the power of compounding has allowed one investment to

grow at a rate almost three times faster than the other investment.

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$10

Thousands

25-year period

Compound Interest

Simple Interest

Exhibit 7.1

Effect of compound interest versus simple interest.

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Now take a moment to study Table 7.1. This table provides the

factor or value by which an investment can be multiplied to calculate

its future value at a specific interest rate and time period. For exam-

ple, to find out how much a $25,000 investment growing at a rate of

12 percent would be worth in 15 years, locate the corresponding

value in the table and multiply it by the amount of the investment, as

follows:

FV of $25,000 at 12% in 15 years, where

PV = $25,000

i = 12.00%

n = 15 years

Corresponding value from Table 7.1 = 5.47357

FV = $25,000 × 5.47357 = $136,839

Although Table 7.1 is useful in helping to determine the future

value of an investment, it is limited to the rates and time periods

within the table. A financial calculator, on the other hand, can be

used to calculate the future value of an investment of any size at any

rate over any period of time. Most financial calculators are very easy

to use. As long as any three of the four variables are known, the

fourth one can easily be solved for. As an example, an investor with

$5,000 wants to know how long she must hold an investment grow-

ing at an annual rate of 8 percent before her investment is worth

$25,000. In this example, we must solve for n by entering into the

calculator the known values as follows:

PV = $5,000

FV = $25,000

i = 8.00%

Once these values have been entered, then simply solve for n.

n = 21 years

In summary, the concept of future value enables businesses and

individuals to determine the value of an investment at some point in

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Table 7.1 Value of $1 at Various Compound Interest Rates and Time Periods

Year 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00%

1 1.02000 1.04000 1.06000 1.08000 1.10000 1.12000 1.14000 1.16000 1.18000 1.20000

2 1.04040 1.08160 1.12360 1.16640 1.21000 1.25440 1.29960 1.34560 1.39240 1.44000

3 1.06121 1.12486 1.19102 1.25971 1.33100 1.40493 1.48154 1.56090 1.64303 1.72800

4 1.08243 1.16986 1.26248 1.36049 1.46410 1.57352 1.68896 1.81064 1.93878 2.07360

5 1.10408 1.21665 1.33823 1.46933 1.61051 1.76234 1.92541 2.10034 2.28776 2.48832

6 1.12616 1.26532 1.41852 1.58687 1.77156 1.97382 2.19497 2.43640 2.69955 2.98598

7 1.14869 1.31593 1.50363 1.71382 1.94872 2.21068 2.50227 2.82622 3.18547 3.58318

8 1.17166 1.36857 1.59385 1.85093 2.14359 2.47596 2.85259 3.27841 3.75886 4.29982

9 1.19509 1.42331 1.68948 1.99900 2.35795 2.77308 3.25195 3.80296 4.43545 5.15978

10 1.21899 1.48024 1.79085 2.15892 2.59374 3.10585 3.70722 4.41144 5.23384 6.19174

11 1.24337 1.53945 1.89830 2.33164 2.85312 3.47855 4.22623 5.11726 6.17593 7.43008

12 1.26824 1.60103 2.01220 2.51817 3.13843 3.89598 4.81790 5.93603 7.28759 8.91610

13 1.29361 1.66507 2.13293 2.71962 3.45227 4.36349 5.49241 6.88579 8.59936 10.69932

14 1.31948 1.73168 2.26090 2.93719 3.79750 4.88711 6.26135 7.98752 10.14724 12.83918

15 1.34587 1.80094 2.39656 3.17217 4.17725 5.47357 7.13794 9.26552 11.97375 15.40702

16 1.37279 1.87298 2.54035 3.42594 4.59497 6.13039 8.13725 10.74800 14.12902 18.48843

17 1.40024 1.94790 2.69277 3.70002 5.05447 6.86604 9.27646 12.46768 16.67225 22.18611

18 1.42825 2.02582 2.85434 3.99602 5.55992 7.68997 10.57517 14.46251 19.67325 26.62333

19 1.45681 2.10685 3.02560 4.31570 6.11591 8.61276 12.05569 16.77652 23.21444 31.94800

20 1.48595 2.19112 3.20714 4.66096 6.72750 9.64629 13.74349 19.46076 27.39303 38.33760

21 1.51567 2.27877 3.39956 5.03383 7.40025 10.80385 15.66758 22.57448 32.32378 46.00512

22 1.54598 2.36992 3.60354 5.43654 8.14027 12.10031 17.86104 26.18640 38.14206 55.20614

23 1.57690 2.46472 3.81975 5.87146 8.95430 13.55235 20.36158 30.37622 45.00763 66.24737

24 1.60844 2.56330 4.04893 6.34118 9.84973 15.17863 23.21221 35.23642 53.10901 79.49685

25 1.64061 2.66584 4.29187 6.84848 10.83471 17.00006 26.46192 40.87424 62.66863 95.39622

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the future by applying the principle of compounding to the amount

of the initial investment. As long as any three of the four variables

are known, the fourth unknown variable can be easily solved for.

PRESENT VALUE ANALYSIS

In the previous section, we examined the concept that deals with the

time value of money as it applies to some point in the future. This

concept, referred to as future value, allows us to determine the worth

of an investment or financial instrument at a future time by intro-

ducing the notion of compounding. In this section, we examine the

exact opposite concept, known as present value (PV). Present value

is derived by adjusting the known future value of an asset at a pre-

determined interest rate, or discount rate, from a known future point

in time backward to its value today. Present value analysis is a tool

used by investment professionals every day in a myriad of business

decisions, including investing in assets such as equipment to be used

for expansion, financial instruments yielding a particular income

stream, and income-producing real estate such as office buildings.

The notion of present value allows investors to calculate the

known future value of an asset or financial instrument in today’s dol-

lars through a process referred to as discounting. For example, it

answers a question such as, “How much do I need to invest today if I

want to retire in 10 years with $1 million in an investment known to

yield 12 percent?” In this example, our terms are applied as follows.

PV = ?

FV = $1,000,000

i = 12.00%

n = 10 years

To solve this problem, recall the future value equation as follows:

FV = PV (1 + i)

Now let’s rewrite the equation to solve for the present value of an

asset, as follows:

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FV = PV (1 + i)

PV = FV 1\(1 + i)

PV = $1,000,000 1\(1 + .12)

PV = $1,000,000 1\(3.1058)

PV = $1,000,000 × .321973

PV = $321,973

You would need $321,973 to invest today in an asset yielding 12

percent to be able to retire in 10 years with $1 million. By experi-

menting with the time and interest rate elements of this equation,

investors can explore various options that may be available to

them. For example, if you don’t have $321,973 today to invest, but

you still want to retire with $1 million, you could either extend the

value of time or increase the yield. Adjusting either one of these

variables would decrease the amount of money needed to achieve

your goal.

Now take a moment to review Table 7.2. This table provides the

factor or value by which an investment can by multiplied to calcu-

late its present value at a specific interest rate and time period. For

example, to calculate the present value of an investment discounted

at a rate of 12 percent that would be worth $25,000 in 15 years,

locate the corresponding value in the table and multiply it by the

amount of its future value, as follows:

PV of $25,000 at 12% in 15 years, where

FV = $25,000

i = 12.00%

n = 15 years

Corresponding value from Table 7.2 = .18270

PV = $25,000 × .18270 = $4,567

The concept of present value calculations is a fundamental and

essential tool used by firms in many aspects of operating their busi-

nesses. While future value calculations rely on the process of com-

pounding to derive value, present value calculations rely on the

process of discounting to derive value. Present value calculations

allow investors to determine the worth of an asset whose future

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Table 7.2 Present Value of $1 at Various Compound Interest Rates and Time Periods

Year 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00%

1 0.98039 0.96154 0.94340 0.92593 0.90909 0.89286 0.87719 0.86207 0.84746 0.83333

2 0.96117 0.92456 0.89000 0.85734 0.82645 0.79719 0.76947 0.74316 0.71818 0.69444

3 0.94232 0.88900 0.83962 0.79383 0.75131 0.71178 0.67497 0.64066 0.60863 0.57870

4 0.92385 0.85480 0.79209 0.73503 0.68301 0.63552 0.59208 0.55229 0.51579 0.48225

5 0.90573 0.82193 0.74726 0.68058 0.62092 0.56743 0.51937 0.47611 0.43711 0.40188

6 0.88797 0.79031 0.70496 0.63017 0.56447 0.50663 0.45559 0.41044 0.37043 0.33490

7 0.87056 0.75992 0.66506 0.58349 0.51316 0.45235 0.39964 0.35383 0.31393 0.27908

8 0.85349 0.73069 0.62741 0.54027 0.46651 0.40388 0.35056 0.30503 0.26604 0.23257

9 0.83676 0.70259 0.59190 0.50025 0.42410 0.36061 0.30751 0.26295 0.22546 0.19381

10 0.82035 0.67556 0.55839 0.46319 0.38554 0.32197 0.26974 0.22668 0.19106 0.16151

11 0.80426 0.64958 0.52679 0.42888 0.35049 0.28748 0.23662 0.19542 0.16192 0.13459

12 0.78849 0.62460 0.49697 0.39711 0.31863 0.25668 0.20756 0.16846 0.13722 0.11216

13 0.77303 0.60057 0.46884 0.36770 0.28966 0.22917 0.18207 0.14523 0.11629 0.09346

14 0.75788 0.57748 0.44230 0.34046 0.26333 0.20462 0.15971 0.12520 0.09855 0.07789

15 0.74301 0.55526 0.41727 0.31524 0.23939 0.18270 0.14010 0.10793 0.08352 0.06491

16 0.72845 0.53391 0.39365 0.29189 0.21763 0.16312 0.12289 0.09304 0.07078 0.05409

17 0.71416 0.51337 0.37136 0.27027 0.19784 0.14564 0.10780 0.08021 0.05998 0.04507

18 0.70016 0.49363 0.35034 0.25025 0.17986 0.13004 0.09456 0.06914 0.05083 0.03756

19 0.68643 0.47464 0.33051 0.23171 0.16351 0.11611 0.08295 0.05961 0.04308 0.03130

20 0.67297 0.45639 0.31180 0.21455 0.14864 0.10367 0.07276 0.05139 0.03651 0.02608

21 0.65978 0.43883 0.29416 0.19866 0.13513 0.09256 0.06383 0.04430 0.03094 0.02174

22 0.64684 0.42196 0.27751 0.18394 0.12285 0.08264 0.05599 0.03819 0.02622 0.01811

23 0.63416 0.40573 0.26180 0.17032 0.11168 0.07379 0.04911 0.03292 0.02222 0.01509

24 0.62172 0.39012 0.24698 0.15770 0.10153 0.06588 0.04308 0.02838 0.01883 0.01258

25 0.60953 0.37512 0.23300 0.14602 0.09230 0.05882 0.03779 0.02447 0.01596 0.01048

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value is known in today’s dollars by discounting it back at a speci-

fied or required rate. Understanding the principle of present value

enables business owners to make prudent decisions relating to the

use of available capital for investment purposes.

NET PRESENT VALUE ANALYSIS

In the previous section, we learned about using present value for-

mulas to determine the value of an asset in today’s dollars of a

known future value at a specific discount rate and period of time. In

this section, we examine another financial tool used to measure

investments. It’s known as net present value (NPV). The financial

analysis of assets using net present value calculations is identical to

that of present value calculations with one exception. In a present

value calculation, an investor simply wants to determine how much

should be invested today to earn a particular rate of return over a

given period of time, so solving for PV is all that is required. In a net

present value calculation, however, the cost of the investment is

already known. Because of this, investors seeking to purchase an

income-producing asset use the PV formula to discount the value of

the asset back at a predetermined minimum expected rate of return.

If the present value of the asset exceeds its cost, the difference is a

positive NPV. In this case, the investor would approve the purchase

of the asset since it met or exceeded her minimum expected rate of

return. If, however, the present value of the asset is less than its cost,

the difference results in a negative NPV in which case, the investor

would reject the purchase since it did not meet her minimum

expected rate of return.

Let’s look at an example to better understand how the net present

value calculation can be useful to a business. Assume a business that

has a minimum required rate of return of 8 percent is considering the

purchase of an income-producing asset with a purchase price of

$500,000. The future value of the asset in eight years is expected to

be $1.1 million. Using the minimum required rate of return of 8 per-

cent, should the company purchase the asset? To answer that ques-

tion, we must first solve for its present value.

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PV of $1.1 million at 8% in 10 years, where

FV = $1,100,000

i = 8.00%

n = 10 years

Corresponding value from Table 7.2 = .46319

PV = $1,100,000 × .46319 = $509,512

To determine the net present value of this investment, the initial cost

of the asset must now be subtracted from the present value.

NPV = PV − cost

NPV = $509,512 − $500,000 = $9,512

NPV = $9,512

Since the NPV is positive, it meets the minimum rate of return

required by the business and therefore merits further consideration.

A NPV greater than zero means that not only does the asset meet the

minimum rate of return, but by definition, it actually exceeds it. By

substituting the actual cost of the asset for PV, we can solve for i

using a financial calculator, as follows:

PV = $500,000

FV = $1,100,000

n = 10 years

i = ?

Using a financial calculator, enter the values as illustrated for each

of the three known variables. Be sure to enter the PV of $500,000 as

a negative value since it represents a cash flow out. All other vari-

ables should be entered as positive values. The solution for i is as

follows:

PV = $500,000

FV = $1,100,000

n = 10 years

i = 8.20%

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To summarize, the yield on this investment is 8.20 percent, which

exceeds the minimum rate of return required by the business. When

analyzing these types of investment opportunities, recall that firms

must take into consideration their cost of capital. In this example, if

the company’s cost of capital was 6.00 percent, investing in the asset

would yield an incremental 2.20 percent. The net present value cal-

culation is a tool commonly used by investors from many different

industries, including real estate.

INTERNAL RATE OF RETURN

In the previous section, the financial analysis principle of net

present value enabled us to first calculate the present value of an

investment and then subtract the actual cost of the asset from its

present value. The NPV calculations were made with a minimum

rate of return already established by the firm. In this section, in-

stead of solving for the NPV, we solve for the internal rate of

return (IRR). The IRR calculation measures the yield or rate of

return on an investment rather than its present value. The present

value is assumed to be the initial cost of the asset. The IRR calcu-

lation measures the yield from a series of cash flows across a spec-

ified period of time and includes the cost of the asset, the cash

flows from the asset, and the salvage value of the asset at the end

of its useful life. In the case of plant and equipment, an asset’s use-

ful life may be exhausted at the end of a period due to functional

or technical obsolescence. The useful life of real estate, which may

actually increase in value over time, is said to be exhausted when

the property is divested.

Let’s look at an example. Assume Investor Lincoln wants to add

an additional space to a small retail strip center. Construction costs

to add the space are estimated to be $100,000. As illustrated in

Table 7.3, Lincoln has two choices. In Scenario 1, he can lease the

space to Tenant A on a lease-option agreement for three years at a

rate of $10,000 per year and then sell the space at the end of the

three-year period for $110,000. In Scenario 2, he can lease the

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space to Tenant B on a lease option agreement for six years at a

rate of $10,000 per year for the first three years and $12,500 for

the next three years, then sell the space at the end of the six-year

period for $120,000.

The internal rate of return in Scenario 1 is 12.94 percent. The

income generated from three years’ worth of cash flows is the equiv-

alent of earning an annualized rate of return of 12.94 percent on

Investor Lincoln’s initial investment of $100,000. If, however,

Investor Lincoln chooses to hold the property for six years, his yield

increases to 13.40 percent. Because the IRRs in this example are

marginally close, there may be other factors such as tax issues that

could affect Lincoln’s decision to choose one scenario over the

other; however, with all other things being equal, the higher yield in

Scenario 2 suggests that Investor Lincoln should choose this alter-

native over Scenario 1.

Let’s look at another example using The Value Play Income Ana-

lyzer, a proprietary model used for analyzing income properties

such as apartment buildings. In Table 7.4, the cash flows of a 50-unit

apartment building are examined to determine its respective internal

rate of return.

In Table 7.4, note the net cash flows from investment section in

the lower portion of the table. This section is used to display the net

cash flows from the property. The first value in the Year 1 exit sec-

tion of −$514,250 is a cash-flow-out value that represents the

owner’s initial equity. This is followed by a cash-flow-in value of

$683,618, derived by adding the following values.

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Table 7.3 Internal Rate of Return

Cash Flows Scenario 1 Scenario 2

Initial Investment (100,000) (100,000)

Cash Flow in Year 1 10,000 10,000

Cash Flow in Year 2 10,000 10,000

Cash Flow in Year 3 120,000 10,000

Cash Flow in Year 4 12,500

Cash Flow in Year 5 12,500

Cash Flow in Year 6 132,500

Internal Rate of Return 12.94% 13.40%

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Owner’s equity $514,250

After-tax cash flows $97,983

Principal reduction $46,385

Gain on sale $25,000

Total $683,618

The cash flow in value of $683,618 assumes the owner sells the

property at the end of Year 1 at a cap rate of 9.43 percent, which is

comparable to the 9.50 cap rate at the time of purchase (shown in the

key ratios section). If the property was sold at the end of the first

year, based on its projected cash flows it would earn an internal rate

of return of 32.93 percent. Take a moment to review the net cash

flows from investment in Year 3. The initial cash flow out, which is

the owner’s equity, of $514,250 is the same as in the Year 1 scenario.

The income earned from Years 1, 2, and 3 is then factored in, as well

as the reduction in principal and gain on sale of $450,000. Based

on the projected cash flows in the Year 3 scenario, the property

would generate an IRR of 46.05 percent. Now take a moment to

examine the net cash flows from investment in Year 5. The cash

flows are derived in the same manner as in the previous two sce-

narios, but include income and principal reduction for Years 4

and 5 as well. Based on the projected cash flows in the Year 5 sce-

nario, the property would earn an internal rate of return of 40.21

percent.

While the internal rate of return calculation is widely used by

investors to measure the yield on a series of cash flows, there is

one caveat. The IRR calculation works best when the initial cash

flow is negative and all subsequent cash flows are positive. Addi-

tional negative values in the cash flow stream can potentially

create multiple solutions. In an excerpt taken from Investment

Analysis for Real Estate Decisions (Chicago: Dearborn Trade,

1997, p. 222), authors Greer and Kolbe note that the IRR calcula-

tion can be problematic under certain conditions. The authors

assert the following.

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Table 7.4 Property Analysis Worksheet

The Value Play Income Analyzer

Cost and Revenue Assumptions

Financing Assumptions

Key Ratios

Rental Increase Projections

Average Monthly Rent

Operating Expense Projections

Operating Revenues

Operating Expenses

Actual Projected

Monthly Year 1 Year 2 Year 3 Year 4 Year 5

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Net Operating Income

Cash Flow From Operations

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Problems associated with the internal rate of return can

result in conflicting decision signals from this and other

discounted cash flow approaches. Generally, such a con-

flict arises because the internal rate of return signal is dis-

torted. If heeded, it might result in serious investment error.

Potential dissonance stems from peculiarities of the inter-

nal rate of return equation, which can yield more than one

solution, and from problems associated with the reinvest-

ment assumption inherent in choices among alternative

investments that exhibit different patterns of anticipated

after tax cash flows.

Mathematicians and analysts alike have attempted to resolve the

problems that occur with IRR calculations resulting from the rever-

sal in signals in a series of cash flows. Three of the more common

methods used to address these issues are (1) the modified internal

rate of return, or MIRR, (2) the adjusted rate of return, and (3) the

financial management rate of return. According to Greer and Kolbe,

the MIRR method “solves the multiple root problem by discounting

all negative cash flows back to the time at which the investment is

acquired and compounding all positive cash flows forward to the

end of the final year of the holding period.” The modified approach

eliminates the reversal-of-signals problem and provides a unique

solution for a series of cash flows. The adjusted rate of return

method assumes the investor has in essence borrowed funds from

one period and repaid them in another period, again attempting to

deal with positive and negative changes in values. Finally, the finan-

cial management rate of return method, developed by M. Chapman

Findley and Stephen D. Messner, integrates two intermediate rates.

The first, a cost-of-capital rate, is applied to negative that which are

discounted back to the beginning of the investment time period

where t = 0. The second rate is a reinvestment rate and is applied to

positive values that are compounded forward to the end of the

investment time period.

In summary, this chapter has focused on several advanced meth-

ods of real estate investment analysis by measuring performance

over multiple periods of time. These financial analysis tools enable

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individuals and businesses to evaluate investments extending over

various periods of time and having various streams of cash flow.

Most financial analysis methods use discounting and compounding

calculations to express the sum of a stream of cash flows in either

present value or future value terms, thereby enabling investors to

make decisions based on predetermined minimum rates of return.

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Chapter 8

The Valuation of Real Property

APPRAISAL DEFINED

An appraisal is an estimate of an object’s worth or value.

Appraisals are used to determine the value of both personal prop-

erty and real property. For example, you may want to have an inde-

pendent appraisal done on a diamond ring with a $20,000 price tag

before investing that kind of money in it. The appraisal could then

be used for insurance purposes in the event the ring was lost or

stolen. Appraisals are also used to determine the worth and value of

real property, such as land or buildings. In Income Property Valua-

tion (Massachusetts: Heath Lexington Books, 1971, p. 9), author

William N. Kinnard states the following as it relates to the appraisal

process:

An appraisal is a professionally derived conclusion about

the present worth or value of specified rights or interests in

a particular parcel of real estate under stipulated market

conditions or decision standards. Moreover, it is (or should

be) based on the professional judgment and skill of a

trained practitioner. Its conclusions should be presented in

a thoroughly logical and convincing way to a client or an

interested third party who requires the value estimate to

help make a decision or solve a problem involving the real

estate in question.

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An appraisal opinion is usually delivered in written

form. A professional appraisal report should contain as a

minimum the essential ingredients of an appraisal identi-

fied as (1) the identity and legal description of the real

estate; (2) the type of value being estimated; (3) the inter-

ests being appraised; (4) the market conditions or decision

standards in terms of which the value estimate is made (fre-

quently identified by specifying an “as of” date or effective

date for the appraisal); and (5) the value estimate itself.

Moreover, the report should indicate the data and reason-

ing employed by the appraiser in reaching his value con-

clusion, any special or limiting conditions that impinged

on his analysis and conclusion, and the appraiser’s certifi-

cation and signature.

THE NATURE OF PRICE AND VALUE

As Kinnard clearly states, the process for appraising real property is

well defined and specific. Although objective in its format, property

values vary widely for many reasons. A 1,000-square-foot house

with three bedrooms and two baths, for example, may be worth only

$60,000 in Dallas, Texas, while in Hollywood, California, that same

house may sell for $150,000. Real estate values are impacted by

many different micro- and macroeconomic forces, including supply

and demand issues, the current interest rate environment, local and

national economic conditions, the desirability of the location, and

differences in tax rates. The same appraisal standards applied to a

particular piece of real property in one region may yield entirely dif-

ferent results for a similar piece of real property in another region.

Likewise, an appraisal of those same properties today would almost

certainly be different than an appraisal conducted 10 years ago.

Although the terms price and value are similar in meaning, they

are not the same. An appraisal is an estimate of value and provides

no indication of what price will actually be paid for a piece of real

property. For example, an individual shopping for a new refrigerator

will first determine all the desired features she must have, and then

begin to shop for one matching her requirements. Once a model is

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selected, she will then most likely shop around at several locations

to determine which store is offering the best price. By purchasing

the refrigerator at the lowest price available, not only is the buyer

able to save money, but she is also said to have received the best

value. Although two identical refrigerators at two different locations

may have the same resell value, the one that originally sold for less

money has a greater equivalent value.

The appraisal provides the basis for price, but buyers and sellers

are free to negotiate. Kinard asserts, “In the perfect market of eco-

nomic theory, informed and rational buyers would pay no more, and

informed and rational sellers would accept no less, than the present

worth of the anticipated future benefits from ownership of an asset.”

As a result of various differences in economic conditions, however,

the actual price paid may be, and often is, different than the stated

value in an appraisal report. Price is therefore a reflection of the

past. It is what has already occurred. Value, on the other hand,

reflects the price that should be paid “in the perfect market of eco-

nomic theory.” Value is therefore a forecast of price. It is what may

occur at some point in the future, not what has occurred at some

point in the past.

THREE PRIMARY APPRAISAL METHODS

Three primary methods are used by appraisers to determine the

value of real estate: the replacement cost method, the sales compar-

ison method, and the income capitalization method. (See Exhibit

8.1). Each method of valuation has its place and serves a unique

function in assessing the worth of real property. Commercial prop-

erties such as retail centers, office buildings, and apartment com-

plexes, for example, rely primarily on the income method, while

single-family houses typically rely on the sales comparison method.

REPLACEMENT COST METHOD

The replacement cost method, or cost approach, is most commonly

used for estimating the replacement value of physical assets for

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insurance purposes. For example, should a house be destroyed in a

hurricane, an insurance company would want to know the actual

cost to replace it. The income method and the sales comparison

method are of little or no consequence in estimating replacement

costs. The insurance policy you have on your personal residence

most likely includes a replacement cost policy with built-in pre-

mium adjustments that automatically increase each year due to rises

in labor and material costs. Butler Burgher, Inc., an appraisal firm in

Houston, Texas, stated the following in an appraisal report that was

completed for one of my apartment projects.

The cost approach is based on the premise that the value of

a property can be indicated by the current cost to construct

a reproduction or replacement for the improvements

minus the amount of depreciation evident in the structures

from all causes plus the value of the land and entrepre-

neurial profit. This approach to value is particularly useful

for appraising new or nearly new improvements.

The replacement cost approach is most commonly used when

estimating the actual costs associated with replacing the physical

assets of a house or building. For example, for an office building

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Exhibit 8.1

Three primary appraisal methods.

1. Replacement cost method

2. Sales comparison method

3. Income capitalization method

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completely destroyed by fire, the value established from the cost

approach would be useful in helping to determine exactly how much

an insurance company would pay for the resulting damages.

An additional factor taken into consideration when the replace-

ment cost approach is used is depreciation, which encompasses

deterioration, functional obsolescence, and external obsolescence.

Deterioration is said to occur when property loses value because

of average wear and tear over a period of time. For example, a 10-

year-old roof that has a 25-year life is said to have deteriorated, or

depreciated, by 10/25, or 40 percent. Functional obsolescence is

described as a loss in property value resulting from outdated home

designs or mechanical equipment. The value of a house with only

gas space heaters rather than central heating, for example, would

be adversely affected. Finally, external obsolescence is described

as a loss in property value resulting from changes in the sur-

rounding neighborhood or community. For instance, the value of a

house would be adversely affected if it were located in a neigh-

borhood that had experienced a significant increase in crime. An

increase in traffic and noise levels may also contribute to a decline

in value.

The underlying rationale of the replacement cost approach is that

an informed buyer would not be willing to pay more for a particular

house than the cost of building an identical house on a comparably

sized lot in a similar neighborhood. The basic formula for calculat-

ing the replacement cost approach is as follows:

Replacement cost = cost of construction − depreciation

+ land value

Let’s look at an example. Assume the subject property is similar

in design, size, and quality to a new house that costs $100,000 to

build, not including the lot. The subject property is 30 years old and

has depreciated in value by 25 percent due to normal wear and tear,

as well as a general decline in the neighborhood in which it is

located. The value of the lot is estimated at $20,000. Using the

replacement cost approach, the value of the subject property is cal-

culated as follows:

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Replacement cost = $100,000 − ($100,000 × 25%) + $20,000

Replacement cost = $100,000 − $25,000 + $20,000 = $95,000

In this example, since the subject property has declined in value,

using the replacement cost approach indicates a value of $95,000.

This compares to a total value of $120,000 for a new house, which

includes a comparable lot, for a difference of $25,000, the amount of

loss suffered by the subject property from depreciation.

SALES COMPARISON METHOD

The second primary appraisal method is the sales comparison

method, or market approach, which is the method deemed most

appropriate for the proper determination of value for single-family

houses. This includes both owner-occupied and non-owner-

occupied single-family dwellings. The sales comparison method is

by far the most commonly used approach of the three methods,

because the number of single-family dwellings is much greater than

any other type of property. This method is based on the logic that the

price paid for recent sales of like properties represents the price buy-

ers are willing to pay and is therefore representative of true market

value. The price paid may vary for many reasons, including changes

in interest rates, changes in unemployment rates, changes in general

economic conditions, as well as changes in the cost of materials and

land. All of these factors combine to cause changes in the supply and

demand of available properties.

The sales comparison method is based on the premise of substitu-

tion and maintains that a buyer would not pay more for real property

than the cost of purchasing an equally desirable substitute in its

respective market. This method also assumes that all comparable

sales used in the appraisal process are legitimate arm’s-length trans-

actions to help ensure accuracy of the data used in the report. The

sales comparison method furthermore provides that comparable

sales used have occurred under normal market conditions. For

example, this assumption would exclude properties bought and sold

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under foreclosure conditions—that is, those purchased from a

bank’s real estate owned, or REO, portfolio.

The sales comparison method typically examines three or more

like properties and adjusts their value based on similarities and dif-

ferences among them. For example, if the subject property had a

two-car garage and the comparable property had a three-car garage,

an adjustment would be made for the difference to bring the values

more in line with each other. In this case, the comparable property’s

value would be adjusted downward to compensate for the additional

garage unit. In other words, the value of the additional garage unit is

subtracted to make it the equivalent of a two-car garage. Butler

Burgher provides further clarification of the sales comparison

method:

The sales comparison approach is founded upon the prin-

ciple of substitution which holds that the cost to acquire an

equally desirable substitute property without undue delay

ordinarily sets the upper limit of value. At any given time,

prices paid for comparable properties are construed by

many to reflect the value of the property appraised. The

validity of a value indication derived by this approach is

heavily dependent upon the availability of data on recent

sales of properties similar in location, size, and utility to

the appraised property.

The sales comparison approach is premised upon the

principle of substitution—a valuation principle that states

that a prudent purchaser would pay no more for real prop-

erty than the cost of acquiring an equally desirable substi-

tute on the open market. The principle of substitution

presumes that the purchasers will consider the alternatives

available to them, that they will act rationally or prudently

on the basis of their information about those alternatives,

and that time is not a significant factor. Substitution may

assume the form of the purchase of an existing property

with the same utility, or of acquiring an investment which

will produce an income stream of the same size with the

same risk as that involved in the property in question. . . .

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The actions of typical buyers and sellers are reflected in the

comparison approach.

According to Butler Burgher, the sales comparison appraisal

method examines like properties and adjusts their respective values

based on similarities and differences between them. This method is

most often used in valuing single-family houses. Recall that the

objective of using this method is to determine the subject property’s

value. Unlike the cost approach, which seeks to establish the cost of

reconstruction for the subject property, the sales comparison

approach seeks to establish its market value. Recall also that the

market value of a property is not the same as its price. The

appraiser’s objective is to determine a value that reflects the most

likely price a buyer is willing to pay for a particular property given

similar properties to choose from.

While the use of sales comparables, or comps, as they are also

referred to, is an important factor to consider in the analysis of esti-

mating the value of larger income-producing properties, greater

weight is usually given to the income capitalization method dis-

cussed in the next segment. The sales comparison method is

designed to examine and compare the physical attributes of real

property, not the income generated by it.

INCOME CAPITALIZATION METHOD

The third primary appraisal method is the income capitalization

method, used to value real property that generates some type of

income, which is employed for investment purposes. In Income

Property Valuation, author Kinard describes the process of capital-

ization as follows:

Real estate is a capital good. This means that the benefits

from owning it—whether in the form of money income or

amenities, or both—are received over a prolonged period

of time. Operationally, this means more than one year; in

fact, it is typically for 10, 20, 40 or more years.

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