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By Katherine Chiglinsky
June 9, 2016
posted on .bloomberg.com
Now let’s wrap the amortization into our example. Using the loan terms I mentioned, the first year of the loan will result in a $14k reduction in the amount you owe.
If the property value stays the same, that can also be seen as a $14k increase in equity. If we add that $14k to the after-tax cash flow, we are left with an all-inclusive after-tax return of 22.4%.
In this example, we assume the value of the property will not go up in value one cent — which is smart because assuming is another word for speculating, and speculating is risky investing. However, in multifamily (5+ units) or other commercial investment real estate, the value of the property is based on the income the property produces. The wealthy love to control things — this is exactly why the wealthy focus on commercial property such as multifamily apartment complexes.
Being that you control the income and expenses in a property, you also control the value. What this means is if you have a way to increase income either by raising rents, billing residents back for utilities, or adding any other source of ancillary income to the operations of the property, you will also add value. Also, the flip side of the equation is if you decrease expenses by renegotiating operating expense costs, billing residents back for utilities, reducing turnovers and vacancy, putting in energy efficient light bulbs and plumbing fixtures, or ANY other way to cut operating expenses, you increase the value of your property.
Increasing Multifamily Value
So let’s look at our example one last time. Say this $1M building was a 20-unit apartment complex. The reason you bought this complex was because you’re smart and you saw opportunity in it
— the opportunity to add value by both increasing income and decreasing expenses. Nothing major, just a few things you could do right after purchasing to help the bottom line.
Before purchasing, you noticed that the previous owner had owned the building so long, they had not been keeping up with market rents. You noticed similar units in your area rent for $900-925, but yours were only renting for $850. Being that all the residents were on month to month leases, you went ahead and implemented a minor $25 a month increase in rents to all units in month one. You wanted to keep rent below market so you wouldn’t lose your residents but thought that was still fair to everyone. This added $5,700 (20 units x $25 x 12 months – 5% vacancy allowance) of income to your bottom line annually.
Another opportunity you wisely saw was in vendor costs. Over the past 20 years, the vendors had slowly crept prices up above market rates for their services. The previous owner was comfortable with the properties operations and had a good relationship
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with his vendors so they never bothered to check the going market price.
Day one of owning the property, you were able to negotiate the following monthly expenses down:
Monthly dumpster fee from $110 to $95 — an annual savings of $180
Per cut grass cut expense from $150 to $100 — an annual savings of $1000
Property management fee of 8% down to 7% — an annual savings of $1,600
This all doesn’t seem like much, and was really simple to do. Let’s see how it effects the returns in our example.
what-is-wholesaling
After increasing income $5,700 a year and simultaneously decreasing expenses $2,780 you were able to increase the money you put in your pocket $8,480. The extra cash is nice, but the real power behind this is the fact that commercial real estate is valued based off the income it produces. Since you increased the income the properties produces, you also increased its value.
Let’s look at how this affected our example. Your property still is in the same market and asset class that awards it with the same capitalization rate of 8% that you bought it for. Now that you have found ways to add $8,480 to the net operating income, this gives you a total net operating income of $88,480. By dividing the net operating income by the cap rate, we can find the new value of the property.
$88,480/.08 = $1,106,000.
That’s right! Making those minor changes increased the value of your property $106k.
Your mortgage didn’t change, so you still owe the same — you simply raised the equity you have in the building $106k without putting a single dollar more into the investment.
New & Improved Totals
To find what the all inclusive return is now that you have added value, add $8,480 you your taxable income, which will result in an additional $2,968 due to the tax man. This takes your new and improved total after tax cash flow to $36,472 — or an after tax cash on cash return of 18.2% Add in your total $120k equity accrued in year one ($14k from amortization and $106k from forced appreciation), and you have an all inclusive return of 78% (($36,472 + $120K)/$200k).
Now that you found a way to make all this money, you may be thinking the taxes will hit hard once you sell the property. My first response is, “Why sell it?” This is a fantastic property. Hold on to this cash cow, milk it, pull all the equity out in a cash out refinance, which is not a taxable event, put it in a trust, and hand it off to your heirs.
Or if you love the velocity of money and are looking for the biggest bang for your buck, sell it. But do so in a 1031 exchange, which defers all tax into the next property purchase. Do this until you die, and the taxes die along with you.
And that is how the wealth is built in real estate.