What is Operating Ratio?

Mar 13, 2019 by

REPORT #3: What is Operating Ratio?

by Anthony Chara

Operating Ratio is a calculation that will tell you how efficiently or inefficiently an Apartment Complex is being operated.

Calculating the Operating Ratio is simple as long as you have all the correct figures to use. The two figures you need to calculate the ‘OR’ are the OE or Operating Expenses (TIMMUR), except your debt service/mortgage payments, and the EGI or Effective Gross Income.

In order to find the OR, you take the Operating Expenses (OE) and divide it by the Effective Gross Income (EGI). Example: OE / EGI = $57,542 / $136,291 = 42.2%. As a rule of thumb, the OR should be between 40%-50%. This will vary depending on several factors such as the age of the building, how recently it was rehabbed and the area of the country where the building is located.

We’ve found that buildings further north tend to have higher OR’s and buildings further south have lower OR’s. The more recently the building has been rehabbed or the newer it is the lower the OR will be too. Of course, that will also depend on how extensive the rehab was. If all someone did was throw on some new paint, replace an appliance and put in new carpet, your expenses will be higher. Now, if they put in all new appliances, new windows, new roof, new mechanicals (AC, boiler/chiller, elevator), new fixtures and/or new kitchens/baths, then your expenses will be lower.

How do you find out what the average OR is for the area in which you want to purchase? One way is to speak with several commercial brokers in that market that specialize in Apartments. We prefer brokers with a CCIM designation. You can find them at www.CCIM.com The second way is to speak with several Property Managers in that market. Another way is to go to the web site www.IREM.org and purchase the information from them. IREM conducts an annual survey of thousands of Apartment owners/managers nationwide and compiles a plethora of information that is extremely useful. The downside is that the report is several hundred dollars to purchase and it may not even include the market that your potential property is located in. You can also find CPM’s (Certified Property Managers) on the IREM web site that can tell you the average Operating Expenses too.

Once you know what the average Operating Ratio is in your market you can use that for comparison purposes. If the average should be between 40%-50% and you find a complex with an OR of 28%, it usually means that the seller is either hiding information or they are just very efficient. In some cases the owner maybe doing their own management and, therefore, they don’t include a management percentage which you will need to do. In other cases they literally are lying to you and trying to hide expenses which you’ll have to uncover during the due diligence phase if you get that far. We’ve seen several complexes that are over 40 years old with no recent rehab work completed where the OR was as low as 26.9% in one case and around 22% in another case.

On the other hand, if you find a complex with an OR above 50% that can mean some big bucks for you. As an example, if you find a property with an OR of 51% and the market average is 44% in that area, and, if you can get the expenses under control, then every dollar you save will literally go straight to your bottom line. However, we wouldn’t recommend buying the complex unless you can figure out why the expenses are out of whack beforehand. If you buy it first with the hope that you’ll be able to figure it out later, you may be in for a rude awakening.

Another reason I look for properties that have Operating Ratios above the market average is something called ‘Forced Appreciation’. In the example above, if I know prior to closing why the expenses are so high and know I can lower those expenses to or close to the market average, then not only does that produce more cash flow for me, but it also increases the value of the property via Forced Appreciation. Let’s say I lower the expenses by $500 per month. Number one, my NOI (Net Operating Income) will increase $6000 per year. ($500 x 12 months = $6000) That also equates to $6000 more in my pocket. Via Forced Appreciation, if my property is in an area that has an average Cap Rate of 10% and my NOI just increased by $6000, then the value of the property just went up $60,000!!! Here’s why; a $6000 increase in NOI divided by the Cap Rate of 10% equals $60,000. ($6000 / .1 or 10% = $60,000)  What if my property is located in an area with a CR of 8%? $6000 divided by 8% equals $75,000. ($6000 / .08 = $75,000). That’s the power of Forced Appreciation at work. Try doing that with a Single Family Home!

Another great thing about Forced Appreciation is that it’s in effect anytime your NOI increases. What if you had a 30 unit property and increased the rent on each unit a whopping $10 per month? That would equate to an annual increase of $3600. A $3600 increase in NOI, divided by the market Cap Rate in your area, let’s say 10%, equals an increase in value of $36,000. What if your market Cap Rate is 8%? That means your equity just increased to $45,000. (30 units x $10 x 12 months = $3600 / .08 = $45,000)

I love apartment buildings!!!

Anthony Chara is managing member of Apartment Mentors and founder of Success Classes. He has owned or managed several successful multi-million dollar companies during the last 20+ years. Anthony owns properties in Arizona, Colorado, Florida, Georgia, Iowa, Kansas, Nevada, Ohio, Oklahoma, Pennsylvania and Texas.  Anthony is the Keynote Speaker at the Georgia Real Estate Investors Association (GaREIA) General Meeting on March 11, 2019. He also is teaching a 1-Day Workshop on March 30, and a 4-Day Boot Camp June 6-9, 2019. Visit GaREIA.com for more details!

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What is Cap Rate and how does it affect the value of an Apartment Complex?

Mar 4, 2019 by

REPORT #2: What is Cap Rate and how does it affect the value of an Apartment Complex?

There are 3 figures that go hand-in-hand when trying to determine a commercial/apartment property’s value. They are; Net Operating Income (NOI), Cap Rate (CR) and Asking Price or Purchase Price (PP). If you know 2 of the figures you can always figure out the third.

Here I’ll be talking about the Cap Rate of a property. More specifically, how the Cap Rate works in conjunction with the Net Operating Income (NOI).

Let’s get started. First off, Cap Rate is short for Capitalization Rate. In short, Cap Rate is, “The process of converting anticipated future income into present value” according to the American Heritage Dictionary. It’s also your rate of return if you bought your property using all cash.

Here’s an example: If I purchase an Apartment Complex for $1M and it generates a Net Operating Income at the end of 1 year in the amount of $100K, then my Cap Rate is 10%. The formula for Cap Rate is:

CR = NOI / PP

Cap Rate (CR) = Net Operating Income (NOI) divided by the Purchase Price (PP) of the complex. Therefore, if we plug in these numbers: $100,000 / $1,000,000 = .1 or 10%. If this same complex generated $90K in NOI, its Cap Rate would be $90K / $1M = .09 or 9%. Lower income, lower Cap Rate, but the Purchase Price stayed the same.

Knowing the Cap Rate allows us to accomplish several things. First, it allows us to determine the value of the property. Second, it allows us to compare our complex to other similar complexes in the same geographical area. Lastly, it allows us to compare the ‘Cost of Money’.

In our example, our complex had a Cap Rate of 10%. If I research the average Cap Rate in a market, I want to make sure our complex falls within the average or slightly above the average Cap Rate. Let’s assume we’re purchasing a complex in Dallas. We research the area and find the average Cap Rate to be between 9%-10% for similar complexes. How does our complex compare? It’s on the high end of the average. This is potentially a good thing assuming the number’s we’re analyzing are accurate. I’ll get into that topic in another article on Due Diligence. But, for right now, let’s assume they are accurate.

One quick thing to remember, since Cap Rate is relative to the Income being generated by our complex, the higher the Cap Rate the better, when we’re buying. Think of it this way, if you had $100,000 to invest and you chose to put it into a bank savings account or CD, would you rather make 10% on your money or 8%? If both banks were equal in quality, reputation and safety, you’d probably pick the one paying 10%.

Now, let’s assume our Cap Rate was at 8% in the same market. The average market Cap Rate was 9%-10%. Is this a good deal? Probably not. You may be over paying for this complex. Would you want to purchase a $1M Apartment Complex and generate $100K a year or only $80K a year? You’d pay the same purchase price, but get a lower return.

A question you’re probably asking yourself right now is, “How do I learn what the average Cap Rate is in a market”? Good question. And the answer is, “Ask”. Contact 3-4 commercial RE Brokers and/or commercial financiers in that market and ask them. Tell them the type of complex, geographical area and quality of the complex and they should be able to give you a one half to one point average. In other words, they’ll tell you that Cap Rates range from 8%-8.5% or 9%-10% or 7.75%-8.25% or 6.5%-7.5% and so forth. Most, if not all of the people you speak with should be in the same ballpark. However, you may find that after you speak with 3-4 people, the overall range maybe slightly broader than one half to one point. i.e. 7%-8.5% or 7.5%-8.75%. You’re just looking for an average. There are other sources available to research the Cap Rate in a market too, but this is a quick, efficient way to get your bearings.

In our first example, we used our NOI and our PP to determine the Cap Rate. Then, we used the Cap Rate to compare our complex to other complexes in the area. But how about this; what if we want to refinance the complex or figure out the value for our own personal balance sheet, what then? Easy, we just swap two parts of the equation to solve for the third.

As you recall, the formula for Cap Rate is CR = NOI / PP. If we know 2 of these values we can figure out the third. In this second example we want to determine value. To do this we just modify the formula slightly to

NOI / CR = PP

Using our first example, let’s look into the future to see how we’re doing. After 5 years our NOI has increased from $100,000 to $127,600 per year assuming a modest 5% increase each year. The Cap Rate in the area is 9.5%. What’s the current value of our complex?

$127,600 NOI / .095 (9.5%) CR = $1,343,000 PP

Therefore, the value of our complex is now approximately $1,343,000. Not a bad return. What if the Cap Rate had remained steady at 10%? It’s the same formula. $127,600 / 0.1 (10%) = $1,276,000. That’s still not a bad return.

If our complex were generating an NOI of $108,555 per year and the Cap Rate in the area where this complex is located ranges from 8%-8.5%, what is this building worth? Break out your calculator; you should be a wiz at this by now!

NOI / CR = PP

$108,555 / .08 = $1,356,938

$108,555 / .085 = $1,277,118

This building’s value ranges from $1.277M on the low end to $1.357M on the high end. Did you notice that as the Cap Rate increased, the value of the building went down? That’s why you’re looking for a higher Cap Rate when you purchase. However, you want a lower Cap Rate when you sell. It’s not like you can just decide to lower the Cap Rate when you want to sell your complex though. The Cap Rate is driven by the sales averages in that market which are driven by the type of return buyers want for their investment.

It’s not uncommon to find Cap Rates in the 3%-4% range in San Francisco or New York City or 8.5%-9.5% in Kansas City. In larger metropolitan areas such as San Fran or New York, buyers pay higher prices because there isn’t anywhere left to build. They can command top dollar for rent in those markets. If the buyer wants to increase the value of their complex, they just increase the rent because they know they literally have a captive audience.

In places like Kansas City or Dallas, there’s room to build so it’s much more difficult to raise rents. Once the vacancy in an area drops below a certain level, a developer just comes in and builds another complex. There’s so much competition, it’s difficult to raise rents. The only way a buyer can get more bang for their buck is to pay less for the complex up-front. Thus, the Cap Rate is higher.

There are several things Cap Rate is used for. First, it is to determine the value of the property. Second it is to compare our complex to similar complexes in the same market. The third is to compare the Cap Rate to the Cost of Money. Many people don’t know about this concept, but you’re about to find out and it could save you thousands or tens of thousands of dollars a year.

The Cost of Money in a nutshell is, “How much is the money you’re borrowing to purchase this complex costing you”? The true Cost of Money, also known as the Loan Constant, is NOT the interest rate by itself, but for this example I will only talk about the relationship between the Cap Rate and the Interest Rate. This is where a lot of novice buyers get into trouble. If you’re purchasing a complex with a Cap Rate of 7%, but your loan is at 8% interest per year, you could still have positive cash flow, but you’re literally losing money on the money you’re borrowing. This is called ‘Negative Leverage”.

We recommend that whenever you purchase a complex you almost always want to look for a minimum 2 point spread between the Cap Rate and the Interest Rate on your loan. In other words, let’s say you find a great complex with a Cap Rate of 7.5%. That means the Interest Rate you are borrowing money at should be no higher than 5.5%. Not an impossible rate to find, but there may be some prohibitive terms connected to it. We’ll save that for another article.

Let’s look at this from another direction. What if you find your financing first and the Interest Rate is set at 6.5%? Using this information, what’s the minimum Cap Rate you want to look for when trying to find a complex to purchase? I hope you said 8.5% or higher! The larger the spread the more money you can make.

Again, if you find a good complex with a Cap Rate of 9%, what is the maximum Interest Rate you want to pay? That’s right, 7% or lower. If you only remember one thing about Cap Rate after reading this article, I hope it’s this part about maintaining a 2 point spread between the Cap Rate and the Interest Rate on your loan.

This concept also comes in handy when trying to negotiate the interest rate on a seller carry-­back loan. Many sellers will want you to pay top dollar in interest, maybe 8%-10%. I’ve used this concept to explain to sellers why I can only pay them 6% interest. It’s because I’m buying their complex at an 8 Cap and if I pay them more than 6% I’d be losing money. Many of them are understandable at that point, many are not. But, as an Apartment Investing mogul, it sure adds to your credibility with the seller when you can explain this to them.

Anthony Chara is managing member of Apartment Mentors and founder of Success Classes. He has owned or managed several successful multi-million dollar companies during the last 20+ years. Anthony owns properties in Arizona, Colorado, Florida, Georgia, Iowa, Kansas, Nevada, Ohio, Oklahoma, Pennsylvania and Texas.  Anthony is the Keynote Speaker at the Georgia Real Estate Investors Association (GaREIA) General Meeting on March 11, 2019. He also is teaching a 1-Day Workshop on March 30, and a 4-Day Boot Camp June 6-9, 2019. Visit GaREIA.com for more details!

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How to Determine the Net Operating Income (NOI) of an Apartment Complex

Mar 3, 2019 by

REPORT #1: How to Determine the Net Operating Income (NOI) of an Apartment Complex

by Anthony Chara

There are 3 figures that go hand-in-hand when trying to determine a commercial/apartment property’s value. They are; Net Operating Income (NOI), Cap Rate (CR) and Asking Price or Purchase Price (PP). If you know 2 of the figures you can always figure out the third.

I will be talking about the NOI of a property. More specifically, how NOI is calculated as it relates to an apartment building.

We are going to start with a simplified version of how to arrive at the NOI of a property and then expand each category. Basically, the formula is: Income -Expenses (other than debt service) = Net Operating Income.

INCOME:

First thing, I determine the income generated by the property. I start with the Gross Potential Rental Income (GPI) or Scheduled Gross Rental Income (SGI). Both terms are used interchangeably within the industry. The GPI assumes that all apartments (100%) are rented at full market value even if some are actually vacant or discounted.

For our example, I will use a 30 unit apartment building that has all 2 bedroom, 1 bathroom units with market rents of $600 per month each. Therefore, the GPI of this complex as an annual figure will be: 30 units x $600/month = $18,000/month x 12 months = $216,000 per year of Gross Potential Income.

The second step in the equation is to determine the vacancy of the property, both physical and economic. If you have a 30 unit complex and 3 units are vacant, the vacancy is 10% (3/30 = .1 or 10%). I will not be calculating economic vacancy in this calculation due to some of its complexities. However, economic vacancy can include a few factors such as a tenant leaving in the middle of the month (or night), a non-paying tenant or ‘incentives/concessions’ given to a tenant to induce them to move in such as ‘Free Rent’ or reduced rent for a certain period of time.

For this example, I’ll use the 10% vacancy factor. Therefore, if we assume that 3 units will be vacant every month for the entire year, we would reduce our Income by $21,600. ($216,000 GPI x 10%) Keep in mind that even if you do have 3 units vacant the entire year to achieve this 10% annual rate, it may not actually be the same exact 3 units that are vacant. The vacant units will typically rotate throughout the year as tenants come and go.

The next factor we want to look at is ‘Other Income”. The most common form of Other Income is from on-site laundry facilities. Other types of Other Income can include vending machines or even cell phone towers. We add this income into our calculations to arrive at a value called ‘Effective Gross Income’ (EGI).

Let’s assume that our annual Other Income in this example is $3,120. This is how our Annual Property Operating Data (APOD) or Financials will appear if we only looked at the Income section.

INCOME

GPI                     $216,000

Vacancy 10%     ($21,600)

Other Income       $3,120

Effective Gross Income   $197,520    (GPI – Vacancy + OI = EGI)

EXPENSES:

Now, it’s time to focus on the Expenses associated with a complex. I will talk about the Debt Service (Mortgage Payments) in another article in greater detail. Debt Service is not taken into account when determining the Value of a complex. Some buyers may pay all cash, some may ‘exchange’ into this complex from another one and only need to finance 50% or so of the purchase price and others may need to finance more. Debt Service is not considered an Expense as it relates to NOI. It is, however, used by a finance company to determine another very important factor called Debt Service Coverage Ratio (DSCR) which I will cover under the Debt Service article.

Expenses can be summarized within 6 major categories which are; Taxes, Insurance, Management, Maintenance, Utilities and Repairs. (TIMMUR). Within each of these major categories there are subcategories, but I will only be referring to the major categories in this article.

Depending on the age, quality of the complex and when the last rehab was completed, the expenses will generally range from about 40%-50% of the EGI. For a complex which is considered ‘All Bills Paid’ (see utilities paragraph below) the expenses will generally range from 50%-60% of the EGI.

Taxes are the property taxes associated with the complex. The amount as a percentage of Effective Gross Income (EGI) can vary widely depending on the state in which the property is located and the value of the property. The seller can provide you with the amount of property tax they’ve paid during a calendar year. You may also be able to determine the amount through on-line resources such as accessing your county Tax Assessors web site. You can even have your Title Company supply this information to you once your contract is accepted and you start due-diligence prior to closing.

One thing you need to be careful about is if and when a reassessment from the sale will occur and how it will affect the property tax for this property. I would highly recommend that when you get to your due-diligence phase prior to closing, you get an estimate of what the taxes will be based on the new purchase price of the complex and use that figure in your calculations.

It’s not uncommon to have a complex that was purchased quite a few years earlier being taxed at a greatly reduced rate. When you purchase the complex, many states will reassess the property and start charging you based on the new value and you could find yourself in sticker shock. Always get an up to date estimate prior to closing from the tax assessor’s office if possible.

Insurance is pretty obvious too. This amount will vary too depending on the insurer, the state the property is located in, your experience with this type of property, how many other units your insurer is already covering for you and the type of coverage you need. Make sure you get a good policy from a reputable company. Many times your best source is to stick with the company that is currently insuring the complex. They know the building and its history. They know whether or not any claims have been filed against the property. Always get 3 estimates anyway, including one from the current provider. Providers other than the current insurer still have access to a database that will inform them of any current or prior claims against the property or policy.

The nice part about a good policy is that if something does happen to the complex, it will pay you the lost rental income while the repairs are being performed, along with helping the displaced tenants find alternative accommodations. Ask the agent for detailed information about the policy’s coverage.

Management is the person or company that will manage your tenants. I know they are called Property Managers, but the reality is that 80% of what they do is managing the tenants. I highly recommend you use a third party company to manage your tenants and not do it yourself. Why would you want to anyway? If you purchase the property the right way, you would have already calculated in the cost of management and the complex should support itself. If it doesn’t, I suggest you find another property. If the only way the property will cash flow the way you need it too is for you to manage the property yourself, go find another property. There are plenty of them out there.

Don’t always go with the company that charges the least amount. Check around. Ask for references from other owners, RE brokers or even your finance company. Good or bad, the word does spread in a community as to who to use, and more importantly, who not to use.

Management fees are determined by the size of the complex and competition in a given area. On a 30 unit complex you could pay in the range of 5%-8% of the monthly rents. Make sure the fee is based on the ‘Collected Rent’ and not the ‘Scheduled Rent”. This gives the Property Manager an incentive to collect the rent. If they don’t collect it, they don’t get paid.

Maintenance/Repair: Rather than getting into a long discussion over what the difference is between Maintenance and Repairs, I’ll spend this time talking about the difference between R&M and Capital Expenditures, sometimes referred to as ‘Cap Ex’.  Considering the IRS looks at R&M as pretty much the same, don’t worry about it. If you have a nagging desire to learn more, call the IRS or just ask your CPA. My CPA just spreads out the expenses over both the R&M categories unless the price of one item/repair is above $1000. If it is, it may be considered a Cap Ex expense and the item/repair may need to be depreciated over a number of years.

Here are some things you’ll find under the R&M category; cleaning the carpet, replacing the carpet, mowing the lawn, replacing a broken window, light bulbs, unclogging toilets, fixing a hot water heater or replacing an AC unit, painting a unit, clean up of a unit, replacing a faucet or toilet; pretty much anything that you would typically repair or maintain during the life of the property on a routine day in and day out basis.

Capital Expenditures are where things can get a little tricky. What if you repair a hole in a roof and the cost is over $1000? Talk to your CPA. Mine will typically consider that a repair even if it’s slightly over $1000. However, if you replace an entire roof or all the roofs in the complex, that becomes a Cap Ex expense and the cost will need to be depreciated over time. Other items that would be considered Cap Ex would include replacing a boiler system, painting or residing the entire complex, redoing the landscaping, completing a major rehab project in which the individual pieces might all be less than $1000, but when added up costs tens or hundreds of thousands of dollars. The nice part is that Cap Ex doesn’t affect the NOI of the property. Thusly, the value of your property doesn’t drop due to some large expense like replacing the entire roof or rehabbing multiple units or the entire complex.

Maintenance and Repairs combined will average between 5%-15% of EGI depending on the age of the complex and how long it’s been since the last substantial rehab performed. Another factor that will affect where a complex will fall within this range is weather. Typically, properties that are in colder winter climates will drift towards the higher range. The warmer the climate, the lower it will gravitate. For our example I am estimating 5% for Maintenance and 5% for Repairs for a combined total of 10%.

Utilities will include, at minimum, the gas, electric and water used on the common areas of the property like the hallways, leasing office, laundry room and landscaping. Some complexes are considered ‘All Bills Paid’ which means the owner pays for most or all of the utilities, even those used directly by the tenants. The downside to this situation, which you’ve probably already figured out, is that you have little or no control over the energy consumption of your tenants. It’s not uncommon to see a tenant’s window open in the dead of winter with the heater running full blast. Most owners will try and do what they can to pass this expense onto the tenants. Sometimes that’s not easy.

You may or may not be able to charge a portion of the utilities back to the tenants. It really depends on what the market will bear. Fortunately, most new owners are doing what they can to charge the tenants. For our example, we are going to assume we are only paying for the common area utilities to include electricity for the hallways, laundry room and outside lighting, plus water for the landscaping and laundry room.

Repairs: See Maintenance above

After determining your expenses your revised APOD will look something like this:

INCOME
GPI $216,000
Vacancy 10% ($21,600)
Other Income    $3,120
EGI $197,520
EXPENSES
Taxes $22,105
Insurance $8,592
Management $13,826
Maintenance $9,876
Utilities $24,690
Repairs    $9,876
Total Operating Expenses $88,965 (45.04% of EGI)
NOI = EGI-Op. Exp. $108,555 (54.96% of EGI)

 

Subtracting your total Operating Expenses (OE) from your Effective Gross Income (EGI) leaves you a Net Operating Income (NOI) of $108,555. This is a very important figure to know because it will allow you and your finance company to determine the value of the complex you’re thinking about purchasing or refinancing. The finance company will take your NOI, and, along with the average Cap Rate for similar properties in the area to determine a value range for your property.

Anthony Chara is managing member of Apartment Mentors and founder of Success Classes. He has owned or managed several successful multi-million dollar companies during the last 20+ years. Anthony owns properties in Arizona, Colorado, Florida, Georgia, Iowa, Kansas, Nevada, Ohio, Oklahoma, Pennsylvania and Texas.  Anthony is the Keynote Speaker at the Georgia Real Estate Investors Association (GaREIA) General Meeting on March 11, 2019. He also is teaching a 1-Day Workshop on March 30, and a 4-Day Boot Camp June 6-9, 2019. Visit GaREIA.com for more details!

 

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From the Archives: A Guide to Real Estate Investing in Georgia (Part 2)

Dec 1, 2017 by

*** This article was first published in the Georgia Real Estate Investors Association Handbook in 2001. Some specific details (i.e. prices and tax information) are out of date, and should be viewed with that in mind. If you are interested in learning more about the concepts covered in this article, please visit www.gareia.com, or contact us at [email protected] or at 770-451-8800. ***

(Continued from November’s blog post “From the Archives: A Guide to Real Estate Investing in Georgia (Part 1))

Purchase Strategies

The primary goal of this program is to control an asset worth a large amount of money while using little or none of your own money. You hope that, eventually, that asset will go up in value, and in the meantime, you are paying it off using other people’s money again (rental income). That being said, you find that time is on your side in almost every real estate situation. Eventually, the property will be worth more than it is today. The one exception to that theory is a property in a bad location. Almost every problem that arises in a real estate investment can be improved – but a bad location is out of your hands. Experienced investors recommend that you NEVER buy a property in a bad location.

Creative financing revolves around the creation and use of “paper,” which is really nothing more than a formal IOU or a “Note.” You can “create” thousands of dollars by simply agreeing to pay at a later time, either in installments or in a lump sum, or a combination of the two. The most common note is a conventional thirty year mortgage, where you agree to pay back money in monthly installments of principal plus interest over 360 months. There is no magical requirement that a note have any interest or even any payments, for that matter. Successful investors believe in the GOLDEN RULE, when it comes to real estate negotiations. If you will do unto others as you would have them do unto you, you will find that you are more successful over the long-haul. In addition, people will want to do business with you.

It is critical to discover the underlying reason that the seller needs to sell. If you can meet those needs creatively, then the opportunity exists for you to have a WIN/WIN transaction. If that opportunity does not exist, or if the seller is not willing to give you the chance to help, then it may be time to move on to the next house for sale. Remember, the seller has only one house to sell – you have literally tens of thousands to buy.

The major areas of flexibility the seller can control are price, repayment terms, interest rate, amount of cash needed at closing, and date of closing.

It is important to try to limit the amount of hard cash going into every transaction, because once you have run out of money, you must forego any future opportunities, no matter how good.

The ideal scenario is one in which the lender will allow you to assume the mortgage, and the owner will sell you the house and carry back a second mortgage for their equity. You must determine how much their equity is worth to you.

If you plan only to buy a house, fix it up, then sell it for a profit, and you have the cash to get started, then you are well advised to use your cash. When you sell, you will be able to get all your cash out, plus your profit, and you can go on to your next deal.

Renovation Techniques for Optimal Profit

Your goal in any real estate investment is to own the least expensive home in the most expensive neighborhood you can afford. If that is the case, then the principle of progression says that the more expensive homes will appreciate at a relatively faster rate than your house, and they will pull your house along with them, giving you optimal appreciation.

Likewise, don’t put so much money in the house that you can never recoup your investment. Be very careful to estimate your improvements accurately in advance, and don’t fall prey to the desire to add on and add on. You can run up a rehab bill dramatically if you don’t watch every penny.

You also need to decide before you start your renovation whether you plan to hold for rental or you want to sell quickly for profit. Because most renters think of their residency as relatively short term, they are willing to accept less in terms of improvements than a buyer will. There is no need to make a rental property fabulous – it simply needs to be reasonably attractive and competitive with the tenants’ alternatives.

On the other hand, if you plan to renovate and resell, you’ll have to add some real pizazz. Visit all the homes that are currently for sale in the area, and see what your competition is like. There is no need for you to vastly exceed what the competition is offering, and you’ll never get the money back if you do. Costs add up quickly, and buyers today expect things to be in good condition. So make sure that you first budget for fully repairing essential items before you spend all of your improvement money on the pizazz. Don’t forget that all buyers will likely hire a professional inspector to go over your offering with a fine-toothed comb. That means you already should have done so!

Resale Strategies for Investors

There are several considerations that must be taken into account if you decide to sell your property quickly.

If you hold the property for less than one year, the profit you make will be considered a short term capital gain, and you will have to pay a large portion of your profit as taxes. Current short term capital gains tax rates are identical to earned income rates, so you will likely be in the 28% bracket or higher.

 

If, on the other hand, you can hold the property for more than 18 months, the profit qualifies for long term capital gains treatment. Currently, ling term capital gains (LTCGs) are taxed at a maximum 20% rate.

 

There are only three reasons why any property won’t sell. Most problems in selling are a variation on one (or more) of the following:

  • It’s not ready to be shown.
  • It’s not being marketed properly.
  • It is priced too high.

One of the best resources for persons interested in owning and managing rental and investment properties is the Georgia Real Estate Investors Association, Inc. We are a non-profit educational organization that serves our members with programs on various real estate topics. For more information about our meetings, call 770-451-8800.

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This article first appeared in the Georgia Real Estate Investors Association Handbook in 2001. Some specific details (i.e. prices and tax information) are out of date, and should be viewed with that in mind. If you are interested in learning more about the concepts covered in this article, please visit www.gareia.com, or contact us at [email protected] or at 770-451-8800.

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Published by Georgia Real Estate Investors Association

Copyright 1998 by First American Management Corporation, All Rights Reserved

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