Today is Day 22 in our drive to freedom. We have two properties under contract that we are actively marketing, and we are getting calls each day on both. Hopefully it’s just a matter of time before they are sold.
Now, today we are going to dive back into our series on the Anatomy of A Deal. In Part 1 we talked about how to find properties and qualify sellers. So now that you have found a property and you have qualified the seller, it is time to run the numbers to see if it truly is a good deal.
When looking at any investment, you should always ask yourself WHAT IS MY RETURN ON INVESTMENT? Your return on investment (ROI) can be described by a simple formula:
ROI = R / I
Where R = Gross Return, I = Amount Invested
ROI is always calculated on an annual basis, so if your numbers are not based on 1 year, you will need to adjust them so they are based on 1 year.
Now, there are several ways to make money on each property and you can break them into the following categories:
- Depreciation (Tax Benefit)
- Interest Deduction (Tax Benefit)
- Principal Loan Reduction
We will talk about each of these briefly.
Cashflow is the income that is produced by a property after all expenses including debt service are paid. When calculating cashflow, many make the big mistake of just subtracting their mortgage payment, taxes & insurance (PITI) from the rent and call that cashflow. However, as an investor you need to be aware that there are many more expenses involved with the operation of a rental unit. The following expenses should also be included when calculating cashflow:
- Property Management
- Pest Control
- Legal Fees
- Office Supplies
- Association Fees
You can see this is a significant list, and in many cases the tenant may pay for some of the expenses (like utilities), but you should at least consider each of them. So, to calculate the cashflow, simply take the rent and subtract all of your expenses, mortgage payment, taxes and insurance.
Appreciation is simply the amount of money made on a property that is bought and sold.
Now, appreciation can be natural or forced. Natural appreciation is just the gradual increase or decrease in a property’s value due to market conditions. (Note, appreciation can be negative.) Forced appreciation, is where you are forcing the property to appreciate. An example of this is when you rehab a property. You buy it in a distressed state, and when you fix it up, you force the property to appreciate.
Now, with any exit strategy that involves selling the home (i.e. not renting) then you need to determine how much you are going to be able to sell the home for. If you are rehabbing, this is referred to as the after repair value (ARV). If you are wholesaling, you need to understand what kind of discount your end buyers are expecting to purchase for. If you are doing a lease option, you need to understand what the market appreciation is to determine what the option price should be at the end of the lease.
Now, I will make a few comments on After Repair Value (ARV) which is the value you will want to establish if you are rehabbing or wholesaling a property. To determine ARV, you need to look at what homes in the area have sold for that are similar in age, size and construction. Normally we like to have at least 3 comparable homes that we can calculate an average price per square foot. We then apply this price per square foot to the home we are looking at to arrive at the value. Normally, we also like to go and look at the comparable homes to get first hand knowledge of them to determine if the number we are calculating is a good number. If we seen things that make the comparable homes better or worse, we may adjust our number from their.
I will also mention that you should not forget about other costs that may be involved with the deal. For example closing costs, holding costs and repairs should all be figured into your calculation on appreciation.
So, to calculate appreciation, take what you expect to sell the propety for and subtract what you have put into the property including purchased price, repairs, holding costs, and closing costs.
You’re probably thinking that depreciation doesn’t sound like a good thing…and how the heck am I going to make money from it? Well as it turns out, depreciation is a very good thing. In fact, for many sophisticated investors it is their favorite form of income from an investment property because it can literally turn the return from red to black.
So what is it? Well, in an effort to encourage investment in real estate, the Federal Government has setup a tax deduction where you can deduct the depreciation of an investment property. In actuality, the property may be increasing, but it does not matter. This is referred to as a paper loss, because you didn’t actually lose the money, but the government is allowing you to take the deduction.
Now, there are rules on how the deduction is calculated and how much you can deduct, and I encourage you to consult with your tax accountant on this. For practical purposes however, I will give you some rules of thumb.
- For residential property, you can depreciate the property over 27.5 years.
- For commercial property, you can depreciate the property over 39 years.
- Generally depreciation is limited based upon your income and/or your profession. Speak with a tax accountant about this. (One hint: Ask how to be classified as a real estate professional because if you can, there are virtually no limits on the depreciation deduction you can take)
- Only the improvements to the land are deductible. The land is not. A good rule of thumb is about 75% of what you paid for the property and improvements is deductible. Again speak with a tax accountant on this.
- You must have income to deduct the depreciation against, in other words, if you have no income, you cannot take the deduction.
Now, to calculate the depreciation on a property you can use the following formula
Depreciation = 75% x B x T
B = Basis (amount you purchased the property plus any improvements made)
T = Federal tax bracket you are in
Again I will mention that this calculation is a rule of thumb and you will need to speak with your tax accountant to get the absolute amount you can deduct. This calculation will get you pretty close though.
Many are aware of the interest deduction that is taken against their personal homes, and it works pretty much the same way with investment property. The interest paid on debt service used to purchase the real estate is generally deductible. To calculate this you can use the following formula:
Interest Deduction = I x T
I = Interest paid
T = Tax
Principal reduction is just simply the amount your loan is reduced over a 1 year period. You can calculate this using an amortization table of your loan by looking at what the principal loan balance after 1 year compared to the original loan balance.
Putting it All Together
I understand that this is a lot of information to put together. I would recommend you put together an Excel spreadsheet to make these calculations to avoid mistakes.
In the Parts 3-5 of this series we will go through example calculations on how we analyze specific types of deals – wholesales, rehabs, & rentals. Stay tuned…