Investment in Real Estate Residential and Commercial

Investment in Real Estate Residential and Commercial Mohammad (Mo) Tehrani, Ph.D., CPA motehrani@scorehouston.org tehrani@tehraniandassociates.com Meeting by Appointment: 713 845 2424 Office Hours: Location: SCORE Houston 1

Investment in Real Estate Residential and Commercial Part One Why Investing in Real Estate Types of Real Estate Economic Cycle and Real Estate Speculation in Real Estate and Consequences Potential Profits from Real Estate Investment and Role of Leverage Part Two Financing Real Estate investment Terms Real Estate Loan Origination Types of Real Estate Loans Risk and Commercial Real Estate Required information for a Real Estate Loan SCORE Houston 2

Real Estate Investment There are a twofold approach to accumulating wealth: Saving as much as possible Could loose value on the long term (reduced purchasing power) Embarking on a long-term Investment Investment in Stocks, Bonds, Collectable, Real Estate, etc. Real estate is superior to other investments and has both advantages and disadvantages: Advantages - 1. It is not subject to daily price fluctuations, as stocks are 2. The relative difficulty of buying and selling encourages investors to hold on for a long-term (capital intensive) 3. An investment in real estate provides a return of 5-10% per year 4. It provides tax benefits through depreciation 5. It provides liquidity through refinancing (appreciated property and payoff of mortgage) and rental income SCORE Houston 3

Real Estate Investment Con. 6. It is an excellent hedge against inflation, its value tends to rise more than inflation. 7. Leverage Can be financed up to 80% of purchase price. Disadvantages - 1. Real estate value, like stocks are subject to ups and downs of economy 2. It is not a liquid assets and should be done with surplus asset 3. Real estate requires more hands on management than stocks Investment in Real Estate is different from Fixer Uppers. The purpose of Fixer Uppers is to buy, remodel as quickly as possible with the lowest cost and then selling it as soon as possible. Investment in Real estate is a long-term goal (3-5 years) investment, which bring regular cash flow (through rent and refinancing) and building equity. SCORE Houston 4

Types of Real Estate Real estate investment can be classified into several categories: 1. Personal Homes and other small residence 2. Other residential properties 3. Land 4. Net leases 5. Build to suite 6. Shopping Centers 7. Office Buildings 8. Industrial/Office Warehouses and Storage Facilities The goal is direct investment in real estate. Investment in real estate securities such REIT or share in real estate development corporations are indirect investment. SCORE Houston 5

Personal homes Personal Homes and other small residence The first real estate investment should be personal home. It is called starter home. It is the soundest investment in real estate because the investor can get up to 90% financing. It should be a modest home and should not go beyond the means of investor. Starter home can be used to purchase a second house down the road. Here is an example of how: Yr. One Yr. Four Cost 100K Selling Price 120K Down Payment 10K Less mortgage Balance 85K Loan 90K Cash Received 35K New Home Cost 150K Down Payment 15K Cash on hand for second home 20K SCORE Houston 6

Personal Homes and other small residence Small Apartment Complexes Relatively inexpensive with profit potential It comes in the form of Duplex, Triplex, Quadruplex or six family Dwelling The owner can live in one and lease the others Income from leased apartment can be used to cover total operating costs as well as to some extent mortgage and use cash flow proceeds to purchase additional properties. Here is an example (15 years mortgage at 8 ½%) Quadplex Four Units Three Units Four Unites Three Units 1. Cost 100K 100K 9. Payment of principle 2,656 2,656 2. Down Payment 20K 20K 10. Total Return 3,202 2,800 3. Mortgage 80K 80K 11. Annual % return 16% 14% 4. Rental Income 24K 18K 12. Appreciation 5,000 5,000 5. Operating Exp. 14K 14K 13. Return + Appreciation. 8,202 2,200 6. Operating Cash Flow 10K 4K 14. Net Return 41% 11% 7. Mortgage Payment 9,454 9,454 15. Depreciation and Tax Saving 2,909 2,182 8. Net Cash Flow 546 5,456 16. Amount Subject to Tax 293 4,982 SCORE Houston 7

Personal Homes and other small residence Advantages: 1. You have opportunity to live in one unit and save on rent 2. Often Owner financing is available 3. The price of multifamily dwelling, regardless of size is a function of income 4. Multifamily dwelling provide a way to learn how to manage a property 5. Provide you with capital to buy up Disadvantages: 1. If you live in one of the units, then you have to handle tenets complaints 24 hrs. per day 2. As the owner you will be responsible for collection of rents, filling vacancies, and doing repairs SCORE Houston 8

Other Residential Properties Residential properties come in a variety of sizes, price range and diverse tenants. Location of property determine the type of tenants and demands (e.g., students are tenants of an apartment complex near university). Residential properties includes: Apartment complexes Attached rows of townhouses Low and high rise apartment buildings Boarding and rooming houses The value of investing in one over the other is relative. If an attached row of townhouses reflects a higher rate of return on cash than a high rise apartment building, then you might decided on the former. SCORE Houston 9

Garden Apartment Complexes Garden apartment complexes consist of groups of two to three story walk up with up to 12 apartments per building or rows of apartments similar to townhouses Advantages They are more management intensive, so sold for lower price and giving a higher rate of return They are build on larger areas of land and often its value goes up over the years It normally requires lower percentage of down payment Disadvantages Maintenance and management cost are higher Insurance costs are higher Due to size it has a higher security risk It is very much subject to local economy In purchasing a garden apartment complex, rent revenue is not the only main factor. Location, land, building conditions and operating expenses must be analyzed. SCORE Houston 10

High Rise Buildings High rise buildings are defined as an elevator building compromising many floors with many apartments They are built in strategic locations where land is limited and expensive Advantages It offers economy of scale (everything is in the building) Easier and cheaper to operate Offer a higher rate of appreciation (difficult to duplicate) It is easier to get financing Disadvantages It is sold for a higher price and not suitable for small investors In certain areas like NY, there might be rent control and other protection regulations It is not easy to demolish and use the land for other purposes. SCORE Houston 11

Shopping Centers The term shopping centers refers to a variety of commercial spaces, ranging from small group of stores on a parking area to megamall shopping centers. Shopping centers can be classified differently, but the most common classification is: Anchored shopping centers The anchor is a major store. The anchor is the main draw which indirectly generate business for other tenets. Examples of anchor stores are: 1. Supermarkets 2. Drug chains 3. Department stores 4. Movie theaters Advantages Easy to manage responsibility include ground and structural upkeep, management, insurance and real estate tax payment As community around shopping center increases, the value of land increases and the land can be used for other purposes in the future. The presence of an anchor store make it easier to get financing. SCORE Houston 12

Shopping Centers Disadvantages Most of the income comes from anchor stores, so if one or more anchor store move out or go out of business, the shopping center need retrofitting Unless there is a cost of living adjustment (COLA) or other escalations, a long term fixed lease can results in slow increase in the value of property (no income increase) Anchor tenants are very much tough negotiators and often impose certain requirements such as who should other tenants be. Anchor shopping centers are excellent investment for new small investors as part of a group (partnership). SCORE Houston 13

Shopping Centers Strip Centers or Strip Malls They are made up a series of retail stores with average size of 1,000 square feet They have good visibility and are located in a densely populated neighborhood They normally have access to freeway Advantages They are an income producing real estate investment and income increases as community develops There is no major risk of loosing a draw tenant They represent a smaller investment Leases tend to be shorter term (re adjustment of rent for inflation) Easy to manage Disadvantages Tenants may not come if it is not well located Tenants tend to leave if their business is not doing well, the rate of vacancy is higher Strip centers are good investment in commercial real estate with lower down payment requirement. They are normally sold below the replacement cost. SCORE Houston 14

Office Buildings Office buildings are similar to apartment complexes in terms of investing, but also are more service intensive The owner of office building provide electricity, heating and cooling, cleaning services and internal repairs The rental income and related value of office buildings fluctuates with economic conditions Advantages 1. They are located in strategic locations 2. Their replacement cost keeps going up 3. Can be purchased during down economic and sold during economic boom Disadvantages 1. They requires a large cash investment 2. They are management and labor intensive 3. Their income and value depends on economic conditions They are too large for small and novice investors specially because of intensive management complexity and demands. SCORE Houston 15

Economic Cycles and Real Estate What is economic cycle? It is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Average cycle is 4 8 years. During growth period purchases create demand which pushes prices higher. It is reverse during recession. As the growth continues, investor forget the real value of what they are investing in and believe they are buying future profits. When the expectation of future profits are not materialized, then they panic and start dumping their investment which results in recession. What factors affect economic cycles? Gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle. What an investor should do to avoid loses? 1. Plans a long term prospective (3 5 years) 2. Avoid getting involved in speculative investment in good times 3. View bad times as an opportunity for investment SCORE Houston 16

Economic Cycles and Real Estate How the economic cycle affect real estate? Growth People would speculate and price of properties increases unreasonably 1. Investor must evaluate economic indicators and their effect on the real estate (low interest rate increase demand for real estate, and later increase in construction) 2. During the late boom or growth period when the prices are reached to an unreasonable level, the investor in real estate should do nothing or sell all or part of his/her properties 3. Low interest rate, ease of monetary policy by Fed, and lower price of energy increases growth in real estate Recession People panic and try to sell their property to protect their assets 1. Increases in interest rate and over construction reduce demand for real estate and price of real estate properties would start to fall 2. The sign of real estate recession include Increase in vacancy, foreclosure, and abandoned properties by speculators 3. High interest rate, tightening of monetary policy by Fed, and higher price of energy reduces activities in real estate The best sign for determining over priced value of real estate is when speculators participate in real estate activities and real users can not afford prices. SCORE Houston 17

An example of wrong speculation Boom Recession Purchase Price 100K 100K In planning an investment in real estate you need to identify: Bank Mortgage 90K 90K 1. The stage of economic cycle Investor Equity 10K 10K 2. National economic status Market 115K 82K 3. Local market economy status Bank Mortgage 90K 90K 4. Level of speculation in the market New Equity 25K 8K 5. Return on investment during boom and recession periods Original Equity 10K 10K 6. Financial status of investor Profit/ Loss 15K 18K Return on Investment 150% SCORE Houston 18

Calculating long term potential profits from investment in real estate Ideally one should invest in real estate when real estate is out of favor (recession) and sell it during the late stage of boom (Does not work most of the time) There are two guidelines to buy property 1. Buy property in a good area that has been overbuilt 2. Buy in deteriorated, but well located areas on the brink of recovery Before you purchase a property, no matter what potentials are offered by the investment, you must calculate the return on the investment. If the cash flow is not positive after payment of operating expenses, do not buy it Real estate profit have three sources 1. Positive cash flow should generate 8 10 cash flow after operating expense and loan payment on a cash investment 2. Appreciation Property appreciate an average of 5 10% per year 3. Leverage Debt remain constant (Interest Payment Only) SCORE Houston 19

Potential Profits Positive Cash Flow Assume: Property selling price $200K Down Payment 50K Loan 150K Interest 8% Loan Term 15 years Expected Rate Return 10% Item Interest Only Interest + Principle Comment 1. Income 32K 32K When an investment has positive 2. Operating Expense 12K 12K Cash flow, the actual rate of 3. Profit before debt (expected) 20K (10%) 20K (10%) Return can exceed expected rate 4. Interest Expense 12K 12K of return. Thus an investor should 5. Net cash flow before interest 8K 8K Calculate return on investment 6. Principle Payment 0K 4.5K under normal, good and bad conditions 7. Net cash flow after principle Payment 8K 3.5K 8. Return on Investment 16% 7% SCORE Houston 20

Potential Profits Cash Flow + Appreciation The second source of profit is appreciation which is not included in the prior example Purchase price 200K Loan 150K and cash payment 50K We assume an annual appreciation of 5% over original purchase price We calculate the value of investment after 5 years Interest only 1. Original purchase price 200K 2. Original Cash flow 20K 3. 5 years later value 300K 4. Cash flow (yr. 5, 10% of MKT value 30K 5. Cash flow over five years (average) 125K 5. Total Value +Cash flow 425K 300K + 125K 6. Property value/original Investment 2.125X 7. Total return Cash flow +Appreciation 225K 100K (appreciation) + 125K (Cash flow) 8. Total return over 5 year before interest 450% 225K/50K SCORE Houston 21

Part Two Financing SCORE Houston 22

Financing Real Estate Investment Terms Investment in real estate can be (1) cash purchased only or (2) cash purchased plus financing Financing real estate purchase means borrowing money or getting a loan. There are two types of loans 1. Secured loans where collateral is used to secure the loan 2. Unsecured loans where there is no collateral and the loan is awarded on the credit worthiness of borrower. An example of unsecured loan is Line of Credit (LOC) awarded by banks to their best customers with good history and sound assets. Real estate loans are secured by a first, second and even third mortgage on residential or commercial property In real estate one often talk about property. So, we need to define property first. Property is divided into two categories 1. Personal property which is anything that is movable. Personal property can be attached to a land or building and then become real property. 2. Real property which are not movable. There are three types of real property 1. Land which is always real property 2. Buildings are real property. Trees and shrubs are also real property because they are attached to land. 3. Fixtures which is a hybrid between personal property and real property (AC initially was a personal property and then become real property). SCORE Houston 23

Financing Real Estate Investment Terms Estate refers to the degree or extent of ownership in property. They are: Free simple estate also called sole tenancy is the greatest and highest degree of ownership in real property Tenancy in entirety It is an estate held by husband and wife with the right of survivorship Tenancy in common is an estate held by two or more persons without the right of survivorship Joint tenancy is an estate held by two or more persons with the right of survivorship Deeds refers to an instrument that conveys title from the grantor (owner of title) to the grantee (recipient of title). There are different types of deed and they are: General warranty deed In addition to conveying title to real property it also contains certain warranties such as the grantor is the owner of the property, the right to convey the title the grantors defend the title against the whole world. Bargain and sales deed Conveys title to real property without any warranties what so ever. It is used by the county or state to convey title to individual since the agencies do not want to warrant title. Check the estate law where the property is located for any variation and special requirements regarding deeds. SCORE Houston 24

Real Estate Loan Origination Origination is the process of creating a real state loan or mortgage. In order to process loan, the following information is required by underwriter or loan broker: Credit Guidelines The underwriter should ask the following questions when processing a loan applications 1. What is the borrower s ability and willingness to pay 2. Is the property acceptable security for the proposed loan Income and Employment The FHA, VA and most lending institutions require written verification of the loan applicant s employment for at lease the past 24 month. This indicate job stability and loan repayment. In addition to income, age, bonus income, other sources of income are also considered Assets Assets are reviewed from two prospective 1. The applicant can demonstrate an ability to accumulate cash and other liquid assets 2. The applicant has enough liquate asset to fulfill his/her obligation Liabilities All lenders consider debt, both short and long terms when reviewing loan application. Liability include credit card debts, child support, other loans and most importantly filling for bankruptcy So, a loan applicant, whether applying for residential or commercial real estate must ensure that he/she has all the requirements before submitting application for a loan. SCORE Houston 25

Residential Loan Types (RRE) Brokers have to follow underwriters rules Conventional Loans It is a loan secured by real estate without the benefit of government insurance or guarantee Eligibility best offers are given to single family detached owner occupied dwellings less than ten years old 1. Town houses/apartments are also eligible 2. Term The maximum loan term is 30 years Interest rate and discount points Current federal law pre empties state usury celling's. As long as this law exits, lenders can charge rate, discount points and fees on first mortgage loans without limitations. Conventional loan income ratio Depends on the lender but the convention is a person should not spend more than 25% of gross income on housing. 1. Monthly interest $800, taxes and insurance $300 2. Ratio 25% 3. Annual income = $52,800 Veterans Administration Loans It is a real estate loan that is made to veterans and secured by Veteran Administration Federal Housing Administration Loan(FHA) Loan is guaranteed by FHA. Borrower must comply with FHA rules not the lender. 1. FHA loan is based on applicant income 2. 35 50 rule is used to determine income eligibility (House expense should net exceed 35% of effective income or combine housing expenses plus other recurring charges should not exceed 50% of effective income SCORE Houston 26

FICO (Fair, Isaac & Company) Nearly all the lenders base their lending decisions and terms on the applicant FICO score It is a numerical computer generated score that predicts a lender s risk of doing a business with a borrow There are three companies (Experian, Equifax and Trans Union) that determine FICO score for individuals: Scoring is based on things like: 1. Job history 2. Time applicant have lived in his/her current address 3. Payment history 4. Outstanding debt 5. Credit history 6. Type of credit used (banks credit or debt card, personal installment loans) 7. Negative information (bankruptcies, late payments, late fees) Income and assets are not considered SCORE Houston 27

Commercial Real Estate Financing Commercial real estate (CRE)are defined as those that are built and operated for the purpose of producing income As long as the property has a steady, assured and adequate income, then it has marketability and can be financed The lender primary underwriting considerations in order of their importance are: 1. Credit (good tenants) 2. Location 3. Type of real estate The only time a CRE loan is foreclosed is when the property ceases to produce income. The market value of all CRE is directly related to the amount of income it produces (basis for value), the reliability or quality of the income stream (basis for loan to value ratio), and duration of income stream (basis for loan term) CRE are generally divided into two categories: 1. General use Apartment buildings, office buildings, shopping centers, retail outlets 2. Special use properties Hotels and motels, banks, mobile home parks, restaurants SCORE Houston 28

Analyzing the Income Property Loan Every income property loan are analyzed for: 1. Feasibility Does the property is a viable property and produces enough income 2. Location Property to be financed should be analyzed for population growth, income level, stability of employment, accessibility by automobile and public transportation, and competing properties 3. Timing Assuming that 1 and 2 above exist, but is the timing of financing a real estate construction project correct? (A similar project is opened 3 6 month the project is completed) 4. Borrower Does the borrower has skill and desire to create value (borrower background is checked) 5. Real Estate For years the value of real estate used to serve as the basis for a CRE loan (75/25 loan to equity ratio). Although valid approach, lender later learn that the value of a real estate directly related to the general economic climate. This resulted lender consider not only the real estate, but also the credit worthiness of the borrower. The stage through which an income property loan progresses are not in the same order of residential real estate. It normally start with feasibility and followed by other steps(complex process and out of scope of this workshop) SCORE Houston 29

Risks Related to Commercial Real Estate There are many risks that are associated with CRE investment that must be considered by both lender and borrower. They are: 1. Business Risk It is a risk that fluctuate with economic cycles, such as interest rate risk 2. Financial Risk This is the risk of debt or leverage 3. Liquidity Risk It is not only the risk of investment not being a liquid asset but also it is the risk that business will have inadequate cash flow or working capital. 4. Management Risk This risk relate to poor management and development of commercial real estate such as delay in construction or tenant dissatisfaction. 5. Risk Management It relates to not be able to identify material sources of risk, measuring and monitoring those risks and devising approaches that reduces those risks (e.g., purchasing liability insurance, hazard insurance, building security) Commercial loan evaluation first focuses on the properties and risks associated with and then on the borrower who expects to own and manage property SCORE Houston 30

Information Required for a CRE Loan There are few standards and little regulation directing a prospective borrower how financial information should be presented Regulations that apply to what type of information are required are exclusively directed by the lenders Specific information that most likely required by most lenders are: 1. Operating statement of property If property is operating, the operating statement for last 2 3 years is required. The underwriter often asked these statements to be prepared by a CPA. The operating statement include: Balance Sheet lists company's assets, liabilities and owner equity. The most important information in BS is the original cost and how it is compared with current value Profit and loss Statement It an statement of income and expenses. The P&L statement describes the nature of expenses and their costs Operating statement It is similar to P&L statement but include debt services, and depreciation 2. Pro Forma Cash Flow Statement It is a projection of both income and expenses. It is mostly used for new property development 3. Personal Financial Statements For Principals involved in project and must be updated within the past 60 days SCORE Houston 31

Information Required for a CRE Loan Con. 4. Business and Personal Tax Returns For the last 2 3 years 5. Current Rent Roll It is a list of space available for rent, vacancies, current rent (gross and effective rate per square foot per year), escalation clause and maturity of rent contracts 6. Accounts Receivables and Accounts Payable To help analyze the overall health of the business (can be found in BS) 7. Purchase Contract (PC) or Warranty Deed (WD) PC and all the addendum if the property is to be purchased and copy of WD the property is owned 8. Insurance hazard and general liability insurance 9. Current Real Estate Appraisal Should include cost, market, and income 10. Survey A current survey of land made by a registered surveyor 11. Property Tax Bill Often used to verify legal description of property, owner and tax assessment 12. Resumes of Principles Should contain a history of experience 13. Articles of Incorporation 14. Authorization of Release Information For checking credit score and filling tax 15. Environmental Audit All commercial loans require an environmental site assessment SCORE Houston 32

Mohammad (Mo) Tehrani, Ph.D., CPA motehrani@scorehouston.org tehrani@tehraniandassociates.com Meeting by Appointment: Tel: 713 487 6565 Office Hours: Location: HCCS Alief Hayes Campus SCORE Houston 33