Investment in Real Estate Residential and Commercial Mohammad (Mo) - - PowerPoint PPT Presentation

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:

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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

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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

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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.

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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.

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Personal Homes and other small residence

Personal homes

• 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:

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• 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

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%)

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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

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

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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.

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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.

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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.

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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.

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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).

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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.

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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.

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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

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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.

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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%

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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

• f 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)

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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%

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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

• f 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%

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

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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

Part Two

Financing

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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
• r 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).

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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
• f 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.

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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.

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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

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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

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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

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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
• f residential real estate. It normally start with feasibility and followed by other

steps(complex process and out of scope of this workshop)

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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

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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

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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

• f rent contracts

6. Accounts Receivables and Accounts Payable – To help analyze the overall health

• f 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

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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