CAP Rate? Cash on Cash? Or IRR?

CAP Rate, Cash on Cash Returns, IRR – What would you use to accurately evaluate the return on your investment?

Having a set of principles, procedures and tools that assist in interpreting financial data is important in itself. More important though is the ability to truly understand and construct them. This is what turns them from numbers on a page into an accurate model of a potential investment.

Investors use different metrics to compare one real estate investment opportunity against another. What is the right metric to use? CAP rates are a very popular way to quickly analyze the return on an investment but this CAP rate only represents a moment in time, that is, it tells you what the return on the investment will be based on that year’s projected net operating income without taking into account the impacts of financing.

For example; say you are buying a 10 unit multi-family property for $1,200,000. The net operating income is $60,000 yielding a CAP rate of 5.00%.

$90,000 NOI / $1,200,000 Purchase Price = CAP RATE of 7.5%

The Cash on Cash Return gets you one step closer towards getting a truer picture of what the return of investment will be to you personally. That is, the Cash on Cash

Return looks at the annual before tax cash flow left over after deducting any debt service against the property and the total cash invested. So depending on your loan to value ratio and the interest rate, the Cash on Cash return will be different for each investor.

The formula for calculating the Cash on Cash return is:

Annual Before Tax Cash Flow

Total Cash Invested

The $30,000 Annual Before Tax Cash Flow / $300,000 Equity = 10% cash on cash return which looks even more favorable than the 7.5% return demonstrated by using the CAP rate to determine the real return on the investment

Using the Cash on Cash return does have its limitations because it doesn’t take into account the other 9 years of operating cash flows in the holding period. It also ignores the reversion cash flow at the end of year 10 that comes from the sale of the asset.

The most accurate way to determine the long term return of an asset is by looking at the Internal Rate of Return (IRR) which not only accounts for financing but uses discounted cash flows and the reversion cash flow at the end of year 10 that comes from the sale of the asset.  Most analysis models assume a ten year holding period and use a discounted cash flow rate. The IRR is as close as you can get to the real return on investment, this being said it is often the most useful in comparing to an expected or desired return and gauging attractiveness of different investment opportunities. A more thorough dialogue about the IRR metric will be coming in a future article.

Catherine Chapnick,

Broker Associate

Keegan & Coppin Co., Inc.

 

1031 Exchange/Strategic Planning is the Key

The basic requirements of a 1031 Tax Deferred Exchange appear simple enough. From the time you close escrow on an income property you own; you have 45 days to identify either 3 properties you may consider purchasing, or any number of properties that all add up to under 200% of the value of your relinquished property. You have to purchase a new property (ties) of equal or greater value, and you have to replace the existing debt. You can exchange any property you own with the exception of your personal residence; and the IRS “like kind “definition extends to any category of property that is held for investment. You can sell land and purchase a retail center; or apartments or an office building etc. Almost any property qualifies as long as it isn’t your personal residence.

You then have 180 days from the time you “close escrow” on your relinquished property to complete your new purchase to comply with the IRS Rules and Regulations for a tax deferred exchange.

Simple enough? Well, as my accountant consultant once said “the devil is in the details “and I will highlight just a few of the challenges associated with the existing 1031/Tax Deferred Exchange time perimeters.

The 45 days requirement can be a “quagmire’ of concern because it (often) isn’t adequate time to perform a thorough due diligence inspection of any new purchase. Often salient facts about a property are not discovered until deep into the Due Diligence Process and the 45 day ID period has expired. Remember that you must purchase a property you identified within the 45 day period and you must close on one of those properties within the next 135 days. This is a real concern and the process can be under estimated by even by the most experienced investor.

Title/ Vesting can be another issue. Often a property has been held for years under a Family‘s LLC or a group of investors that own it as one entity. If you/your group are planning to sell a long held asset; it is imperative that you all decide to exchange at the time of the sale; or change the vesting well ahead of the sale. If you own properties with a partner/partnership; make sure you own them as Tenants-in-Common, so you are able to exchange out your interest on your own behalf.

I think you get where this is going. There are almost no wealth generating plans as powerful and effective as the 1031 Exchange Process as a way to accumulate wealth. The potential to continue to build equity exponentially through a long range planning is unparalleled.

The thing to be aware of is the importance of a well thought out strategy developed in advance of marketing your property; getting a real sense of where you want to reposition your equity, and understanding your goals in selling. You may decide to do a reverse exchange; in spite of the added expense. Knowing and uncovering your options can reap financial rewards if you take the time to educate yourself and identify what you want to achieve.

A well thought out plan; developed in advance of your initial sale may save you hours of (last minute) anguish. With advanced planning; you can position your estate for years of prudent appreciation and you can “Swap ‘til you Drop”. Got you thinking? Contact us; your investment specialists and put our experience to work for you.  Annette Cooper/Senior Investment Advisor.

Investment Buzz from the Business Insider – August 2015

We are continually monitoring the Investment Climate and tracking the trends for commercial investment opportunities as they present themselves.

Californians are experiencing unprecedented returns on long held properties as cash remains cheap and cap rates making sense in the sub-five range for many investors. The appetite for 1031 Investments remains brisk and the robust demand for top retirement income generating returns is strong as baby-boomers opt for retirement and troll the Country for income as well as stability of principal.

I came across an article from the Business Insider (dated 8/4/15) and I thought it was really kind of interesting. It was a ranking of the top State economies from the absolute best to the worst.

In all fairness; there are a number of these tables, lists and surveys to explore. Forbes does a comprehensive list in the spring that I like to research to get their take on the investment climate.

What was interesting to me regarding the Business Insider was that North Dakota was ranked Number One as the Top State in the US Economy. Who Knew? The Oil Fracking Industry is going strong in that area, and the climate for investments in that area is worth noting.

Number Two on the list was Colorado. No surprise to me because I am bullish on that area; not only for the number of great businesses/companies headquartered there but also the robust amounts of revenue being generated by the Marijuana Industry .The Marijuana Industry is probing and thriving its way through antiquated mores and is developing from an underground business to a prolific business resource. It appears to be setting records in its ability to create a number of business opportunities from cosmetics to paper as well as adult recreational bars and places for entertainment.

Number Three was the District of Columbia, understandable as the seat of Government, but not a place I typically think of as a place to invest.

The rest of the top ten included (in this order) Texas, Washington State, Massachusetts, Utah, New Hampshire, New York, and Oregon.

Got you thinking?…I hope so. The World is rapidly changing, and opportunities abound for those willing to “step out of their box” and look to the future. Happy Investing!!!

Annette Cooper
Senior Real Estate Advisor

CAP RATE CONUNDRUM

Someone recently approached me asking a question about Cap Rate Evaluations. In evaluating hundreds of cap rates, I have noticed the following well-known areas where I believe people “fudge” in order to “polish the cap rates,” and areas I believe deserve a little more scrutiny when looking at a Leased Investment. Here goes:

  1. “Pro-forma Income”: One of my pet peeves because they are calculating income that is not there yet. Obviously upside is important, but so is a clear reflection on what it is you are buying.
  2. Property Tax Re-calculation: Why repeat a number that will be re-adjusted after a sale? It’s easy enough to estimate a new tax assessment, and not considering a new calculation for the property located in California is not helpful to a new investor’s bottom line…
  3. Vacancy Rate/Reserves: Most standard Income and Expense Statements allow for both a reserve factor and one for vacancy. It iss an accepted prudent guideline when planning an annual budget, and they are often ignored in an Income and Expense statement.
  4. Repairs and Maintenance: These may be issues but if they are non-recurring, where do they fit in? Are they accurate? What deferred maintenance issues are not mentioned and may need to be accounted for? Can you pass any of them on to the tenant?
  5. Management Fees: Can vary depending on the owner’s interest and geographic proximity to the investment. An investor buying out of state to achieve a better return will no doubt need a bigger factor set aside for both management and the costs to travel periodically? I have seen this variable grossly under-estimated for a new manager.

Hope these highlights prove helpful in comparing “Apples to Apples” in understanding your next investment decision. Comments and questions always appreciated.

Annette Cooper
Senior Real Estate Advisor

Tax Deferred Exchange Primer

A Quick Guideline to the Art of the 1031 Exchange/2014

The New Year is a good time to re-visit the recent developments in the Capital Gains rates that were established in 2013. In essence; as predicted for years, the Federal Capital Gains Rate is “inching up” for high net worth investors from 15% to 20% and the State is adding another 3.8% from its current rate of 9.3%. These dubious factors (income levels, health care insurance costs, and mental health costs) that loom large in the background are positioned to accelerate capital gains ratios upwards to over 35%.  This is a big shift from the old standard “rule of thumb” that was approximately 25%, and there is more reason than ever to re-visit the 1031 Exchange Option that is alive and well.

The 1031 Exchange Option still requires an Investor to identify their potential replacement properties within 45 days of the Close of Escrow of their current property; and actually complete that purchase within 6 months of the Close of Escrow of that underlying property. So, you have approximately 4.5 months to actually purchase a replacement property after the 45 day identification period expires.

On the surface, these arbitrary time frames (as dictated by Congress) may appear to provide an investor adequate time to re-position real estate equity, but my experience tells me that these time frames are woefully inadequate.

The biggest looming pitfall to orchestrating a 1031 Exchange is that initial 45 Day Identification Period. These stringent, unyielding identification requirements require the investor to spend some introspective time evaluating what they want to buy before they decide to sell.

The most common error is waiting too long to begin/define a new property search. I have seen investors languish with a property search and wait until the 45th day to identify 3 properties that just appear to be a reasonable investment.

This approach is just fraught with peril. Often, the Due Diligence Process has not even been initiated, and the property not vetted for acceptability.

How many times has an Investment Prospectus contained a significant error and/or a glaring omission that significantly changes the property’s desirability? It is such a common cliché, yet it still remains common for investors to identify a property in an Exchange that has not been significantly investigated.

In my humble opinion, the search for a new property really begins even before you market your existing Investment.

It is so important to acquaint yourself with the Investment arena you desire, research the market you want to explore, know the reasonable expectation for the new cap rate, safety of principle, any lending/loan requirements, tax implications from your accountant, and/or any prepayment penalties.

I have personally witnessed some of the following consequences of waiting too long to begin a replacement property search:

  1. You nominate a property in your exchange that is no longer available.
  2. The Due Diligence process reveals a Cancellation Clause in the primary lease “no one” knew about (I know this sounds ludicrous, but I have seen it happen).
  3. You discover there is a significant environmental issue that was not initially disclosed.
  4. The building has some latent defects that were not known when the Investment initially hit the market.
  5. There is Mold Damage that was not discovered until deep into the inspection process.

I was once representing a client, and as we were finishing up the Due Diligence Process, we discovered that the nearly new 5 year old building never received an Occupancy Permit from the local Municipality. The building had had a tenant for over 5 years. Really!!!

I think I have made my point. I am not panning the Exchange Process. Quite the opposite. Capitalizing on long held equity through the Exchange Process is still one of the last remaining wealth building options in this country. It can protect your estate and your assets from the “Government Tax Shave”, and expedite building wealth through Real Estate Appreciation. You can take advantage of the depreciation available and interest deductions.

The key is understanding the process, allowing careful planning and preparation to save a lot of “heart-burn” and deliver the financial rewards you have worked for. It’s the “devil is in the details”, and that’s what you can avoid by planning ahead.

An Ounce of Prevention is Worth a Pound of Cure.

Annette Cooper
Senior Real Estate Advisor
Keegan Coppin/ONCOR International

Locking out the Lockout Clause

So on a beautiful quiet day in pastoral Sonoma County, after almost 3 years my 61 year old client Diane finally received the final order from the Court. It was ordered that Bayview Financial/M & T Bank was to return the excessive PREPAYMENT/lockout fee that they had woven into the loan documents, unbeknownst to Diane at the time of origination.

The money ordered to be returned was money the bank collected when Diane went to sell her home/ income property and discovered a Lockout/ Yield Maintenance clause in addition to another CLEARLY stated prepayment penalty.

At the time my only experience with Lockout Clauses was with Large Commercial Investment Loans that had an experienced high net-worth borrower. In the case of Diane she owned a Small Multi-Unit Property that she had inherited from a close friend when he died. Here’s what happened to Diane.

She was in contract to sell her home/ 9 unit property for APPROXIMATELY $995,000 and had a (year and a half old) First Mortgage in the range of $450,000. When reviewing the Seller’s Escrow Closing Statement we noticed that there was not only a 5% prepayment penalty, but another lender demand for approximately $220,000. I am not making this up! As astounding as this story sounds it turned out to be true. The Cover Page/Abstract of the loan’s terms and conditions did mention the 5% Prepay Penalty. However, not listed was a Lockout Clause in the body of the contract.

Diane had to perform on the Sale or face a prospect of a 1031 inspired lawsuit from the buyer. She paid under duress and was able to convince two very gutsy and talented attorneys to take on the case to sue to get the money returned that was collected from Lockout /Yield Maintenance Penalty.

This was a tricky proposition for the attorneys because the law approaches Residential and Commercial loans in much different ways when it comes to Predatory Lending Practices. While residential loans have strict criteria for these kinds of lender “shenanigans”, commercial lenders function in lending practices based on something to the effect of ” Not Shocking the Conscious of the Community”.

In the case of my client, fortunately she won!! It took approximately 2 years to get a judgment in her favor and another year (or so) to wade through the appeals. While I am not privy the Court Costs and/or the attorney fees that accumulated over the 35 month process, I believe the fees must be triple what my client collected. ONLY HER OWN money was returned. That’s what it took to pry the money back from the lender.

Moral of the story – Understand your Loan Documents and all penalties associated with paying off your loan, and know the meaning of the Lockout Clause.

Will there be any opportunities for the commercial investor with health care reform?

The passage of the 2010 Patient Protection and Affordable Care Act (ACA) may result in some unique and interesting opportunities for the alert investor.

OVERVIEW

While the recession has been brutal to the commercial real estate industry forcing occupancy levels across most asset categories to painfully contract, the implementation of the ACA may afford savvy investors new opportunities to meet the needs of accelerated, “good old-fashioned” demand in health care sectors.

Expanded health insurance coverage will surely expand the need for medical office space, as well as the retail, manufacturing and industrial space for health-related businesses.

Remember that approximately 32 million of the 46 million uninsured Americans will receive insurance coverage under the new legislation in 2013.  Approximately 260 million people in the U.S. enjoy some kind of medical insurance coverage.

MEDICAL OFFICE BUILDING (MOB)

The need for new medical space for patient care appears not to be tied to any one asset type.

For instance, observe retail space morphing into medical use becoming a new part of the retail sector’s economic recovery.  The marriage of medical use and retail space is becoming an important and growing part of the U.S. primary care delivery system. This new strategy is providing increased visibility and easy accessibility to a potential patient.

“Owners of better-quality, performing medical office properties should enjoy stable returns over an extended period, as tenants tend to make significant investments in improvements and on-site equipment, discouraging relocations.”( Marcus and Millichap report)

Medical office building (MOB) investment opportunities should begin to outperform other real estate sectors as hospital and medical group executives move ahead with plans that have been on hold. Long-term stable leases, diversity of income sources (i.e. insurance companies, government reimbursements, and private sources) coupled with the matrix of expanding tenants (Assisted Living facilities, Pharmaceutical companies, Biotechnology companies, etc.) all contribute to these contemporary investment strategies evolving within the healthcare industry.

Consider the industry multiplier of 1.9 sq ft required per patient. This estimate should eventually increase the amount of requisite “patient space.” It can be estimated that 64 million additional square feet may be required to meet the increased demand.  The surge in demand for space is estimated to happen almost immediately.  Vacancy rates in retail and office make both sectors ideal candidates to absorb the increased medical demand.

TRENDS TO KNOW

16% of hospital executives indicate future projects for them are outpatient facilities in neighborhood settings. (ASHE2011 Construction Survey)

We will be watching this trend through in the upcoming year 2013.

A Peek at Capital Gains for 2013

The Health Care and Education Reconciliation Act of 2010 (HCERA) added Internal Revenue Code §1411, which imposes a new 3.8% tax on net investment income, effective January 1, 2013.

The new law imposes a 3.8% tax on the lesser of the taxpayer’s net investment income or the excess of the taxpayer’s adjusted gross income over the specified thresholds (i.e. $250,000 for married filing jointly; $125,000 for married filing separately; and $200,000 for other taxpayers).

In addition to the new 3.8% surtax on capital gain, the Bush tax cuts are set to expire beginning January 1, 2013, which will increase the top capital gains tax rate from 15% to 20%. With the new 3.8% surtax starting in January of 2013, the effective top capital gains tax rate will be 23.8%.

Since the issuance of HCERA, many taxpayers have expressed concern about whether an IRC §1031 exchange could be used to defer this additional 3.8% tax on capital gain. Now, under newly published “proposed regulations” — 26 CFR Part 1[REG-130507-11] — for those who were worried that an IRC §1031 exchange could not be used to defer this additional 3.8% tax on capital gain, §1.1411-5(C)(i)(2)(ii) alleviates that concern by providing as follows: “to the extent gain from a like-kind exchange is not recognized for income tax purposes under section 1031, it is not recognized for purposes of determining net investment income under section 1411.”

Although these regulations are not yet final, section 12 of the proposed regulations provides that taxpayers may rely on these proposed regulations for purposes of compliance with §1411, until the effective date of the final regulations.

Taxpayers should review the proposed regulations with their tax advisor to ensure proper compliance and interpretation thereof.

The proposed regulations may be viewed at the following link: https://s3.amazonaws.com/public-inspection.federalregister.gov/2012-29238.pdf. A hearing on these proposed regulations is scheduled for April 2, 2013.

Make Hay While the Sun Shines

The story goes that an ambitious young man was praying to God daily for months; intensely imploring the higher power to help him win the lottery. After many months of praying, the man received a message from the Lord, “Sir, if you want to win the lottery, you have to buy a ticket.” Investors serious about building wealth and developing a comprehensive strategy to maximize the appreciation and income potential of their Investment Portfolio will be well served to investigate the opportunities available in today’s commercial real estate market. There exists an almost unprecedented opportunity to position your portfolio for exponential capital growth.

Consider the fact that today you can purchase stabilized investments with cap rate returns starting from 7% (and up in most investment categories) and capitalize on the 5.5%-6.75% lending options to finance the investments.

Today’s lending environment offers a comfortable spread for both new purchasing and creating prudent leverage. Multi-Family investments may offer an even better return with interest rates for Apartments/Multi-Family quoted as low as 4.5%.

Remember that the options available in purchasing income property run the gambit from Multi-Family Residential Investments to Industrial Facilities to Shopping Centers, Mini-Storage or Mobile Home Parks. Whether your comfort level is centered on Multi-Family apartments, NNN Leased Opportunities, or more aggressive Value-Added Investments; both the inventory levels and income accelerating opportunities are substantial.

There are other important advantages to consider when investing in Commercial Real Estate; leverage and positioning yourself to take advantage of the “wealth building” capability of the 1031 Exchange Option (eliminate the tax bite of Capital Gains to keep all your hard-earned equity intact). In addition, you receive of the tax benefits of both depreciation and interest tax write-off.

1% to 4% annual returns available in the stock and bond market pale when compared to the multi-dimensional estate building capability of real estate: income, appreciation, leverage, and generous tax advantages.

As one savvy investor once said, “One good investment is worth a lifetime of toil.”

Stretching Your Retirement Dollar

It’s no secret that prudent investors have discovered the income potential of purchasing property out of their immediate area. Quick, inexpensive airline flights and easy internet access make it convenient to participate in this relative new and lucrative investment opportunity.

One “management free” option for enhancing your retirement income is a Triple Net Leased Investment. A Triple Net Leased Investment (NNN) is typically a commercial property occupied by an established tenant with a long-term lease that obligates that Tenant to pay all the expenses of occupying the property (real estate taxes, insurance, and all the common area maintenance). When you purchase the real estate; you also purchase the lease, and the underlying income stream. A typical tenant for this investment category can be a drug store (Walgreen’s), restaurant (sit down or fast food), a gas station, a bank, an industrial distribution center, or a large grocery store (Safeway).

To explore this investment alternative, consider the following criteria before making your decision. Here are some prudent guidelines:

  1. TENANT CLASS: Who is the tenant behind the lease? Who is the guarantor? If you require ultimate security from your investment; be prepared to sacrifice a little on the return. A good example of this would be buying real estate leased to Walgreen’s. Walgreen’s has stellar credit, offers supreme safety, but the return is usually a little under the rest of the market.For a more aggressive bottom line, you may want to consider real estate occupied by an established franchisee. An established franchisee operates hundreds of locations and will have an impeccable management résumé. More important, the return from a franchisee may be 2% more than the return from the Walgreen’s investment. They can be extremely reliable, but they’re not Walgreen’s. Still, the accelerated income is often worth the trade-off.
  2. LEASE TERM: I’m almost always comfortable with the longest term I can find. A long term lease gives the buyer the comfort that the tenant believes in this location, and the investor has a very saleable product should they decide to trade up or want to liquidate in the years to come.
  3. LEASE BUMPS (Increased lease rate over time): Most long term leases will not have “annual” increases, but there should be a provision for rental increases every 3 to 5 years. This will create another appreciation hedge, besides market forces. (Interesting to note that the majority of Walgreen’s leases have NO provision for rental increases – another trade-off for that security.)
  4. LOCATION: Typically, the better the location, the lower the return. But what’s a good location? This gets interesting when you research geographic areas in the country and examine where growth is occurring. The ability to quickly research information has opened up investment opportunities that just weren’t accessible before the internet, and it has created a dynamic pool of investor opportunities. It’s exciting, lucrative, and worthwhile to become familiar with this investment strategy.
  5. KNOW THE LEASE DOCUMENT: A careful review of the actual lease document is critical to your success. KNOW WHAT YOU’RE BUYING! When an NNN leased investment is purchased, consider it a bond with a real estate component that will give you real estate tax advantages and appreciation (without the management headaches). The lease should be reviewed by a real estate attorney and the real estate broker representing you. Both professionals will examine it from a different vantage point, and it will help you accumulate all the information you need to make an informed, intelligent decision.

As they say:

You’ve worked hard for your money. Now let your money work hard for you. One good investment is worth a lifetime of toil.