Why Investors Should Turn to Real Estate Agents

Anyone who wants to sell or buy rental property would be wise to consider using the services of a real estate professional to assist them. I know, it sounds strategic, but my intention is not to dissuade real estate investors from selling or buying rental property on their own, or to promote any real estate service.

My intention is merely to offer investors an insight often overlooked about ways a real estate professional can be of benefit inside the sale and purchase aspects of investing.

1) You Want to Sell Rental Property

In this case, you have two concerns: You don’t want to set a price so low that you lose money (of course not), or too high that the property just sits on the market and collects dust. Your objective, of course, is to close the transaction as quickly (and profitably) as possible so you can collect your money and move on to the next investment opportunity.

Here’s how a real estate professional can assist you.

They understand the market where your property is located and have a number of resources generally at their disposal that can help you set the correct market value for your income property. As a member of the local MLS, they would have easy access to Sold, Pending, and Expired data, so they can tell you at what price other properties have been selling or not selling.

Real estate agents also commonly have open dialogues with local real estate appraisers. Why is this important? They would have reliable, first-hand information about the cap rate and cost per unit that income properties similar to yours recently sold. This is especially helpful for those transactions that were not listed in the MLS, and otherwise not so readily available to the public.

Simply by virtue of their profession, then, real estate agents have a better understanding of the local market than a layperson, and thus better prepared to suggest a true fair market value for your apartment or commercial building.

2) You Want to Buy Rental Property

Fair enough, you want to purchase investment property, but where do you look to find one? For unlike residential properties, commercial property owners typically are reluctant to openly expose the fact that they are selling the property; fearing that it would be a disruption to their tenants and could cause vacancies. So you have to rule out the classified section of the local newspaper and For Sale signs. Consequently, unless you personally know of someone selling rental property, you might not find anything to purchase.

Here’s how a real estate professional can assist you.

They might be aware of a “pocket listing” on a rental or commercial property. That is, they are privy to a property wherein the owner has expressed an interest to sell but not formally “listed for sale”. This is very common with commercial property, because as stated, owners tend to hold their cards close to their chest and seldom openly broadcast their intentions around town.

Bear in mind that real estate agents rub elbows with investors and others who deal with investors. After all, this is the nature of their business. Therefore by turning to them to become your eyes and ears in circles where you are otherwise excluded, chances are good that they could turn you on to investment opportunities few others ever will learn about.

More can be said how you can benefit from a real estate professional, of course. We just touched on two aspects of the process, and just barely. But hopefully you get the point. If you are serious about building and growing your real estate investing business, and currently making decisions about selling or buying, by all means, work with a competent professional. At the end of the day, you will be glad you did.

What Really Are a Rental Property’s Operating Expenses?

The industry standards for measuring returns to real estate investments are rate of return on equity and cash flow. To do this successfully, however, the calculation of annual cash flow must be made in a series of steps with meaningful data for gross scheduled income (all rental income from the investment), vacancies and bad debts (based upon the experience of the subject property and current market conditions), operating expenses, and financing consideration.

For our purposes, we will defer the other aspects of the calculation to another discussion and focus strictly on the operating expenses associated with a rental property because it is commonly misunderstood by those engaged in the real estate investment analysis process.

Operating expenses are those expenses necessary to maintain and keep a rental property investment in service. For example, maintenance and repair costs, property taxes, insurance, management fees, water and sewer, utilities, garbage collection, landscaping costs, pool service, telephone, and advertising. They are not the mortgage payment (i.e., debt service) or personal income tax payment. Debt service is later deducted to calculate cash flow before taxes (CFBT), and income taxes the cash flow after taxes (CFAT), but don’t mistake them as expenses required to keep the investment in service.

Here’s the schema:

Gross Scheduled Income – Vacancy = Gross Effective Income
Gross Effective Income + Other Income = Gross Operating Income
Gross Operating Income – Operating Expenses = Net Operating Income
Net Operating Income – Debt Service = CFBT
CFBT – Income Taxes Payable or (tax savings) = CFAT

Operating expenses must be accurately accounted for income tax purposes also. For example, certain expenses may be paid by tenants under a net lease agreement and therefore must be offset by an appropriate addition to income. If tenants under a net lease agreement, for instance, reimburse you five hundred dollars a year for maintenance and repair costs then that amount would be included as income (in effect neutralizing the expenses’ impact on net operating income for that given year).

Moreover, expenses for the operation of rental property must be distinguished from expenditures for capital improvements. Capital improvements are defined as expenditures that will lengthen the life of an improvement, make it more useful, or increase the value of the property. In this case, the IRS tax code states that that improvement must be capitalized and then depreciated (not deducted in full for the year it was expended).

There is, however, a gray area (not unlike most tax issues) between the two definable extremes. For example, if a hand full of shingles is replaced to repair the roof on a rental property in order to keep the roof from leaking, it may fall under the definition of an operating expense. However, if the same number of shingles were used to replace one section of the roof exposed to wear and tear by weather elements, the expenditure may be regarded as extending the life of the roof, and therein might not be classified as a repair, but a capital improvement.

Another potentially troublesome allocation is that of reserves for replacements. In a planning sense this is a proper allocation of cash flow because it enables investors to make annual allowances for anticipated future expenses. However, from a tax shelter standpoint any allocation of funds in anticipation of future expenses cannot be deducted under federal tax code until they are incurred and paid.

As a real estate investor, these tax shelter implications are, of course, significant. Whereas expenditures classified as an operating expense could be deducted in the year of the expenditure, those classified as a capital improvement must be depreciated over the appropriate life of the improvement. So always seek good tax counsel if you own real estate investment property.

You can preview an APOD and other reports that reveal the cash flow schema on the website that I maintain for my real estate investment software. Simply open the Reports section of any of my three real estate investment software solutions. You will find numerous rental property analysis reports that you can freely preview.

What is a Proforma Income Statement?

A proforma income statement is a report investors and analysts who are engaged in real estate investing commonly use for the purpose of forecasting the cash flows generated by a rental property. The concept is simple. By projecting out over some number of years the income that a rental property might likely generate, investors and analysts are able to conduct a cash flow analysis that will help them evaluate the future performance of a property during the real estate investing decision-making process.

There are no restrictions on the number of years you want the proforma income statement to project. I’ve seen real estate investment software, for instance, that create statements ranging from ten to twenty years; a few even boast that their software provides for thirty-year forecasts. However, I personally feel that these longer range projections can become too misleading to be given much weight. There are just too many factors that can alter any cash flow forecast, especially for that many years. My own real estate investment software creates a proforma income statement that allows you to measure the financials for ten years, and I consider that adequate for any investment property cash flow analysis.

Likewise, a proforma is not limited to the type of financial data that it reveals. A good statement should include cash flows, rates of return, and proceeds resulting from a sale (known as reversion) at the very least. But the better ones also include calculations for the elements of tax shelter, so that cash flows, rate of return and proceeds resulting from a sale “after taxes” is revealed as well. I believe that prudent real estate investing decisions should include projections for cash flows and returns after taxes, so my real estate software provides both.

The bottom line, of course, it that you are seeking to evaluate how well a rental property might perform in future years. So whether you prefer to forecast a property’s financials out ten or twenty years, with or without taxes, is up to you. The most important thing is that the proforma reflects your own real estate investing objective, and in turn provides the data you require to conduct your investment property cash flow analysis.

Of course, no proforma income statement is worth the paper it’s printed on unless the projections you want to make are based upon sound data. For example, if you feel that rental income can realistically appreciate two percent per year, than use that percentage for your forecast, and fight off the temptation to bloat that percentage to three or four percent just because you hope so. You might even consider staggering the percentage of growth just to be safe. Perhaps two percent for the first two years, zero percent for years three and four, and one percent for each year thereafter. My real estate investment software will allow you to do this.

If you are engaged in real estate investing, and choose to create your own proforma income statement, please feel free to refer to mine as a guidepost. You can preview several samples on my website at www.proapod.com under reports for my three solutions. All you will need is a spreadsheet program like Excel, and some extra time. Well, maybe a lot of extra time, but it’s worth the effort because you certainly don’t want to exclude having a cash flow analysis the next time you invest in real estate.

Why Real Estate Investment Includes Risk Analysis

The bottom line about any real estate investment analysis is that it is a risk analysis. If risk was not an issue with investing, and all the results of any given investment were known with certainty, than creating an analysis for any type of real estate investment would simply be a matter of arithmetic. But the truth about real estate investing is that many factors come into play (i.e., the economy, tenant trends, etc.) that make it impossible to ever know with absolute certainty enough about a typical property to remove every element of the unknown.

Since the ability to accept varying levels of risk will differ from investor to investor, many simply avoid real estate altogether and opt to put their money only in relatively risk-free investments such as government Treasury bills. But the price for this lower level of insecurity, of course, is a lower rate of return. Why, because a relationship always exists between risk and rate of return. Therefore, when investors are attracted to the certainty, they in effect force down the rate of return they are willing to accept as a trade-off for their unwillingness to accept uncertainty.

Okay, so what about the risk takers? What can investors who prefer to collect the higher rates of return associated with real estate investment do to deal with (and perhaps minimize) the ambiguity? Investors must exploit tools that can potentially measure this risk. One method is by applying what is known as a “probability distribution” to prospective real estate investment opportunities.

For example, rather than using just one set of rents to ascertain potential cash flows and returns for a rental property, the investor should consider several rent scenarios that reflect an estimated probability of their occurrence.

In my real estate investment software, for instance, a form is provided that allows users to apply three different rent scenarios to a rental property. This way, rather than just having to accept whatever rents are presented by the seller, the investor can analyze the cash flows and returns based upon a range of rent probabilities (i.e., most likely, somewhat likely, and not likely but “wow, wouldn’t it be great”).

The logic is straightforward. Say, for example, that you’re doing an analysis on a ten-unit apartment complex made up of ten two-bedroom, one-bath units each reportedly with the potential of renting for $700 per month. My own experience warns me that “potential” rents may (or may not) be likely, so I always prefer to run my own rent scenarios. In this case, then, you would use our Rent Scenarios form and assign three rent probabilities based upon your own measurement of risk, and instantly you are the results so you can analyze what impact each rent might have on cash flows, rates of return, and profitability. The outcome if monthly rents are more likely at $650, for instance, could affect your willingness to chance buying the property.

This is only one of a variety of mathematical and statistical approaches to risk analysis that will help you address the uncertainties of real estate investment. But you get the idea. The best way to deal with uncertainty is to measure it. And the probability distribution we illustrated for rents is a good first step.

You can see a screen shot of our Rent Scenarios form by clicking here real estate agent software