Archive for the ‘How to’ Category
Sometimes I’m guilty of throwing around yield numbers on this blog without providing specifics. I’ll say “we legged into a 9% un-levered yield” or “the cash-on-cash yield on this deal is 6%”.
Some of you are probably sitting there thinking that you can compare those yields with, for example, what you can get by lending money on Lending Club or buying treasury bills or whatever.
Those aren’t apples to apples comparisons, but those aren’t apples to apples comparisons, because they don’t take into account the tax treatment of the cashflow coming in.
To start, you need to understand that interest income of any type is taxed at normal interest rates. That means, for someone in the highest marginal tax bracket, making a loan to someone at 8% nets you something like 4% / year post tax.
Rental income is also taxed at normal income tax rates, with one big difference: You get to take advantage of depreciation.
Consider the following example of an 8% yield deal:
- Buy a property for $1MM cash
- Collect net operating income (rents less all operating expenses, including property tax) of $80,000 / year
- That’s an 8% yield ($80k / 1MM = 8%)
- But we’re not done…
- Assume of the original $1MM price, 50% of the value attributable to the structure (eg not the land)
- Depreciate the $500k structure straight-line through 27.5 years, implying 18,182 of annual depreciation
- To calculate the after tax yield, deduct the depreciation from the NOI…$80k – 18k = $62k
- Pay 50% tax on $62k, leaving $31k after tax PLUS the $18k that was sheltered by depreciation
- Total post tax cash of $31k + 18k = $49k
- $49k / $1MM = 4.9% after-tax yield
So, two different investments, each boasting an 8% yield. But one gets you 4% after taxes and one gets you nearly 5%.
If you don’t think that’s a big deal, then I invite you to mail me an annual check equal to 1% of your post-tax income from investments.
Get a sales person license.
Join a decent brokerage.
Get your personal expenses under control so you can survive for 6 months without earning.
Read voraciously to learn about the business.
Hustle like crazy to bring in your first deal.
Work your first deal as hard as you know how.
Ask questions of your broker if you think there’s a chance you might not understand something perfectly.
Deal honestly with everyone and put your clients’ interest before you own.
Close your first deal.
Put the money away so that you can survive for 6 more months.
Close your next deal.
Make sure the world hears about your success.
Keep hustling to meet people.
Keep reading / learning.
Keep doing deals.
Repeat. You’re on your way.
Yesterday, the Eastsider reported on the proposed sale of a piece of land on Temple entitled for 69 units.
That got me thinking about the value of land in Echo Park and how it impacts the income taxes of property owners there. (Warning: This piece is a little heavy on the math, but it’s critically important. Not understanding this cost me thousands of dollars in income tax over-payment for roughly five years until I figured it out.)
When you buy a piece of property, the county assessor assigns a portion of the purchase price to the value of the land and the rest to the value of the structure. Here’s an example, from ZIMAS:
This is the assessor information for 2143 Clinton St., a property in Echo Park we flipped through Better Dwellings back in 2011. Note towards the bottom where it says “Assessed Land Value” and “Assessed Improvement Value”. That’s the assessor making a wild-ass guess and attributing $440,591 to the land (65% of the total) and $235,665 to the structure (35% of the total).
Why does this matter? Unless you instruct them differently, most tax preparers will pick up the assessor’s breakdown for use in calculating depreciation. Remember: Depreciation is a non-cash charge against income (sort of an accounting fiction) that reduces your tax liability (so, you want depreciation to be as high as possible). Depreciation is ordinarily calculated as 1/27.5 of the value attributable to the structure at the time of purchase, charged against income for the first 27.5 years of ownership. So, if the value of the structure is higher, the depreciation will be higher, and your taxes will be lower.
For 2143 Clinton:
- Purchase price of $660,000
- Assuming a stable ratio of structure to total value: $235k / $675k = 35%
- Value of structure at purchase 35% x $660k = $231,000
- Annual depreciation, assuming assessor’s structure value is used = $231,000 / 27.5 = $8,400
That means the owner’s first $8,400 of cashflow from the property will be tax free. Not bad right? Wrong… the owner is probably getting a raw deal.
Consider that the seller of the land on Temple seller is trying to get $4.95MM for 69 units worth of entitled land. That’s equivalent to $4.95MM / 69 = $71,739 per unit of land. That’s pretty high and it’s much, much higher than the price of land at the time 2143 Clinton was purchased. I checked back on some comps for that period and I think the price of land in Echo Park in 2011 was somewhere between $40-60k.
2143 Clinton is on a 5197 sq ft lot (see above). The zoning is RD3, which calls for 3,000 sq ft of lot size for each dwelling unit. Can you see what I see? 2143 Clinton is sitting on land that only allows for building one unit on it (though it’s grandfathered as a triplex). If, at the time the buyer bought 2143 Clinton from me, the value of the land was $60k, that means the value of the structure was $660k (the purchase price) – $60k = $600k.
This means there ought to be $600,000 of value attributed to the structure. This makes sense; after all, most of the value in the property is in the fact that there are three income-producing units in Echo Park (plus the fact that we fixed them up and got high rents for them)!
Assuming $600,000 as the value attributable to the structure, the depreciation ought to be $600,000 / 27.5 = $21,818. That means the first $21,818 of cashflow ought to be tax free. The difference in the depreciation between this number and the original $8,400 is $13,418. Assuming a marginal tax rate of 50%, the difference in the depreciation should result in a tax savings of $13,418 x 50% = $6,709. Annually.
If you have additional tax savings of $6,709 per year for the first 27.5 years you own a property, that’s $184,497 in cash that you got to keep instead of paying out in taxes… which will make a huge difference to your net worth, particularly multiplied across an entire portfolio of properties.
The lesson, as always, is to query all of the assumptions made by your tax preparer. At the end of the day, you’re responsible for keeping money that is fairly yours, and knowledge of land prices and how they affect depreciation ought to be one tool in your tool box.
A few very important caveats:
- If you go around claiming to the IRS that land is 10% of total value, they’re probably going to audit you eventually… probably worth keeping it a bit more reasonable; and
- I’m not an accountant or a tax attorney, so don’t rely on this advice. Consult your own professionals!
A contact just sent me this link to an excerpt from Warren Buffett’s most recent Berkshire Hathaway shareholder letter.
Buffett’s approach is pretty much exactly how I think about multifamily real estate in improving parts of LA:
- Pay a reasonable price, such that the yield in year 1 is acceptable
- Don’t put yourself in a position where you might be a forced seller (so, don’t over-lever)
- Manage for yield
- Ignore swings in market prices, except to buy more when prices get low
- Never sell
If you just do this, my guess is that you’ll end up very happy about your investment(s).
Oh, and if you are interested in investing, you should 100%, absolutely, no question read Buffett’s collected shareholder letters, which are available as a collection on Kindle.
(Hat tip to EZ for the link!)
We have a buyer inspecting one of the properties from Fund 1 today, so I thought this would be a good opportunity to discuss how you ought to behave when you, as a seller, attend a buyer’s inspection of your property.
Here are the key things to keep in mind:
- Be honest. You never, ever want to lie during a sale process. If you get caught, the buyer instantly loses all faith in what you’ve told him through the entire process, making it much harder to make a deal. If you don’t get caught, you’re setting yourself up for a lawsuit later on, once the buyer finds what you’ve hidden from him.
- Admit when you don’t know something. It’s ok not to remember something about the property. A perfectly fine response to a question about, say, whether you replaced the sewer line in addition to the drain lines is to say “I don’t know. Let me get back to you in writing by tomorrow afternoon.” That’s a much, much better answer than lying.
- Don’t ramble. I’m guilty of this one all the time. When someone asks you a question, answer it. But there’s no need take off on a major lecture. The buyer is there to see the property, not interview the seller.
- Give the buyer privacy with his inspector(s). Don’t hover / eavesdrop. It makes everyone uncomfortable and possibly causes the buyer to doubt the veracity of what his inspector tells him (“maybe he was holding back because the seller was there…”). If there’s something wrong with the property, believe me, you’ll hear about it in writing from the buyer or his agent.
- Don’t take things personally. Some buyers like to spend the inspection period pointing out niggling little issues with the property. That’s their trip; you don’t need to go on it with them. Just smile, nod, and move on.
- Be personable, but not overly friendly / jocular. You would be amazed at how many deals go bad because buyer and seller interact and decide they hate each other. It’s hard enough to make a deal without that kind of interpersonal nonsense getting in the way. So, keep it calm and friendly, but also business-like. No need to risk screwing up a deal by rubbing the other guy the wrong way.
Our on-going drought was a big part of Gov. Brown’s State of the State speech today.
One of the iron-clad rules of conservation is that people only conserve when they directly feel the cost of not doing so. And yet, in LA, the majority of households do not pay their own water bills, and therefore have zero incentive to conserve water.
Why don’t people pay their own water bills? Because 60% or so of households are renters, most in multi-unit buildings. Very, very few buildings are separately metered for water, so the landlords eat the water bill for the entire building each month.
Why aren’t buildings separately metered for water?
- DWP makes it incredibly difficult / impossible to do so for all but the largest buildings; and
- Tenants groups would resist a change, because they would be worried about landlords putting this new expense on tenants
But there is an easy solution: Force DWP to institute a program whereby water can be separately metered, just like they already do for electricity and just like the Gas Company does for gas. DWP already charges for new electrical meters; there’s no reason they couldn’t charge for water meters as well. And owners would pay, because even a relatively high upfront cost would be offset by the permanent savings in operating costs.
But what about the tenants? Under the law, you can’t unilaterally change terms of an existing tenancy, so landlords have no right to spring a water bill on tenants while they are in residence. However, if a landlord separately meters his building and a unit turns over, then she can include in the new lease that the tenant will pay for water.
The change outlined above would not correct our conservation problem immediately, since very few units turn over year-to-year. However, over time, as more landlords separately metered their buildings and more units turned-over, we would gradually move from being a city that wastes water to one that conserves it.
Go buy a 2-4 unit apartment building in reasonable condition, at a reasonable price, with reasonable debt.
Don’t sell it, even when the price goes up.
When you’ve saved enough, buy another one.
Do this four times, after which you won’t be able to get another 30 year fixed mortgage.
Then move on to larger buildings.
Don’t sell those, either.
If you carry out the advice above, you will 100% die rich. How long it takes for you to get rich will depend on how quickly you can save up down-payments. But the outcome is not in doubt, so long as you have the fortitude to stick to the plan.
The problem for most people is that they don’t have the fortitude. Do I? Not sure.
I see what people search on Google that brings them to my blog. This was a question yesterday that I thought begged for an answer.
First, let’s review what “NOI” is. It’s “Net Operating Income”, or what’s left over after you take in your rents and pay out all of your expenses, including property taxes, but not including mortgage payments or income taxes.
For example: Say you have a duplex where each unit brings in $2k / month. Let’s say the property taxes are $6k / year and the other expenses (property insurance, maintenance, utilities, etc.) are $10k / year. The rent is $2k x 2 = $4k / month x 12 = $48k / year. The expenses are $6k + $10k = $16k. So, the NOI is $48k – $16k = $32k / year.
Sounds good, right? Well, knowing the NOI number without know the price of the asset is kind of meaningless, and that’s the problem with the question that is the title of this piece.
Imagine you paid $5MM for an apartment building, all cash (so there’s no mortgage payment). If the NOI is $32k / year, the return on your $5M investment is $32k / $5M = 0.6%. 0.6% / year is a horrific return. [Note: Regular readers probably recognize this calculation as a CAP rate, which is NOI divided by price.]
Now imagine you paid $350k for that same asset. Now you’re making $32k on a $350k investment, or $32k / $350k = 9.1%. Getting to a 9.1% cash-on-cash return is pretty incredible!
Bottom line: Knowing the NOI alone is somewhat meaningless. You need to know what someone is asking you to pay for that NOI to figure out if you want to own it.
There are a lot of new readers here recently. Welcome.
You may have noticed that the topics here jump around some. I tend to write about whatever I’m working on at any given moment, and that can vary. But it’s important to me that you get what you are presumably here for – an education about buying, managing and selling apartment buildings in Los Angeles.
Here are some pieces I think are particularly important, grouped loosely by topic. Note that there’s a lot more in the blog… I’ve been writing almost every day for nearly 18 months now, so there’s plenty to dig into if you have the time.
Why you should own apartment buildings:
How to think abiout value and how it increases:
The buying process:
Thinking about managing buildings:
- Introduction to Los Angeles rent control
- Why the tenants and lease are important
- What to keep in mind when you’re managing