All yields are not the same

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.

How to get started in real estate

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.

Keep saving.

Repeat. You’re on your way.

How the price of land affects your income taxes

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.)

Here goes:

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:

Screen Shot 2014-04-08 at 9.32.38 AM

 

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:

  1. 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
  2. I’m not an accountant or a tax attorney, so don’t rely on this advice. Consult your own professionals!

How I think about LA real estate

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!)