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Case Studies

Case Study #1: "Being Creative to Make Everyone Happy!"

Case Study #2: "Investment Decisions Not Always Obvious."

Case Study #3: "Investment Property Equals Very Affordable Home!"

Case Study #4: "Good Investments Often Made, Not Found!"

Case Study #5: "Best Not to Panic When Dealing With Problems."

Case Study #6: "Real Estate is an Expanding Investment."

Case Study #7: "Big Deals Don't Always Require Big Money!"

Case Study #8: "Don't Overlook The Ugly Ducklings!"

Case Study #9: "Hot Market Mortgage Rates Drop, Prices Rise:"

Case Study #10: How the Banks look at Investment Properties

Case Study #11: "Rising Executive"

Case Study #12: "High-Income Professional"

Case Study #13: "Middle-Aged, High-Income Professional"

Case Study #14: "Middle-Income, Empty Nesters with Recent Inheritance"

 

Case Study #1: "Being Creative to Make Everyone Happy!"

 

The Property: A large (3400 sq.ft.), 4 level, 4-plex containing 2-1 bedroom and 1 - 2bedroom licensed apartments plus 1 unauthorized 2 bedroom basement suite on a 30’ x 88’ corner lot. The building is structurally sound, but required repair work in a number of areas including roof, plumbing and wiring.

The Revenue: At closing, the gross rent was $3,005/mo., or $36,060/yr, with upside potential as some of the rents were below market. Taxes and expenses were approx. $7,000/yr, providing a Net Income of $29,000/yr or $2,422/mo.

The Sale: The property was listed for $428,000. The sale agreement was for $450,000 with the seller “giving back” a repairs rebate of $25,000 upon closing. This made the actual sale price $425,000. The seller also agreed to “take back” a 2nd mortgage of $30,000 @ 7% for a 2 yr. term with “interest only” payments of $175/mo or $2,100/yr.

The Financing: As well as the 2nd mortgage from the seller, the buyer arranged a 1st mtg of $337,500 @ 4.7% for a 1 yr term with payments of $1,905.68/mo or $22,868/yr. This amount was based on 75% of the “contract” sale price before the seller’s $25,000 rebate. The buyer agreed that 75% of this $25,000, or $18,750, be held back and disbursed to the buyer once he had completed the planned repairs on the building. The initial down payment, therefore, was the sale price ($450,000)less the rebate ($25,000) less the 1st mtg ($337,000) less the 2nd mtg ($30,000) plus the “holdback” ($18,750) or $76,250. Closing costs of approx. $7,500 brought the initial investment to $83,750.

The Investment Analysis: In this case, the potentially conflicting requirements of the 3 participants (buyer, seller and lender) were met by creative collaboration to get the deal done.

The Buyer: acquired a large, high income rental property in a prime area with good financing and a relatively low down payment. The net income of $29,000/yr less the 1st & 2nd mortgage costs ($22,868 + $2,100 = $24,968/yr) provides a positive cash flow of over $5,000 in year 1! The 1st mtg. structure gives him $18,750 to immediately do repairs to get the building into 1st class condition (and allow rent increase). The 2nd mtg. “takeback” allowed him to do all this with a down payment of less than 18%, avoiding high ratio financing premiums while increasing his positive leverage and overall % return!

The Lender: required some convincing and got additional safeguards to approve a well secured loan backed by a strong appraisal and good income in a preferred location. By “financing” the repairs for the property (via the $18,750 initially held back), they contributed to an increase in the property’s value and its income potential. This both secured and reduced the risk of their loan.

The Seller: was able to sell a property that no longer met his needs at 99% of his asking price while avoiding issues of repairs and maintenance. The 2nd mtg he “took back” allowed him to defer a bit of capital gain tax from the sale, as well as giving him a decent return of 7% (well above GIC or term deposit rates) on his $30,000 investment in the 2nd mtg.

 

Case Study #2: "Investment Decisions Not Always Obvious."

Not all investment decisions are obvious ones, and the requirements and circumstances of an investor can change a seemingly questionable investment into a profitable opportunity. This example shows how a buyer takes into account his total portfolio of properties and finds a “fit” for a new purchase.

The Property: A large 3 level triplex (legal duplex with unauthorized basement suite). The building is approx. 2900 sq.ft., with 1-2 bedroom suite and 2-1bedroom apartments on a 50’ x 120’ lot. The condition is excellent and the large yard is well kept. The property generated rent of $32,400/yr. or $2,700/mo. from good tenants. Taxes and expenses are approx. $8,400/yr. or $700/mo.

The Sale: The property sold for $615,000 to an investor who used the income and equity for his other holdings to “100% finance” the sale, including $11,000 for property purchase tax and closing costs. A mortgage of $626,000 was arranged at 4.9% on a 1 year term and 25 year amortization, with total monthly payments of $3,605.

The Investment Analysis: For most investors, this would be a difficult purchase to justify. After expenses, the property generates a net income of $2,000/mo., which carries financing of only $347,000 - even at the low interest of 4.9% - requiring a down payment of almost $$280,000 or 45% for it to support itself without the investor subsidizing it from his own pocket.

For the buyer, however, the property fit his requirements nicely. Firstly, he considered the property a bit of a jewel - great location, large lot, classic character building in excellent condition, good long term tenants, and rental “upside”.

Secondly, he calculated the financial picture as follows:

With a net income of $2,000/mo. and mtg. payments of $3,605/mo., the property showed a negative cash flow of $1,600/mo. The buyer’s other rentals generate enough income to support this purchase and place him in a 50% tax bracket so that his net negative cash flow after tax is actually $800/mo. or $9,600/yr. He anticipates that this property will appreciate by at least 3.25%/yr. so that after three years the value will have increased by at least $60,000. He also anticipates being able to refinance the property at that time and “take out” at least 70% of the increased value or $60,000 x 70% = $42,000. After he “pays back” the after tax income shortfall of $9,600/yr. x 3 years. or $28,800. he is able to put the rest (42,000-28,800) = $13,200 in his pocket - tax free! In fact, the rents for the property are below market and the buyer has been able to increase total rent by $150/mo before completing the sale.

This extra income reduces his after tax negative cash flow to $725/mo or $26,100 for the 3 years, so that by refinancing after year 3 he will receive ($42,000-$26,100) = $15,900!

 

Case Study #3: "Investment Property Equals Very Affordable Home!"

The Property: A small, 3 level triplex (legal duplex with unauthorized extra apt). The building is approx. 2100 sq.ft., with 3 1 bedroom apartments on a 40’ x 66’ lot. The condition is good, as the owners had done renovations during their 4 years of ownership.

The property generates rent of $1,750/month, with tenants paying heat and light. Taxes and expenses are roughly $350/mo.

The Sale: The property sold for $260,000 to an owner occupier planning to live in the smallest unit, and collect rent of $1,250 from the other 2 apartments. Down payment was $65,000 (25%) and a 1st mortgage of $195,000 was arranged a 6.25% on a 5 year term, 25 year amortization. Monthly payments are $1,276 plus $90 net taxes. The selling Realtor observed that “Someone with a paper route could afford to own this house!.”

The Investment Analysis: For an investor, the initial “numbers” look like this: Down payment of $68,500, including property purchase tax and closing costs: 1st year net income of $16,800 less $15,320 debt service = $1,480 before tax. Assuming that net income will increase at an average rate of 3% year, the net income after 5 years will be $18,910, or $3,590 after debt service, and the mortgage balance would be $175,800. At a capital appreciation of 3% per year (very conservative), it would be worth $301,500 after 5 years. At that point, the investor could refinance or sell. If the property is kept, the monthly net income of $1,575 could support a new 1st mortgage for the balance of $175,800 to a rate of 11% - providing some interest rate “risk insurance” for the owner. If Interest rates stayed the same (6.25%), the income would permit the investor to “take out” his original investment of $68,500.

If the property is sold at $301,500, the net proceeds (after commission and mortgage balance) is $113,370. The internal rate of return to the investor for the 5 years (before tax) is 13.5%.

 

Case Study #4: "Good Investments Often Made, Not Found!"

The Buildings: Two “Duplex Buildings”, with a total of 4 three level (including full basement) townhouse units. Each of the units is totally self contained with its own hydro and gas meters, hot water tank, furnace and laundry hook-up. The units are just over 1600 sq.ft., for a total building area of 6500 sq. ft. The buildings are very plain and about 60 years old, but are in reasonable condition with no pressing maintenance issues. The basements are mostly unfinished and have further development potential.

The Land: is a 66’x115’, (Multifamily) zoned, corner lot. The zoning allows for redevelopment of the property to a multifamily building of 8 to 14 units, and up to 10,800 sq.ft. of floor area. The neighboring properties had recently sold (for $135 PSF) and a large condo development has been built.

Replacement Cost: Land prices for similar types of property in the area had ranged from about $110 PSF to $135 PSF. Building costs under current City code would be about $100 PSF. Total replacement cost would be about $220 PSF or ($220 x 6,500 sq.ft.) = $1,430,000.

The Revenue: 2 of the units were rented at an “undermarket” rate of $1,100/month, while the other 2 units had been brought to “market rents" of $1,400 and $1,500 for a total monthly income of $5,100, or $61,200/yr. The units are fully self contained, there is no common area maintenance and the tenants pay all utility costs. So expenses are quite low - after taxes, gardening, garbage removal and maintenance, yearly expenses are about $12,500/yr.

The Sale: The property was listed for $875,000 and sold for $780,000. Offers were received from developers planning to build a new multifamily project, at a higher price than the eventual sale price. These offers were marred by the requirement for lengthy “tie-up” periods, and other conditions unattractive to the seller. The successful buyer is an investor who plans to hold the property.

The Financing: The buyer received a mortgage for 75% of the sale price ($585,000), at 6.5% interest with a payment of $3918/month or $47,000/yr. The Setup:

Gross Yearly Income: $61,200

Less Expenses & Reserves: (12,500)

Cash Flow From Operations (CFO): $48,700

Less Financing Costs (FC): (47,000)

Cash Flow After Financing (CFAF): $ 1,700

- Return on Assets (ROA): $48,700/$780,000 = 6.25%

- Financing Cost (FC): $47,000/$585,000 = 8.03%

- Return on Equity (ROE): $1,700/195,000 = 0.87%

The “Upside”: The buyer purchased an “easy care” property in good condition at a price close to “land value”. The property was “under rented” and the units contained “unimproved” space in the basements, allowing the buyer to add value immediately. By renovating the basement areas and adding a bathroom and bedroom at an estimated cost of $10,000/unit, he should be able to increase rents to a total of $1,700/unit. If he finances the improvements at the same rate as his purchase, his “New Setup” looks like this:

Gross Yearly Income: $81,600

Less Expenses & Reserves: (12,500)

Cash Flow From Operations (CFO): $69,100

Less FC ($625,000 @ 6.5%): (50,240)

Cash Flow After Financing (CFAF): $18,860

- Return on Assets (ROA): $69,100/$820,000 = 8.43%

- FC: $50,240/($585,000+$30,000) = 8.17%

- ROE: $18,860/$205,000 = 9.20%

 

Case Study #5: "Best Not to Panic When Dealing With Problems."

Most property owners know how it feels to discover a sudden problem needing immediate repair in their home or rental property. The following “Case Study” illustrates the importance of taking care when selecting the tradesperson or company to fix the problem.

The First Sign: A musty smell filling the dwelling and getting worse each day.

The Cause: Standing, stinky water in a portion of the crawlspace.

The Fear: Oh no a drain tile problem - call the Bank!

The Search: 3 drain tile companies were selected to assess the problem. Company #1 was selected because they were the best known. Company #2 was selected because they had the biggest yellow pages ad. Company #3 was found via personal references from a local plumbing company.

The Proposed Solution: Company #1 and Company #2 had a quick look around the outside of the property and recommended the following: Dig through a concrete patio, expose the drain field, scope, roto rooter & flush the drain tile system.

The Proposed Cost: Starting at $750 to $850 and climbing as high as $3000 plus, if a portion of the drain field needed replacing. They were ready to begin immediately.

Company #3 took some time to inspect the area where the water was in the crawlspace.

His Conclusion: The problem wasn’t drain tile, but a broken discharge line from the dishwasher in the kitchen above the crawlspace.

The Actual Cost: To remove the water, and disinfect the area: $100. To reinstall a new dishwasher line: $85. Total cost: $185.

The Saving: Between $700 and $2700 plus!

The Moral: The best thing is not to panic! Get lots of opinions until you are sure the person knows what they are talking about and can do the job for a fair price!

 

Case Study #6: "Real Estate is an Expanding Investment."

One of the most compelling reasons for buying and owning rental investment real estate is the phenomena of expanding value and expanding return on investment. This occurs as a well bought and well maintained property experiences income growth and decreasing debt over the investment period. As rents increase (modestly) year to year, and mortgages are paid down on a regular, escalating basis, the prudent and patient investor can watch while other people (tenants) work to pay off his property - bought (largely) with other peoples' (the bank's) money.

The following Case Study illustrates dramatically how this can be done.

The Property: A legal 6-plex containing 3 - 1 bedroom apartments and 3 bachelor apartments in a well maintained building, with an area of approximately 3650 sq. ft. (including laundry, storage, mechanical areas etc.) It sits on a 50" x 124" zoned. The roof is newly replaced, the drain tiles have been redone and an underground oil tank has been removed. There is a rear yard garage containing 3 separate single car bays, each with their own doors and electrical power.

The Income and Expenses: The current rental income is $4,030/month from the 6 apartments, laundry and garage rental. This income may be immediately increased by renting out 2 of the garage bays (currently used by the owner for storage) for $125/month each.

Current expenses (adjusted for the latest Gas, Electric and Water increases) are $10,000/year, plus an additional $2,000/year for maintenance reserves. The Net Operating Income (NOI) is:

Rental Income (including garages): $4,280/month
Expenses (including reserves): 1,000/month
Net Operating Income (NOI) $3,280/month or $39,360/year.
We are predicting that Net Income will increase at a rate of 3% each year over the 5 year analysis period. This assumption is supported by historical rental information from NMHC, and by the fact that Dallas has been experiencing a up and then down rental (and real estate) market for several years, and is now poised for a period of higher demand. The rental increases may not be as "straight line" as the analysis shows, but will average out over the 5 year period.

At a purchase price of $450,000, the analysis for this property is as follows:

Investment Analysis for Legal 6-plex

Purchase Price: $450,000 Capitalization Rate: 8.75%
Expense ratio: 23.4%
Net Income (NOI): $3,280/mo. or $39,360/yr Gross Rent Multiplier: 8.76

Financing: Purchased with a $337,500 (75% loan to value) 1st mortgage @ 7% interest, 5 year term, 25 year amortization and payments of $2,364/month or $28,368/year...

Down Payment: $112,500 Net Income (yr. 1): $3,280/mo or $39,360/yr
Closing Costs: 8,000 Less Debt Service: 2,364/mo or 28,368/yr
Total Investment: $120,500 Before Tax Cash: Flow: $916/mo or $10,992/yr

The Mortgage Balances and the mortgage pay downs at the end of each of the 1st 5 years:

Year 1 Year 2 Year 3 Year 4 Year 5
$332,257 $326,641 $320,624 $314,179 $307,275
$5,243 $5,616 $6,017 $6,445 $6,904

5 Year Cash Flow Pro-Forma: Including NOI increasing @ 3% each year illustrates the expanding value and expanding return nature of this investment. Note that these return figures do not include, or rely on, capital appreciation of the property.

If the property is sold in year 5, using a capital appreciation factor of 3%, the price would be $522,000 for a net gain (after sales costs) of over $50,000. If the property were sold at a Capitalization Rate of 8%, the price would be $554,000: at 7.5% the price would be $590,000. Its only a question of the amount of return "bonus" the future market will dictate. But why would you want to sell as long as the investment promises to expand?

 

Case Study #7: "Big Deals Don't Always Require Big Money!"

There is a common perception that only those with large net worth's and high incomes may buy significant real estate assets. The following case study defies that logic, and illustrates that the most important factors can be the investors’ will to work with what they have, and their patience to look past the surface of a situation to realize value.

The Property: A 4 level, 13 suite apartment block on a 75’ x 120”. The apartments are large, with nine 1 bedrooms over 750 sq.ft each, and four 2 bedrooms over 1,100 sq.ft. Four of the apartments have ocean and City views with the 2 large penthouses having fantastic, unobstructed views from their private, large roof decks. The building had been neglected, with obvious deferred maintenance, especially in a vacant, 2 bedroom suite, and in the owner’s 1,300 sq. ft. penthouse unit.

The Revenue: At the time of listing, the “pro-forma” revenue was stated as $158,500/year, which included the vacant suite factored in at $1,100/month and the owner’s penthouse suite at $2,000/month. The yearly expenses were shown at about 33% of gross income, or just over $52,000/year, for a net income of just over $106,000/year. This provided a Capitalization Rate of 6.4% on list price, considered better than the average market.

The Buyers: A mother and son, both school teachers, were immediately interested in the property. Both persons lived modest lifestyles and had a total, combined yearly income of approximately $90,000. They own, jointly, 2 houses - one as a family home, and one as a rental. The houses are vintage, and sit on 25’ x 120’ lots. One of the houses is clear title, the other is encumbered by a mortgage.

The Sale: The property was listed at $1,650,000, and it was assessed at $1,733,000. Because of the location and income, there were many showings to qualified buyers. Two factors, however, caused these persons not to purchase the property. First was the shabby appearance of the building and the 2 apartments mentioned above, which caused the fear that a large budget would be required to “fix” the building. The second concern was that the seller, as a condition of sale, insisted on remaining as a resident in the building. Because the seller had 2 large dogs, and because of the condition of his suite and building, most buyers considered this requirement as too large of a risk. The successful buyers, however, were patient, and able to look and work past these obstacles. After a very long negotiation, and a number of options explored, a simple contract was achieved at a price of $1,550,000. The agreement included the provision that the seller would remain as a tenant (paying market rent), and move into the vacant suite once the Buyers had renovated it.

The Financing: Except for an initial deposit of $5,000, the Buyers were able to 100% finance the purchase! Their mortgage brokerage team structured the financing in 2 stages: A NMHC insured 1st mortgage of approximately 74% of the value, at a rate of 6.65% was secured by the property. The balance of monies required, including down payment, property purchase tax, closing costs, plus a “renovation fund” to begin building repair immediately, was achieved by a conventional refinancing of the 2 Kitsilano houses.

Summary: The Buyers were extremely pleased with the purchase. Upon inspection, they discovered that the repair requirements of the building were not as onerous as indicated at 1st glance, with much of the work being cosmetic, or within the scope of their own abilities. They also identified savings of several thousand dollars in the expense schedule of the building, and an updated rent roll delivered to them just before closing indicated that the adjusted yearly rental would be closer to $164,000 - approx. $5,000 more than the original pro-forma! The owner remained in the penthouse suite at $2,000/mo, and they were able to rent the renovated suite for $1,350/mo, or $3,000/year more than planned. The combination of savings and increased rent pushed their net income projections above $120,000, giving a Capitalization Rate in the 1st year of ownership of almost 8% - an exceptional return for this 1st class area!

 

Case Study #8: "Don't Overlook The Ugly Ducklings!"

Ugly Ducklings don’t always turn into Swans, and concerns over location, tenant mix and shabby conditions are usually valid reasons for a Buyer to pass on a property. Here, however, is another instance where an experienced and capable investor was able to accept a bit of a “project” in order to realize handsome returns.

The Property: A 4 level, 12 unit Apartment Block on a 33’ x 120’. The building is almost 9,000 sq.ft. in total area, and has “character” elements with high ceilings, wood floors and spacious apartments (10 x 1 bdrm & 2 x 2 bdrm). It is fully sprinklered, with upgrades to electrical & plumbing, but had been quite neglected with obvious deferred maintenance, a leaking roof & 3 apartments vacant due to extensive renovation and repair. The tenants were a mix of short & long term, and mostly low income persons.

The Revenue: At the time of listing, the “Year 2000” revenue was stated as $78,000/year, less vacancy of $5,640 and operating expenses of $20,713, for a net income of $51,647 giving a Capitalization Rate of 10.6% on list price. In fact, with the vacant apartments and an adjustment for higher energy costs, the actual, annualized net income at the time of negotiation was approximately $20,000/year less than this.

The Buyer: After a number of offers for the property, a successful and determined buyer emerged. This person was a real estate professional and had, in the past, owned a building much similar in location, condition and tenant mix. Although he never said so during the negotiation of the contract of sale, the buyer was confident that he could overcome the shortcomings of the property and make it a smooth running and very profitable investment.

The Sale: The property was listed at $489,000, and it was assessed at $491,000. Because of the income, and in spite of the location and appearance, there were many showings to qualified buyers. The factors that caused most of these buyers to back off was the fact that the building condition and tenant mix were issues needing immediate attention. The successful Buyer carefully considered this situation and negotiated a sale price of $450,000, but made the sale conditional on an extensive list of due diligence items. Over a 30 day period, these items (building inspection, environmental assessment, City work order search, appraisal, etc.) were systematically satisfied and the subjects were removed. Even after this, though, there were a couple of last minute delays in completing the sale as “suprise” issues regarding environmental factors and building insurance coverage had to be dealt with.

The Financing: This was not a “slam dunk deal”. Even though the Buyer had a down payment of $150,000, and was borrowing only $300,000 (2/3rds of the sale price), securing and finalizing the mortgage commitment was a laborious process. As mentioned, the lender looked for a very clean environmental report, and was very sticky regarding the building insurance. A mortgage was arranged at 7 3/8%, on a 3 year term, with a yearly debt service cost of $26,000.

Summary: The Buyer regarded the property as a project, and immediately began doing repairs and upgrades to the building, starting with a new roof and renovation of the 3 vacant apartments. The building is heated by a natural gas boiler and hot water radiators, but every suite is also completely equipped with electric baseboard heaters tied into the electric panel in the unit. This allows the owner to convert (on a suite by suite basis) the heating system from gas to electric, and the utility costs from owner to mostly user pay! A vacant storage area (complete with its own electrical panel and plumbing) on the lower floor will become a coin laundry area for tenants. The Buyer expects to spend in the neighborhood of $70,000 to $80,000 on the repairs and “beautification” of the property over the next 2 years or so. By doing this, he expects to achieve rents averaging $650/mo. for the 1 bdrms, and $800/mo for the 2 bdrms, for a gross income of $97,000/yr. Adding laundry income of approx. $2,000/yr, and reducing heating expenses by approx. $8,000/yr could allow a net income of $75,000/yr for a Capitalization Rate of about 14%, and a “cash on cash” return of about 25%! This “ugly duckling” might never be a swan, but it will likely be a “goose” laying golden eggs for its owner for a good long time!

 

Case Study #9: Hot Market Mortgage Rates Drop, Prices Rise:

Prices Way Up Over Past Year!

Yes, we are in a hot Real Estate market! To understand why, you only have to look at the numbers - especially interest rates and listing inventory. The following “Case Study” shows how the past year’s drop in mortgage rates has allowed prices to rise:

4-plex generating a Net Operating Income of $30,850/yr or $2571/month.
Sold Jan. 2002 for $375,000. 5 year (discounted) mortgage rate in January 2002 = 5.5%

For an investor buyer with a total cash investment of $100,000 (25% down payment + closing costs) and a 1st mortgage of $281,250, the numbers are good. Net income of $2571/mo. Mortgage payment of $1717/mo. leaves $854/mo. or $10,250/year cash return, for over 10% cash on cash return on invested down payment!

For a 1st time occupier buyer with a 10% down payment ($44,000 including closing costs), and living in the main floor suite (currently rented at $960/month), the cost of owning & living in the house is as follows: 1st mortgage (including NMHC premium) of $346,000 = payment of $2112/mo. Net income less main floor rent ($2571 - $960) = $1611/month as mortgage helper, for a total cost of ($2112 - $1611) = $501/mo!

In January 2001, the 5 year (discounted) mortgage rate was 6.75%. If these buyers had been in the market at that time, and had wanted the same return or benefit as shown above, they could have afforded to pay only $334,000 for the property. The drop in interest rates has allowed a price increase of over 12%!

The other major factor driving the market, and causing prices to rise is the low number of listings on the market, and the relatively high number of sales or absorption compared with 2001!

The total number of listings at January 2002 is down as much as 25% compared with January 2001, while the number of sales for the month of January 2002 has increased between 60% to 200% over January 2001! The shortage of properties for sale, combined with a high number of sales has created urgency amongst buyers and the market, and this has driven prices up!

As the same time, some areas are beginning to see growth in the number of listings coming on to the market - up to 60% higher than in 2001. This means that although sales figures are high, supply is starting to catch up to buyer demand. This may relieve some of the pressure or urgency, and cause the market to cool down in the near future.

Timing is important in Real Estate, and the current time strongly favors Sellers. If you are thinking of selling your property, don't wait for inventories to rise and don't miss this market! For more information, or to discuss how this market can benefit you, call Joanna Tipton at 972-267-9377.

Case Study #10: How the Banks look at Investment Properties

Lenders have been making it easier to purchase small rental properties by applying “residential lending rules” to purchases of rental buildings of up to 10 units or less. In the past, these deals would have been passed to their Commercial Lending Division, which has much more rigid qualification rules, stricter loan to value and debt service ratios, and higher interest rate schedules. Now these purchases are often handled at the branch level where the current residential rates apply, and approvals are a much less bureaucratic process.

It is also more feasible now to use “high ratio” financing to purchase investment or rental properties, or to use the rental income from extra apartments in a property to help a home purchaser qualify for mortgage financing. Formerly, anyone buying a property with less than a 25% down payment had to deal with PMI private mortgage insurance, and policies toward suite or rental income was as follows:

1. Only legal income was allowed and unauthorized suite income ignored.

2. Only one-half of the legal income was added to the personal income of the borrower.

3. The Gross Debt Service Ratio of 30% to 33% was applied against personal income to determine the amount of mortgage payment allowable. This means, in effect, that NMHC considers only one sixth of any rental income as being applied directly against the mortgage payment.

One lender now has a program that allows up to 85% loan-to-value ratio, with 75% of all rental income (including unauthorized apartments) coming “off the top” of mortgage payments, so that the borrower only has to qualify for that portion of the mortgage payment “net” of the allowable rental income.

Example - On the purchase of a $300,000 triplex where the buyer will occupy one of the apartments and collect the rent of $1600/month from the other 2 apartments, First Line will lend up to $255,000 at posted interest rates (no discount), and apply $1200/month directly against the mortgage payment. At an interest rate of 6.95%, with a payment of $1780/month the borrower will only have to qualify for $580 of the monthly payment, and require a total personal income of only $1,900/month with a down payment of $45,000!

Other lenders are also very willing to “net” the suite or other rental income directly against payments on their conventional mortgages. Hong Kong Bank routinely accepts 70% of rental income, while Citizens Bank will accept up to 100% of suite rental income.

 

Rising Executive:

 

Objectives:

A higher rate of return than achievable in money market funds; tax savings; some liquidity for other opportunities that may arise.

"Kim Rutledge" is a 30-year-old salesperson with a small corporation involved in retail sales. She averages about $60,000 a year and will soon take a management position. She has $30,000 she can invest in real estate.

Financial situation:

Kim is single, with no dependents. Her income has been rising steadily for five years and is sufficient to support her. She owns a condominium for her own use. She has no retirement fund at her company. Cash is currently in a money market fund. She usually pays $15,000 to $16,000 in income taxes yearly.

Discussion points and alternative strategies:

  • Purchase condominium for rental?

  • Consider speculation on a house in new subdivision?

  • Suggest hiring management or lean toward professionally managed property?

  • Hold back some of the $30,000 for liquidity?

  • Analyze after-tax effect of money market fund?

  • Consider partnership unit of a project?

  • Start with a small commercial property for first purchase?

  • Invest in a REIT?

Solution:

After physically viewing various condominium projects, Kim decided to invest $20,000 in a limited partnership involved in renovating a small downtown office building. She received 10% interest in the property for her investment. The first year of ownership will yield $4,000 in taxable loss, plus over $1,000 in cash flow.

The $4,000 taxable loss will continue for a few more years. The cash flow before tax has been minimal; the building is still carrying a 20% vacancy factor, but is expected to attract tenants in a tightening market. The partnership projects a sale in Year 10 of ownership.

With this project doing so well, Kim has decided to concentrate on tax-oriented partnerships for her portfolio and to avoid smaller projects that she might own herself. She now uses Internal Rate of Return (IRR) as a comparison tool to measure her real estate investments against the current money market rate.

 

High-Income Professional

Objectives:

Building a portfolio; diversifying investments; tax shelter; avoiding negative cash flow; appreciation in value.

"Brian Kile" is an investment banker in his late 20s who is enjoying an excellent market, two back-to-back years of earning $200,000 annually, plus end-of-year bonuses. Although he has a 401(k) and a number of investments in stocks and mutual funds, he wants to diversify into real estate. He is not sure how many more high-earning years he will enjoy before the market cools. He often works 80 hours a week and thus has little time or inclination for hands-on management.

Financial situation:

Brian can live comfortably on $75,000 per year. He is not interested in purchasing a home. He estimates that at his current level of earnings, he could afford to invest at least $100,000 per year in real estate investments. He does not necessarily want to hold on to an investment until retirement; future income could come from the sale of his portfolio, in whole or in part, as the real estate market dictates. He is seeking to shelter his income, but wishes to avoid negative cash flows in case the stock market experiences a downturn.

Discussion points and alternative strategies:

  • Structure partnership with tax benefits going to Brian.

  • Realize that locate property could be located anywhere in the U.S.

  • Invest cash now to receive benefits at a later date when taxed at capital gains rates.

  • Provide strong down payment to guard against heavy negative cash flows.

Solution:

Brian joined 3 partners in the purchase of a 48-unit apartment project. The purchase price was $2.3 million, with the owners carrying financing for 10 years. The owners guaranteed a gross income for the first two years of ownership. The down payment was $230,000. Management has been hired and the property is operating as expected.

Brian has set a strategy of buying one or two investment properties per year to help build his portfolio. He likes small partnerships because of his intense work schedule.

 

Middle-Aged, High-Income Professional

Objectives:

Positive cash flow; tax benefits; avoiding overly speculative investments; professional management needed.

"Dr. Thomas Painter" is a 45-year-old cardiologist. He has a well-established practice, two children at home, a son in college, and an annual income of $200,000 to $300,000. He currently owns a 20-unit apartment project, a partnership unit of a piece of development land, and a vacation home on the beach.

Financial situation:

A high-tax-bracket professional, Dr. Painter has owned apartments for seven years, has a low interest mortgage, and a $150,000 to $200,000 equity position in the apartment project. He has $150,000 cash in a CD available for investment; and has open credit lines of another $100,000 if needed. Property does not have to be local and liquidity of invested capital is not important to him. His income is expected to continue at the current level or higher.

Discussion points and alternative strategies:

  • Refinance, sale, or exchange of apartments to use additional capital.

  • Stay with income-producing property.

  • Partner with other doctors to enable exposure to larger properties.

  • Purchase office building for doctor's practice.

  • Buy apartment units to provide more cost recovery.

  • Consider down payment of $250,000 to enable larger purchase.

  • Secure line of credit serviced by personal income.

Solution:

The owner of the building that houses Dr. Painter's office was approached about selling the office building, to which he agreed. The sale price of the building was $950,000, requiring a $175,000 down payment. The balance was financed by the doctor's bank at 8.5%. The property is an attractive building and the doctor seems very satisfied with the benefits it could provide. Additionally, his corporation pays rent to the buildings account. The doctor's accountant and broker are currently working on a way to help him take advantage of his $200,000 equity position in the apartment project.

 

Middle-Income, Empty Nesters with Recent Inheritance

Objectives:

Low-risk investment; income for retirement; liquidity; tax shelter.

"Mike and Stacy" are in their mid-50s and have two children who have finished college and live independently. Mike is a blue-collar worker whose salary is $55,000; Stacy earns $35,000 as a nurse. They own their home outright, having paid off their mortgage early. They have some management and maintenance capabilities, but do not want management "headaches."

Financial situation:

The couple will receive $200,000 after tax from Brad's father's estate. Brad's income is secure and is likely to remain at this level until he retires. They have $20,000 in savings, in a CD.

Discussion points and alternative strategies:

  • Purchase quality real estate, even if low cash flow, such as an apartment (three or four units).

  • Buy small office building or retail store; Bradley's can maintain exterior.

  • Buy condominium in vacation area for eventual retirement.

  • Generate cash flow for retirement.

Solution:

The Bradley's purchased a five-year-old brick building leased to a union's credit union. The credit union has signed a 20-year lease with increases built in every three years. The Bradley's maintain the exterior, parking area, and yard, but the union handles everything inside.

Owner financing was used, which increased the projected IRR (Internal Rate of Return) to over 18% after tax. The rental increases were projected at 10% every three years and the building was conservatively projected to appreciate in value by 15% over the next 10 years. The purchase price of the building was $570,000, with a $142,500 down payment. The mortgage will fully amortize in 15 years.

 

The case studies are actual mortgage applications successfully processed to completion, they are intended for the purpose of providing an example only, and every mortgage application is underwritten separately on its own merits.