Is buying cheaper than renting? Property Check

While I was out looking at properties with a client and I came across a newly constructed duplex.  On a price per square foot basis it was cheaper than the other properties listed in the area.  I was curious to look at the numbers and see if it would be cheaper to own and rent out one unit or rent something comparable in the area. 

1728 S Highland Ave.
Listed at $1,199,000
Duplex
Unit 1 3 Bed 2.5 Bath, Unit 2 4 Bed 3 Bath
Total Square Footage: 3316
Lot Square Footage: 6250
Year Built: 2015

To view the property details follow this link

I started looking at closed rental leases in the area on the MLS and I found 2 rentals that went for $2,800 and $3,500 a month. I believe this is a much nicer property than those rentals and you could get around $3,400 a month.

Here are the numbers with a renter paying $3,400 a month and the owner paying for the remaining expenses. Purchase price $1,149,000 with 20% down ($229,800) at 3.7% interest rate for a 30 year fixed loan. For the depreciation expense I estimated that the improvement would be 50% of the value. I only depreciated half of the improvement value because only half of the units are being used for rental income. Depreciated over 27.5 years. 

PROJECTED CASH FLOW:
			Monthly	Annually
		Gross Potential Income	3,400	40,800
	-	Vacancy / Bad Debt	(142)	(1,700)
	+	Miscellaneous Income	0	0
	=	Effective Gross Income	3,258	39,100
	-	Operating Expenses	(1,417)	(17,003)
	-	Capital Expenses
	=	Net Operating Income	1,842	22,098
	-	Principle and Interest	(4,231)	(50,771)
	=	Before Tax Cash Flow	(2,390)	(28,674)
Payment Breakdown & Depreciation
		Interest Paid	(2,810)	(33,723)
		Equity Added	1,421	17,048
		Depreciation	870	10,445

The tenant is paying $40,800 annually and the owner is paying the remaining balance of  $28,674 annually as noted in the "Before Tax Cash Flow." 

At the end of the first year after adding back the benefits from tax deductions, rental income and added equity the owner will definitely be in a better position.

If you want to learn more about owning real estate contact me. 

The information on the Site is provided for educational or information purposes only; it is not intended to be a substitute for professional advice, whether tax, legal, or otherwise. Please consult your tax professional about the specifics of your tax situation. Rents and expenses are hypothetical actual results may vary. 

References

IRS Publication 936 "Home Mortgage Interest"

IRS Publication 946 "How to Depreciate Property"

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Los Angeles County Housing Market Report: February 2015

Los Angeles County Housing Market Report: February 2015

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Under Appraisal Risk

I received an email from a lending offer discussing some strategies for dealing with under appraisal and I wanted to talk about them.

"When home prices increase rapidly like they have. Appraisers can have a difficult time or don't put in the effort to appraise properties at the current market value, this can lead to appraisals coming in low and ruining transactions... "

What is an appraisal?

If you're getting a loan to purchase real estate the lender will want to verify that the property has value to support the loan. The lending officer does this by ordering an appraisal from a neutral third party that's paid for their services. The most common method for valuing a residential home is the sales approach. The appraiser will look at the comparable properties that have sold within the last 12 months within a mile radius. This distance can change depending on the location and the quantity of recent sales. Appraisers like to stay within any natural boundaries like freeways or rivers. The appraiser will select 3 comparable properties and make adjustments to each property to make it similar to the subject.

What is under appraisal?

An under appraisal is a difference between the purchase price and the appraisers opinion of value. If you're buying a home for $500,000 with 20% down ($100,000) and it appraises for $480,000. You have have an under appraisal of $20,000. 

When your property is under appraised there are a few ways to fix the problem.

1. Seller accepts a reduction in the purchase price to the appraised value.
2. Buyer makes up the cash difference in appraised value and the purchase price. This may require the buyer to use cash that would have gone towards the down payment  and result in a higher loan to value ratio.
3. Buyer and Seller come to a mutual agreement on a price and they both share the burden.
4. Challenge the appraisal.
5. Cancel the contract if there can't be an agreement.

Buying a home in Los Angeles can be very competitive. In a multiple offer situation in order to get the property under contract you need to be aggressive with your offer. Unfortunately the risk for under appraisal can't be completely eliminated. You can be better prepared by getting a list of comparable properties that have sold in the area and accept the possibility that you might need to make up any difference.

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How to Calculate Real Estate Returns

“Investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings.”

— Tobias Carlisle, Deep Value

            When you invest in rental property you will own all or a part of the earnings from that asset.  In addition to cash flow you will also receive equity payments and tax deductions which shield some or possibly all of your income.

In real estate when looking at your income statement it should look like this.

Purchase Price: $79,000, $15,800 Down, $2,500 Closing Costs

Cash Flow:			%	Year 1
		Gross Potential Income		$13,200
	-	Vacancy / Bad Debt		$ (660)
	+	Miscellaneous Income
	=	Effective Gross Income		$ 12,540
	-	Operating Expenses	45%	$ (5,902)
	-	Capital Expenditures
	=	Net Operating Income		$ 6,638
	-	Principle and Interest		$ (3,512)
	=	Before Tax Cash Flow		$ 3,125
		Interest Paid		$ (2,350)
		Equity Added		$ 1,162
		Depreciation, Improvements over 27.5 Years		$ (2,298)
		Taxable Income (GPI-OE-Interest-Depreciation)		$ 2,649

Real Estate is commonly valued using two popular metrics Gross Rent Multiple and Capitalization Rate. Gross rent multiple or GRM can be calculated quickly be taking the price of the property and dividing it by the annual gross rent of the property in the example above 79,000/13,200=6.2.

The other calculation is Capitalization Rate or Cap Rate which can be calculated by taking the Net Operating Income and dividing that by the purchase price of the property in the example above 6,638/79,000=8.4%. The Cap Rate isn't going to give you your exact return on investment. However it will give you an idea of what you COULD make if you made a full cash purchase of the property. Because the Cap Rate doesn't take into consideration the costs of financing, the return is unlevered. The Cap Rate should represent the bottom level of your returns, if your estimates for expenses and vacancy are reasonable. To take into consideration the added benefit of leverage, you can take a look at your Cash on Cash returns. This can be calculated by taking the Before Tax Cash Flow and dividing it by the total cash needed to own the property in the example above 3,125/15,800=19.8%.

I believe the most accurate picture of what you're going to get is going to be something I'll call Total Real Estate Yield until someone corrects me. Total RE Yield will be Before Tax Cash Flow + Equity Added / Down Payment + Cash to Close + Equity Added, which is (3,125+1,162)/(15,800+2,500+1,162)=22%.

Real Estate returns typically reflect the market's sentiment for at particular area. If you look at Month's Supply Inventory you can get an idea for the demand in a given area. Attached are 4 Charts looking at MSI in Los Angeles, United States, Lake County Ohio, Cuyahoga County Ohio. You can't possibly look at a single number in real estate and assume a complete picture. But what the hell, here are some charts.

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