Real Estate Economics

Introduction:

The New York Real Estate market is a unique market. It magnifies the conditions of any ordinary market and brings its own set of attributes to the marketplace. First time homebuyers, whose income ranges from minimum wage earners to annual incomes well into the 6-figure range, drive the market. The cost of living is one of the highest in the world and yet its population steadily increases. Our discussions today will yield a better understanding of this marketplace and improve the value of the service we, as real estate professionals, provide.

What are the basic elements of this market?

1.  First time homebuyers: With the steady influx of new residents from all over the world there is a constant flow of individuals looking to become owners.

2.  Investors: One of the reasons people are drawn to New York is to “strike it rich”. Immigrants come from their home countries to have a better life for themselves and their families. Companies recruit from all over the country to fill their employment needs. One way or another people are coming here to make money. Once they accumulate some cash they typically want to make an investment.  They will either invest in the stock market or into real estate. Historically real estate has generated the most wealth in this country, so there is a natural attraction to real estate. With the recent bloodbath in the stock market, there has been a revised interest in real estate investment for its inherent security. Should we move into an inflationary period, there will be a substantial increase in the investment appeal of real estate.

3.  Population Growth: The more people that move into the area, the more people need a place to live. This increases a demand for a commodity that’s already is short supply.

4.  Construction Issues: Most regions of the country can simple build more housing to meet the demands of a growth in population. We don’t have that luxury. New construction in New York usually starts by buying an existing property, demolishing the existing structure and then building new. This has an adverse effect on cost.

5.  Quality of Life: One of the basic reasons people want to live in this part of the State is the quality of life. There is something here to satisfy every desire. Museums, theaters, beaches, nightlife, variety of restaurants, sports, rock concerts to symphonies are just a few of the amenities we take for granted. No place else in the world has diversity of this magnitude. It doesn’t come cheap, but we are willing to pay for it.

6.  Transportation Costs: Because of the high costs related to transportation in the area, developers are limited as to how far outside of New York City they can comfortably build. As much as industry has spread out from the city, there still exists a hub-spoke relationship to New York City.

7.  Creativity of the Industry: Due to physical and economic constraints we are forced to work with, we have developed an extremely creative real estate industry. We’ve developed ways to convert existing rental housing stock into co-ops and condos in order to create space that can be affordable to purchase. We’ve found ways to convert abandoned industrial buildings, and in some cases entire neighborhoods, into desirable housing.

Motivations of the First Time Buyer:

1.  Shortage of Available Rental Housing: One common comment you will hear from anyone who has looked for an apartment recently is that there is very little to choose from and what’s worse, the monthly charges are unrealistic. Not being happy with what can be rented is a strong motivation to move into an ownership position.

2.  Shortage of Land: Vacant land is impossible to find. Additional housing stock can only be added to the marketplace through spot building or acquiring and then demolishing existing structures. Both approaches add substantially to development costs. Inside the city limits you have government intervention, through the rent stabilization laws, acting as another disincentive to develop more rental stock. It also has the additional negative effect of encouraging residents in apartments that are too large for their needs to stay in them because their current rent is being kept artificially low. In a free market rent environment empty nesters would find it cost effective to downsize, since it would mean lower housing costs. Under rent stabilization, staying where you are is more cost effective.

3.  Tax benefits: For those individuals that have come to the area based on the salary they are being offered, tax benefits become very important. Because we are in an area with a high cost of living, salaries need to be high to attract qualified people. This obviously puts them into a high tax bracket. The tax benefits of ownership then become very valuable.

4.  Stability: People reach a point in their lives when they begin to seek stability of where they live. It could be because they are tired of rent increases or because they are starting a family and are seeking a secure place to live. Whatever the reason, stability plays a major role in the home buying decision.

5.  Safety of the investment: People, in general, have short memories. When the real estate market softened in the late Eighties many were afraid to invest in real estate. After all, real estate prices never go down but that was exactly what happened. Now we’ve entered the new millennium. The stock market now has replaced real estate as the “perfect investment”. Stock prices can only go up, becomes the popular belief. Reality sets in. Investors found themselves losing money by the day. The “perfect investment” proved to be nothing more than an illusion. People are beginning to look for safer investments. Area real estate values have been appreciating at a steady rate of 10% to 15% a year depending on the area. These rates of return are now beginning to look pretty good.

6.  Wealth effect: People who own property feel rich. They proudly boast about what their homes are worth to the friends that are renting. Regardless of how inflated their estimates are, they look like they have made a very smart investment. Weather it is the power of suggestion or the “keeping up with the Jones” their friends become motivated to buy.

Remember, at his point, we are concentrating on the owner-occupied market. We’ll address the investor market later on. The market elements are the same but the driving forces of the investor are different then what we are noting here.

If we are in agreement at this point, you can’t help but come to the conclusion that purchasing a place to live is a no-brainer. To have any exposure to a loose, there would need to be a change in the basic elements of this marketplace or a change in perception of the potential buyer.

This is exactly the condition that existed in the late Eighties. There were underlying changes in the both the national and regional real estate markets adversely impacted the perception of the marketplace.

Overview of the market for the last 20 years:

Real estate prices were driven to excessive levels in the eighties and the market paid the price as we entered the nineties. If we are going to have any chance in recognizing the next market peak before it happens we need to take a closer look as to what happened twenty years ago. The rapid growth of real estate values during the eighties was driven not only by investor greed but also by the outside influence of the government.

Zoning changes in Manhattan were responsible for a good portion of the problem. Due to a major zoning revision it became advantageous for new construction to begin prior to the effective date of the changes. Construction was beginning all over the city, not because of market demand, but to beat a deadline. If a foundation wasn’t poured before the effective date, the physical size of the building would be greatly reduced. This would jeopardize the feasible of the project. So in essence, the city was responsible for much of the overbuilding that occurred in the eighties. This abundance of space flooded the market and the market needed time to absorb it. With this increase of supply, prices needed to drop to compensate for it.  

Nationally the banking industry was going through major changes. If you recall, up to the Eighties there was a large number of savings banks in the country. Savings banks were, for the most part, local institutions that made their money by taking in deposits from the local community, paying a savings account interest rate, and then lending the money back out. Most residential mortgages at the time were written by the savings banks. Their cost of funds was 5% and they were lending money out at 8%. Mortgages were held as an asset of the bank. Life as a savings bank was simple and profitable.

Then along came the concept of mutual funds. Consumers now had an alternative to keeping their money in the bank. They needed to do no more than open a money market account, with any number of brokerage houses, and earn a higher interest rate on their money with little or no increase in risk. As money flowed out of the savings banks, they needed to respond to a new marketplace.

Simply put, they responded by selling their portfolio of mortgages into the secondary market in order to have the capital available to write new mortgages. To make matters worse, they now had new competition in originating mortgages. Companies were formed for the sole purpose of originating mortgages with the intent of selling the mortgages immediately into the secondary market. These companies are known as mortgage bankers. They didn’t have the overhead costs of a branch, bank tellers, etc. All they needed was an office to work out of, commissioned originators to generate business and a secondary market person to arrange for the sale into the secondary market. This gives the mortgage banker a competitive advantage over the saving bank in the origination of new mortgage business.

In their drive to survive, the savings banks directed their lending to more risky mortgages. Mortgages that the mortgage bankers had no home for. Properties or projects that could not be done before due to a lack of financing now became doable.

Remember, during this time the economy was totally different than it is today. The inflation rate was high. There was a fear that it was going higher and everyone’s greatest fear was that they couldn’t afford to maintain their standard of living. We, as a people, took for granted the idea that each generation would have a higher standard of living than the previous one. This unquestionable fact of American life was coming into question. Individuals began moving their savings into tangible assets such as gold, collectables and real estate. This move was perceived as a prudent course of action.

These conditions lead to an appreciation rate for real estate that was unprecedented. Then the marketplace had a reality check. Most of the growth in real estate prices was not a result of a true market demand; it was a result of the population looking for a safe haven from inflation while the banking industry experimented with new avenues of lending.

Even the State and the City decided to take advantage of the profits being made in the Real Estate market. Both the State and the City had budget gaps to close. As a way to increase their revenues, with the least amount of strain on the public, they elected to increase the taxes on the sale of property. The State extended the reach of the Real Property Transfer Tax (RPT) to include all co-op sales with an effective date of July 1, 1989. The City thought this was a great idea and also began to do the same thing except their effective date was August 1. This is also when the State began imposing the mansion tax. Although the RPT’s are a seller’s expense, the mansion tax was a buyer’s expense. Any residence (either owner occupied as well as investment) that sold for more than 1 million dollars would be taxed an additional 1% of the sale price payable to the State, by the buyer.

Then things began to change and change quickly. Lenders soon began to realize that property values don’t make mortgage payments, borrowers do. As borrowers began to have financial problems in making their mortgage payments, lenders could no longer depend on the income stream. This became especially troublesome for the more aggressive lenders. Remember this was the time when the saving banks were loosing their underwriting standards for both the borrower as well as the property type.

Due to their lack of experience in this type of lending the saving banks started to see higher and higher default rates, much higher than the commercial banks or the mortgage bankers. As their looses mounted, their financial viability become in question. The real estate market began to cool down, their foreclosures began to increase and the industry effectively collapsed. The Federal government stepped in, bailed out the stronger savings banks, arranged for stronger institutions to take over some of the weaker ones and closed down the weakest ones. The Resolution Trust Corporation (RTC) was created for the sole purpose of disposing of the inventory of foreclosed property that was left in the government’s hands.

An article that appeared in the New York Times, Thursday, December 21, 1989, illustrated the problems facing the Saving Bank industry, specifically The Dime Savings Bank.  “Harry W. Albright Jr, the chief executive at Dime, said that ‘it is too early to hang the crepe’ for the New York housing market, because ‘this is a market that is driven by an undersupply of housing’ not a surplus, as in other regions of the country. But he acknowledged that problems already in place were enough to cause an increase in the amount of troubled real estate loans next year….From 1985 through 1988, when home prices in New York were rising, Dime Savings Bank began to lend heavily, making 11 billion of mortgage loans. Because most of them were ‘low documentation’ loans, in which the bank relied on the underlying value of the property and made only a cursory check on the buyer’s income, Dime has been hard hit recently as homes prices have declined.”

The one outstanding event that had the greatest influence on the market correction of the eighties was the federal tax law change that went into effect in 1986. One major feature of this change was to limit the passive losses that an investor could take. Passive losses that were once limited only by the income of the filer was now limited to $20,000. Real Estate investments that were structured as tax shelters now had no value. They were quickly being dumped into the marketplace.

This closer examination of the real estate market of the eighties shows that a unique set of events came together causing the largest price correction this area has ever seen.

Is history repeating itself? We’ve again gone through nearly 10 years of rapid appreciation. Lenders are anxious to lend money. People are paying more for their energy and food costs re-igniting their inflation fears. The recent stock market correction is forcing people to find safer avenues to invest their money. The region has experienced the worse terrorist attack in recorded history, straining the local economy in ways no one could ever imagine. At first glance a drop in real estate prices seems unavoidable.

There is no question that we’ve seen a rapid increase in real estate values. When compared to the increase in the Eighties, an argument could be made that currently we have seen an even higher growth rate than that of the Eighties. The overall inflation has been virtually non-existent during the nineties unlike the eighties. The big difference between the decades appears when you compare rental prices.

During the Eighties, sale prices were escalating at a much higher rate than rental prices. The difference between the cost of ownership and the cost of renting continued to increase all through the eighties. Potential buyers began to be priced out of the market so they started to put off the buy. The condition today is different. The cost of renting has been increasing at a similar rate as the cost of owning. The entry level pricing for ownership in most communities yields a monthly carry that is no more than the market rent for the same space.

Even the laws governing rent stabilized apartments have been revised. Apartments with a monthly rent of $2,000 or more can now be released from the rent stabilization restrictions. Landlords that can prove a tenant’s annual income is in excess of $175,000 per year can have the rent restriction removed. The government has acknowledged, through these revisions, that the existing laws were protecting individuals that didn’t deserve protection. Individuals with substantial incomes or could afford to pay $2,000 or more for rent didn’t need government protection. The rent stabilization system was never intended to provide cheap rents for those who could afford to pay market rent. It was intended to protect low and middle class families from being put out of their homes because a landlord could get a new tenant who was willing to pay more.

The incentives for an individual to upgrade from being a tenant to an owner are:

1.  Stability of housing expenses. Unless the renter is protected by rent stabilization or some other government regulation, he is at the mercy of the market and the greed of the landlord.

2.  Tax benefits. There are no tax benefits in renting, however as an owner the IRS becomes your partner in the expenses.

3.  Secure Investment. The stock market crash is driving people to safer investing and real estate is again being viewed as a safe investment.

When a potential homeowner takes a closer look at purchasing he will see an opportunity where his rate of return on his investment is almost too high to calculate. A superficial look a buying a home will lead to an incomplete picture of the investment. The simple analysis of taking the purchase price, cash requirements for the down payment and closing costs, the monthly carry costs for the period of ownership and then calculates the rate of return overlooks one major component. The carry cost would have been paid even if the investment wasn’t made. It just has a different identity. It’s called rent. By moving from a rental to an ownership position, an individual has the unique opportunity to take an expense, rent, and make it a component of an investment. The carry cost component of the analysis is an expense that would be incurred with or without making the purchase. This substantially will increase the rate of return. You are taking an expense item and converting it to an investment item. Opportunities like that don’t come along often.

These points are in addition to the driving forces behind first time homebuyers that we discussed earlier. So it would be logical to conclude that for housing prices to drop from the level of today it would require market rents to also decrease. The local housing inventory is effectively decreasing, due to the lack of construction. The population is increasing, as confirmed by the latest census figures. The only unknown component is what the long term effects of September 11th will have on the marketplace. Will rents collapse? Will companies relocate out of the city? Will people no longer want to live in Manhattan? If companies and/or people move, where will they go?

Lenders have again begun to loosen their lending standards, just like they did in the eighties. The only difference this time around is that they are smarter at it. The industry has begun to think like the insurance business. That is to evaluate the risk of a program, property type or borrower profile and then price the mortgage to reflect the risk. A driver with 3 moving violations will pay substantially more for his car insurance that a driver with 1 violation, who in turn will pay more than a driver with a clean license. A borrower with a poor credit history and questionable income will pay a much higher rate than a borrower with good credit and provable income.

For example, the borrowers that closed on the “low documentation” mortgages that The Dime Savings Bank was offering in the Eighties paid little more for the product than the borrowers that supplied a complete financial package. For whatever reason, they didn’t recognize the true risk associated with this lending criteria. Today, you will see wide pricing variations from program to program and lender to lender covering the complete spectrum of risk levels. By receiving higher yields on higher risk loans lenders hope to have the necessary cash flow to cover the loans that don’t perform. They won’t be right all the time, but they will be in a much stronger position than they were coming out of the Eighties.

On the commercial side, there is no longer any money available for spec building. In the Eighties it was easy for a developer to approach a savings bank with a project and get it funded based on the anticipated rent roll. When the tenants didn’t materialize, the lender foreclosed and became the proud owner of a vacant building. Today, unless you have your own cash to build, you will only get financial backing if your project is substantially pre-leased. This prevents the glut of new space that was a contributing force to the market collapse 20 years ago.

We have been through 10 years of almost nonexistent inflation. We are only now beginning to notice the early signs of inflation and we are becoming concerned. Serious inflation is right around the corner. This will only increase real estate values in the coming years. The increase in the cost of energy recently is the wake-up call. The events of September 11^th have added a new operating expense to all businesses. Security costs are now going to escalate for everybody. It will show up as a direct expense, such as additional manpower. It will also show up as an indirect expect, such as additional shipping expenses incurred due to delays caused by the security checkpoints. Security and energy costs are just the beginning of the inflation issue. When the U.S. economy begins to heat up again, which it will, the cost of labor will become the major force behind the acceleration of the inflation rate.

The Baby Boom, the 75 million people born in the 15 years following World War II, poured into the labor market in the 1970’s and 1980’s. The unemployment rate, no matter how healthy the economy, seldom fell below 6%. It even reached double-digit levels in the early Eighties. The 1990’s, even with all the increases of worker productivity brought through the technological advances, were categorized by low unemployment. We began the millennium with the unemployment under 4% and a labor shortage. There have been major layoffs throughout the country, the unemployment rate rose to 6.0% for a period and is now back down to around 4.5%.

Generation X, the “Baby Bust” generation, born in the next 15 year window compromise of only 42 million individuals. The number of 20 to 34 year olds, your entry level work force, increased by 18 million between 1970 and 1980 but decreased by 3 million between 1990 and 2000.

Generation Y, the children of the Baby Boomers, consisting of 72 million people won’t impact the workforce for sometime. The number of 20 to 34 year olds is projected to grow by only 4 million over the next ten years. As the Baby Boomers retire (the oldest are approaching 55 and the youngest are almost 40) the shortage of workers becomes a bigger and bigger problem. Economics 101 tells us that when you have a shortage of a commodity, in this case workers, the price of the commodity goes up, in this case wages. It is estimated that 60% of the cost of any product is attributed to labor costs.

Baring a lengthy recession, there will be a labor shortage for some time. This will contribute to a higher inflation rate and therefore higher housing prices. The current real estate market more accurately reflects the early eighties, prior to the escalating price period than the market correction 10 years later.

What normally will keep the inflation rate in check is the quality of life component of the region. New York is one of the countries largest points of entry for immigrants. As our labor pool becomes strained, local businesses will reach out first to other parts of the nation to attract workers and then globally. When industries run short of workers in the U.S. labor pool, the federal government typically issues more visas to foreign nationals permitting them to work in this county. The question here is, will the terrorist activity encourage the United States to close its doors to immigration? And if so, how tight? In the near term there will be tighter restrictions on immigration. With short-term unemployment on the rise, this is probably a good thing.

The United States is still the most desirable country to immigrate to. New York has always attracted more than its share of new arrivals. This region has one of the most diverse ethnic mixes of any city in the world. Immigrants quickly find a place they feel comfortable in one of our many communities. So even in an environment of restricted immigration, this region’s population will continue to grow.

Once these new arrivals attain permanent residency status, they typically want to move into an ownership position. Most cultures give homeownership a high level of respect and it is something to attain as early in one’s life as possible. So the net result of the labor shortage ends up being an increase in the number of first-time buyers in the market. This will result in even higher prices for real estate.

This paints an interesting picture for our region. The overall inflation rate, although increasing, should be kept in check due to the increase in the availability of skilled workers. Once the region gets accustomed to a higher rate of inflation, investors will then be attracted to tangible investments such as real estate. Any increase in the workforce will increase the demand for housing. Both these conditions will contribute to real estate appreciation.

The only problem that can arise is if the local economy enters into a prolonged recession. If businesses accelerate their downsizing, there could be a real problem. Although there are no guarantees, there seems to be little evidence that this will happen as each day we get better and better economic reports.

The technology industry collapsed with little impact to the region. The financial industry has laid off large numbers with a nominal impact to the region’s economic base. We have a diverse business mix in this area and fortunately it is knowledge based not industrial based. There is little or no manufacturing done in our area, we are mainly a service economy. Companies need to invest their money in people, not plants and equipment. This helps insulate the area from industry specific problems and therefore aids in minimizing the damage of a recession.

There is much talk of the financial industry decentralizing their operations from Lower Manhattan. This will definitely happen. The question is, where will they move their operation? The most likely answer is that they will use smaller offices located near their existing manpower. Most workers in Lower Manhattan are commuters from the boroughs, New Jersey, Long Island and Connecticut. So companies will most likely not move out of this region, just relocate inside it. There may be an adverse impact on the commercial real estate market in Manhattan itself but the adjoining communities will benefit. Workers will end up with the added benefit of reduced commuting times.

This observation of our marketplace is supported by data collected by the appraisal company of Mitchell, Maxwell & Jackson. They are the largest appraisal firm in the New York City area and are considered a reliable source of housing trends in the region. Their conclusions are based on actual appraisals done over the years and are summarized here:

“The mid 1980’s saw a massive increase in housing supply driven by a strong economy and generous tax incentives. The end of the decade brought changes in the tax laws affecting real estate investments, the stock market crash in 1987, the Gulf War and a weakening of the economy. The combination of these factors caused market wide recession and a period of declining values. From 1988 to 1992 the real estate market went through a re-adjustment. New construction nearly disappeared and values declined 10-20% per annum while the market struggled to find equilibrium. 

Declining interest rates, a lack of new inventory and the general recovery of the local and national economies stabilized the market between 1993 and 1994. General market conditions steadily improved until mid 1998 with various sub-sectors of the housing market recovering in waves. The epicenter if the recovery was the architecturally appealing, owner occupied, family sized apartments in prime locations. A Mitchell, Maxwell and Jackson, Inc. study of over 1,000 re-sales between 1990 and mid 1998 indicates that the rate of appreciation during this period was between 5% and 25% per annum. By the end of this period recovery reached nearly all property types and locations in the borough of Manhattan south of 96th-125th streets. During this era marketing time declined to between 1 and 3 months and shortages of inventory were noted. Sales activity was at or above its highest level since the mid 1980's and the average price of a New York apartment broke through the 1980's high average. The relatively few new construction owner occupied residential projects initiated from 1993 to mid 1998 were very successful and many sold out well ahead of expectations.

From 1994 to mid 1998 property values increased citywide driven by improving economic conditions. Increases in residential real estate values were 10-20% per year during this period of growth. In 1999, the New York residential real estate market resumed its climb upward. The first half of 2000 data indicates the strongest appreciation rates in recent history, with prices increasing 20+% over a six-month period. Marketing time was reduced to days, rather than weeks or months, and many properties sold for full ask or more. Bidding wars were regularly noted and shortages of inventory became acute.

Marketing data from 2000 Q3 through 2001 Q2 indicate a soft landing. Prices re-adjusted during this period and are considered to be flat overall. Marketing and exposure time returned to a healthy range of 3-6 months. Inventory levels increased into the area of 'in balance' as new residential construction brought on line additional housing units in the luxury end of the market.”

Real Estate Investing:

What attracts people to invest in real estate:

1.  Historically, real estate is where a family’s real wealth is formed. If you look at all the powerful family names in this country you will see that no matter have much wealth they accumulated through their business interests, the majority of their wealth was derived from real estate. People have always admired the wealth effect of owning real estate.

2.  People with a “hands on” approach to life or are “control freaks” will choose real estate over other forms of investing. A real estate investor selects the property, decides on how leveraged he wants to be, directs the improvements that are done, determines the asking rent and chooses his tenants. This is a far cry from reading a prospectus, taking a recommendation from your stockbroker and hope that the management of the company is smart enough to make you money.

3.  Real estate investing allows for much higher leverage than any other investment and at a relatively low cost of funds.

4.  A typical real estate deal requires that the cash flow of the property be high enough to cover all expenses, including financing, and still turn a profit. If a property doesn’t fit this criteria, it typically isn’t purchased. There is no stock purchase than can be made on margin where the dividend flow is adequate to pay for the interest on the margin account. In the event that the stock price goes down, the investor is responsible to put up additional cash to cover the margin position. The real estate investor, when faced with a decline in market value, may not be happy but he is also not required by his bank to reduce his mortgage amount.

Even with the revised tax laws there are still substantial tax benefits in real estate. For instance, it is the only investment vehicle that the government permits tax-free exchanges. If you are a investor in the stock market and you like the automobile industry but want to sell General Motors and buy Ford, you must pay a capital gains tax on whatever profit you had on GM before you can make the Ford purchase. A real estate investor who wants to move from residential to commercial property can execute a tax-free exchange of one for the other while deferring the capital gains tax.

The driving forces of the investment market are similar to the forces that stimulate the first-time buyer but with some differences. Obviously the shortage of available housing stock and land encourage potential increases in real estate values. The tax benefits of real estate investing aren’t as large as for the owner-occupied purchaser but still positively influence the investment return.

Due to the high transaction costs associated with real estate purchases, investors normally have a long-term time horizon. Over the long haul real estate values have always gone up. Take any 10 year period and compare housing prices. You will see an increase in property values. There may be bumps in the road over the timeline, but the net result will be an increase. So the safety of the real estate market is an important attraction for the investor.

In order to generate higher profits in real estate transactions an investor needs to be creative. Just buying a property at market value and waiting for the market to appreciate will yield a reasonable return on investment. In analyzing a prospective purchase an investor will try to find ways to increase the market value, therefore the rate of return. By addressing weaknesses in the property an investor can greatly enhance his rate of return.

Deferred Maintenance:

This is the most obvious condition than can be addressed. A property is located that, for whatever reason, needs substantial renovations. The property was neglected due to lack of interest, or cash, of the current owner. The investor brings the property up to speed and then either sells the property at full market value or rents it out. If he plans on holding onto the property, he will refinance the property to take his cash out and move on to the next venture. Properties of this type are difficult to finance. The investor will be faced with a higher interest rate, lower loan-to-value ratio, or both. He will probably need to pay for the renovations with his own cash.

Insufficient Rent Roll:

In this case the property is undervalued because the rent roll isn’t up to where it should be. The investor needs to identify why the rent roll is low and come up with a plan of action to correct the problem. His tools here start from not renewing leases through evictions and tenant buy-outs. Estimating the costs involved in doing this is not easy but can be done. Remember here you are dealing with 2 costs: money and time. Once completed this project in now brought up to full value.

Property not being used at its highest and best use:

Through changing the use of the property, its value can be substantially enhanced. Buying a house, tearing it down and building a new home is one possibility. Replacing the house with 2 houses or a multifamily is another variation of the same idea. Converting factory space to residential lofts has become a popular approach inside the city limits. This approach not only has time and money costs but the added expense of dealing with the local building department. Subdivision issues, certificate of occupancy issues, etc. involve additional expenses. Converting a rental property to a co-op or condo will have similar issues.

Assembly of properties:

Acquiring adjoining properties to create enough land to do a large project is another way for investors to work. They may want to assemble enough land to build a shopping center or build an office building. It could be the purchase of air rights to build a higher structure on an existing parcel.

Typically a project will have several of these approaches, working together, in creating a higher value than the property initially had. The profitability of the project will be dependant on the quality of the initial analysis.

Some creative examples:

·    When Citibank was looking to build their new corporate headquarters in Manhattan several years ago, they had a problem with the building site. There was a church on the property. They solved the problem by purchasing the land the church was on and in exchange built a church on the ground level of their building. Thus giving the congregation a new church with a lease to stay there for as long as the location suited their needs. Citibank got the building they wanted and by incorporating the church on the lower level created a unique look. The church is glass enclosed and can be seem from the street creating a one of a kind look in the heart of Manhattan.

·    As you know, the purchase of air rights in Manhattan was a fairly common event. I came across an unusual version of this some time ago. I was arranging a mortgage on a condominium, which had no property tax assessed to it. Needles to say, I needed to know why. In looking into this it turned out that a deal was struck with the owner of the building next door. In exchange for the air rights over the condo, the adjoining property assumed all the condo's obligation for future property tax. The condominium association was able to enhance the value of every unit owner by giving up the right to add additional stories to its structure. A project that a condominium association would never take on. Another win-win situation.

·    It’s also possible to be too creative. Parking a car in the five boroughs can be a difficult experience. Especially in Manhattan but also in some parts of Brooklyn, the Bronx and Queens. In the eighties an investor, Howard Pronsky, converted a garage in Park Slope into a condominium. He initially was looking to sell the spaces for $29,000 each. As of now he has sold 118 out of the 145 spaces at $25,000 each. It’s reasonable to assume he didn’t expect it to take 15 years to reach these sales figures. According to a recent New York Times article, he is currently bringing his asking price of his remaining spaces back up to the $29,000 figure in response to the healthy Brooklyn real estate market. Mr. Pronsky may have been just ahead of his time. Thanks to construction restriction imposed by New York City, the number of off street parking spaces is reducing each year. 20 years ago, developers were required to provide 40 parking spaces for every 100 apartments. In an attempt to discourage air pollution the city revised the building code in 1982. Developers were no longer required to provide any off street parking in their new buildings. Even when developers elect to provide garage space, they are limited to the number of spaces they can provide. Construction south of 60^th street is limited to 20% of the number on new unite or 200 spaces, whichever is less. North of 60^th Street it’s 35% or 200 spaces, whichever is less. The concept of purchasing parking spaces as an investment may become a reality. Stranger things have happened. It wasn’t that long age that Japanese investors were buying golf club memberships in Japan for their investment potential.

·    The conversion of rental housing into co-ops and condos became a driving force of the appreciation through the Eighties. When done right, a conversion is a perfect win-win situation for all involved. You start off with a landlord owning a building whose value is based on the current rent roll. If the property is located within the city limits, the value is further reduced because of the lower rents that come with rent stabilization. An investor looks at the property, its financial situation, and is willing to buy the property based on its conversion potential. This is a higher value that the landlord could sell the property for based on cash flow. The investor (now identified as the sponsor) purchases the building and then begins the conversion process. He typically will renovate the structure. Replacing windows, electrical and plumbing upgrades, remodel the lobby, etc. This improves the quality of life for all the residents. Vacant apartments are offered to potential buyers and existing tenants are offered to purchase their apartment at a discounted price. The existing tenants will also be offered buyouts. Essentially the sponsor purchases their lease and now has more units to sell at the outsider price. When this is done right everyone becomes a winner. Existing tenants benefit by the property upgrades if they stay on as tenants. If they want to take advantage of the buyout, they get to move with money in their pockets instead of just rent receipts. They can buy where they live with a built in profit based on the discount from the outside price. The outside purchaser gets an affordable place to live in a building that has been recently renovated. The sponsor makes the profit he expected. If structured properly and the sponsor is reasonable with his target profit, all parties involved benefit.

Small Investors:

In examining the economics of real estate investments, it will be easier to break investors into 2 groups, the small investors and the major players. Both groups have in common the desire to accumulate wealth through real estate investing. Obviously the differences in financial capabilities will impact the type of property each will be interested in as well as the size of the project. We will start with the small investor.

The small investor probably owns his own home and is expanding into either a small residential building or a commercial property. His source of funds for purchasing will be limited to his own cash, savings banks, mortgage bankers and, in the case of 1 to 4 family homes, the same channels available to the owner-occupied purchase. In most instances he will be facing higher down payment requirements (sometimes as high as 30%) and a higher cost of funds than either the owner-occupied purchase or the major player’s funding sources.

In bidding on his purchase, the small investor will be competing with other investors as well as individuals interested in occupying the property for their own residence. This is an important issue. The investor looks at the property on a cash flow basis whereas someone looking to live in the property is more concerned about how much he would like to live in the property. This additional competition will force the investor to purchase at the higher end of his price range.

Example 1: Purchasing a 2 Family home:

Let’s step through the analysis that a small investor will do to determine the price range for a particular property. Our subject property is a 2 family home in Queens County. The seller occupies first floor and the 2^nd floor is rented out at $1,800 per month. The asking price is $500,000 and the property tax is $2,400 per year.

The first step will be to develop a sense of the current neighborhood values and how the neighborhood is appreciating in relationship to other areas of interest to the investor. Unless the investor is confident that the area shows good growth potential, there would be no reason for him to go any further with this property. The market analysis shows that within the last 6 months 2 similar homes closed. One sold for $440,000 (5 months ago) and the second one closed at $450,000 (2 months ago).

Next, let’s look at the rental income. There are 2 questions that need to be answered. First, is the $1,800 that’s being paid for the apartment market value and, second, what will the first floor rent for? Research has concluded that the 2^nd floor should be @ $2,000 per month and the first floor should rent for $2,800. So he’s comfortable working with a monthly rent of  $4,600 per month.

The monthly expenses on this property are:

1.  Taxes of $200 per month ($2,400 per year)

2.  Water & Sewer charges of $50.00 per month

3.  Insurance of $100 per month (based on a conversation the investor had with his insurance broker)

4.  Utility costs of $500 per month (based on information supplied by con-ed, the gas and electric utility company servicing Queens County)

5.  Average maintenance cost of  $200 per month (based on the investor’s personal experience)

6.  Management fees of $100 per month (although our investor will be managing the property himself, he does need to factor in expenses such as accounting, legal fees, etc. There will always be outside experts that need to be involved and their costs need to be addressed)

7.  The Queens rental market is a very tight one. Rentals are scarce and as quickly as an apartment becomes vacant, tenants are waiting on line to take it. Even in a tight rental market a vacancy factor should be used. Our investor is using a 5% factor, which yields a monthly expense of $230.

The total monthly expense, in this example, comes to $1,380. The monthly income is anticipated to be $4,600. This gives us a monthly cash flow of $3,220 to work with before debt service.

Now that we have the operating expenses regarding the property, we can begin to look at the investor’s personal position. How much capital does he want to commit to this venture? What is the annual rate of return he is looking for on his investment? For the sake of discussion, the investor confirms that the $500,000 list price is reasonable and will look at his options based on paying full price. Should he be able to negotiate a better price, his numbers work out even better. At this point he is looking to find his top end price.

Scenario 1:

Our investor starts by looking at financing at the lowest interest rate. This will require him to put 30% down. We will use a factor of 5% of the mortgage amount to cover all the buyer’s expenses. 30% of $500,000 = $150,000. 5% of  $350,000 = $17,500. The total case invested in this case will be $167,500. His mortgage is for $350,000 for 30 years at 7.75% comes to $2,507.44 per month. Our anticipated cash flow was $3,220, leaving $712.56 a month profit. This gives a 5.10% cash-on-cash return before any tax benefits and without considering the amortization of the mortgage. Remember, even a 30-year mortgage has a principal pay down component to it. In this particular case there is $3,071.87 in principal reduction during the first year. Factoring this into our return increase the rate to 6.94%.

Scenario 2:

Our investor wants to commit less money into the deal. He now wants to see what happens when he puts 10% down. His down payment reduces to $50,000 and his closing costs increase to $22,500. He now only invests $72,500 but his monthly payment goes up substantially. He now will be paying an interest rate of 9.5% as well as carrying mortgage insurance. His mortgage payment increases to $3,783.84 plus the mortgage insurance of  $131.25 totals to a payment of $3,915.09. With only $3,220 available after expenses, we’re left with a negative cash flow of  $695.09. This would not be an acceptable position to a lender and probably not to the investor.

In order for this deal to work with less money down, it will need to be bought a lower price, financed at better terms or a combination of both. This is where the negotiating skills of the investor come into play. May be he can get the price down or convince the owner to hold the mortgage at an attractive interest rate.

At this point the value of the property, based on its cash flow, will yield a lower value than a comparable market analysis yields. This is almost always the case when analyzing 2 family houses. The potential buyers who are looking to personally occupy one of the apartments are willing to pay more for a home than an investor will.

When an investor buys a property for appreciation, while ignoring its cash flow, he is no longer an investor. He is now a speculator. Equity doesn’t make mortgage payments. An investor is looking for appreciation, without taking money out his pocket each month to meet the bills. A speculator is betting that the rate of appreciation will be high enough that he will be able to sell the property, or refinance the property, before his cash runs out.

Lenders will always look at the cash flow to cover the mortgage payments. They don’t share in the appreciation of the property. They are only there to foreclose when the investment doesn’t work out as planned. The savings banks, back in the Eighties, learned an expensive lesson when they began to back the speculators. They found themselves foreclosing on properties that had a current market value substantially less than the outstanding mortgage.

A prudent lender wants the investor to share in the risk of the venture. This means they want the investor to have enough of his own money at risk that he will do whatever it takes to protect it. By protecting his own money, he also protects the bank’s investment.

How can the small investor make money if his competition is willing to pay more for the properties than his can? He needs to work his strong points. The person looking to purchase this property for the purpose of moving in needs one of the apartments to be delivered vacant and in a timeframe that fits his needs, the investor doesn’t have these restrictions. From the investor’s prospective he has all these things going for him:

·    Since he’s renting out both apartments, he can accept the property with the existing tenancies.

·    Repairs don’t scare the investor away. He just adjusts his offer to reflect the additional costs that will be incurred to make the repairs.

·    Timing is rarely an issue. The investor can close immediately, wait for the seller to be ready or even close and let the previous owner stay on as a tenant.

·    He can be more aggressive in his offer. Having more experience in the purchase process, he is able to go into contract without a mortgage contingency if necessary.

·    The investor can purchase a property with building violations or certificate of occupancy problems. His experience and contacts in the industry will allow him to put a dollar value on the problems instead of being scared off like the owner occupied purchaser might be.

·    The property condition may be such that conventional financing is not available. The investor is capable of being more creative in his financing options.

·    A problem tenant would scare off most people looking to move into the property, but not the investor. He again, can put a dollar cost on evicting the tenant and repairing the apartment. He could even be willing to purchase a property without seeing all the apartments. All he does is reflect this in the sale price.

The investor is in the strongest negotiating position when the property has some issues with it. They could be minor problems or major ones, either way the problems will take the owner/occupied buyer out of the picture. For the small investor to be successful, he needs to be accurate in his analysis of the purchase and creative in his negotiations.

Example 2: Purchasing a small apartment building:

For our next example we are going to examine the purchase of a small apartment building, located in Queens. A common size building throughout all the boroughs is a 6 Family building. These are typically older building that were built as cold water flats that were upgraded over the years adding central heating systems, etc. The two unique components of a purchase of this type are first, higher maintenance and utility costs. We have an old structure, no idea of the quality of workmanship of the work that was done over the years, poorly insulated and probably an outdated heating system. The second issue is that the tenants are protected under rent stabilization or possibly even rent control.

The Division of Housing and Community Renewal (DHCR) is the State agency, which is responsible for the rules governing rent control and rent stabilization along with the enforcements of those rules.

Rent Control is the older of the two systems of rent regulation. It dates back to the housing shortage immediately following World War II and generally applies to buildings constructed before 1947. In order for an apartment to be under rent control the tenant must have been living there continuously since before July 1, 1971. When a rent controlled apartment is vacated, it either becomes rent stabilized (where the building contains at least 6 units) or is completely removed form regulation. Rent control limits the rent an owner may charge for an apartment and addresses the right of any owner to evict tenants.

Rents charged in controlled apartments are set and adjusted on the basis of registration filed by owners when Federal rent control was imposed in 1943. The rent control law allows DHCR to determine how much rents can be increased based on an assessment of what it costs owners to operate their buildings plus a reasonable profit.

In New York City, apartments are under rent stabilization if they are in buildings of six or more units built between February 1, 1947, and December 31, 1973. Tenants in buildings of six or more units built before February 1, 1947, who moved in after June 30, 1971 are also covered under rent stabilization. A third category of rent stabilized apartments covers buildings with three or more apartments constructed or extensively renovated on or after January 1, 1974 with special tax benefits. Generally, those buildings are only subject to stabilization while the tax benefits continue or, in some cases, until the tenant vacates.

Like rent control, stabilization provides other protections to tenants besides limitations on the amount of rent. Tenants are entitled to receive required services, to have their lease renewed, and may not be evicted except on grounds allowed by law. Leases may be renewed for a term of one or two years, at the tenant’s choice.

Each year the Rent Guideline Board (RGB) of the City of New York decides want the allowable rent increases are for rent stabilized apartments in the city for the upcoming year. They will set the allowable increase for one and two year renewal leases, any vacancy increases, etc. Landlords must comply with these guidelines or face treble damages. If the landlord is found violating any of these guidelines, he must roll back the rent charges to where it is supposed to be and pay the tenant 3 times the overage that was collected during the period in question.

The analysis of this property is similar to what we did with the 2 family house. The main differences are that we need to consider a higher cost factor for maintenance and utility costs and our projections for rent increases need to take on a different slant.

Our subject property has a rent roll that looks like this:

Apt 1       $575.00           (rent stabilized)

Apt 2       $800.00           (rent stabilized)

Apt 3       $950.00           (rent stabilized)

Apt 4       $240.00           (rent controlled)

Apt 5       $900.00           (rent stabilized)

Apt 6     $1,100.00          (rent stabilized)

Total    $4,565.00

This spread of rents is typical for a 6 family house. The rent of an apartment is dependent on the turnover frequency of tenants and the amount of renovation done on the apartment. DHCR permits a landlord to increase the rent by 1/40^th of the cost of improvements in the apartment. If the apartment is occupied, the tenant must agree to the renovations and the increase. If the apartment is vacant, the landlord s free to renovate as extensively as he wishes and therefore increase his rent by that 1/40^th factor.

A building wide renovation can also be done (without tenant permission) and a general increase can be passed through to all your tenants. This is called a Major Capital Improvement (MCI). The catch is that your proposed renovation needs to be submitted to DHCR, they need to approve the job with its associated costs, and upon completion confirm the work was done according to the plans submitted. Although possible to do on a small building, it typically is not cost effective as a means to increasing rent.

The monthly expenses on this property are:

1.     Taxes of  $270.00 per month

2.     Water & Sewer Charges of $150.00 per month

3.     Insurance of $200.00 per month

4.     Utility costs of $800.00 per month

5.     Average maintenance costs of $1,000 per month

6.     Management fees of $150.00 per month

You’ll notice that I’m not factoring in a vacancy component with this example. The reason for that is simple. The main reason for an investor to consider this type of property is that he is purchasing the property based on a rent roll that is substantially below market. When a tenant vacates there is no shortage of potential tenants to take over the apartment. The question is how much of an increase can you get on the unit. The highest rent in this building is still less than 50% of what we were getting in the 2 family example.

The total monthly expenses here come to $2,570 leaving $1,995.00 for debt service and profit. Our investor now needs to arrange for financing. This is a commercial mortgage and a small one at that. His choices for financing are limited and his closing costs are going to be on the high side. Instead of a closing cost factor of 5% we are going to use 7%. Everything is more expensive with a commercial mortgage, the mortgage tax is greater, legal fees and appraisals are more expensive and an environmental study will need to be done. Anticipated down payment requirement will be 25% (maybe 30%).

The asking price on this property is $350,000. 25% down will be $87,500 and the closing costs will add another $18,400 bringing the total cash invested to $105,900. Our mortgage payment at 8.25% will be $1,972.07. Leaving $22.93 as a monthly return on the $105,900 investment. 

Why would an investor consider a property like this?

1.  In our 2 family example our list price worked out to be approximately 9 times the annual rent. This is a pretty normal relation. In this example we are less than 6.5 times the annual rent. This is again a typical relationship. Because of the added problems with rent regulation and maintenance, the market will not support as high a premium on the 6-family as the 2 family.

2.  The rent roll of the 6 family is not at market rent. Any vacancy gives the landlord the ability of a substantial rent increase without needing market prices to rise. The 2 family investor, who bought a property based on rents that are at market or close to market, needs the market price to go up before he can get any sizable rent increase.

3.  Again, because of the low rents in some of the apartments, especially those that are rent controlled; the landlord could induce a tenant to leave by making him a cash offer. The investor may have already had made a deal with one or more of the tenants prior to bidding on the property. This gives him a built in profit immediately upon closing.

These examples illustrate 2 extremes. The buyer of the 2 family is making a more conservative investment and he is paying for it in price. The 6 family investor is more of a risk taker. He is betting he can work the rent roll to increase the monthly profit of the building as well as increase the marketability of the property down the line. The higher he can bring his rents, the more attractive the property becomes. His group of potential purchasers will begin to include the more conservative buyers as the property moves from being less a speculation to becoming more of an investment. The more competition there is to buy the higher the sale price becomes.

Major Players:

Investors in major real estate ventures begin to analyze a property in much the same way that we looked at the 6 family purchase. No matter what type of investing they’re doing, they start from the basics. What’s the current income, what’s the current expenses followed with what can be done to increase the income and potentially decrease the expenses. One thing they have going for them, that the small investor doesn’t, is economy of scale. They can afford to have staff dedicated to rent collections or purchasing of supplies. They typically will have in house legal counsel as well as an accounting staff. We’re dealing here with a full business set-up with professionals doing what they do best.

In general there are six main variables associated with income producing properties. The investor, and more important his lender, will start analyzing the project from these numbers. Those variables are:

Ø     Net Operating Income (NOI)

Ø     Debt Coverage Ratio

Ø     Cap Rate

Ø     Break Even Ratio

Ø     Cash on Cash Return

Ø     Loan to Value (LTV)

Net Operating Income

You start off by using the actual gross rental income and take off a factor for vacancy, usually 5% or the actual vacancy rate if it’s higher. If there is something unusual with the rent roll, then a projected rent roll can be used. An unusual condition may be a vacant commercial space that the investor wants delivered vacant because he has a tenant for the space. Another possibility would be that the current owner has been warehousing his vacant residential space to make the property more attractive for conversion. Situations like this would warrant using a projected rent roll.

Now that we have a rental figure with a vacancy factor built in we can now add in any ancillary income the property generates. The building may have a laundry room generating income, garage space which has its own income flow or may be the roof is rented out to a cellular phone company for antenna placement. Whatever additional income that’s there now gets added in. This total is called the Effective Gross Income (EGI).

The next step is to look at the expense side of the equation. After totaling up all the fixed expenses, taxes, insurance, utilities, etc. we need to address the variable ones. A management fee factor (even if it’s done in-house there is a cost factor associated to it) depending on the property 5 to 10% should be used. A one tenanted commercial property will have a lower management cost than a 200 unit apartment house although the EGI could easily be similar.

In examining the 6 family property we took a relatively high monthly expense for maintenance to cover both minor and major repairs. This was appropriate for a building of that size. In dealing with larger properties a better approach needs to be used. An engineering report on the property will estimate the remaining useful life of all the mechanical systems. A reserve account must be funded out of monthly cash flow to be sure there is money available as systems need to be replaced or up graded. So the last variable expense we will need to use is a Replacement Reserve factor. If the engineering report yields no unusual or immediate issues a factor of 2% of rent roll can be safely used.

All we need to do now is subtract the total of all theses expense from the EGI and we are left with the Net Operating Income (NOI).

Debt Coverage Ratio

Since the project is going to need financing, the investor needs to anticipate the calculations the lender will use to approve the financing. One of the most important considerations of any lender is to check to see how close the deal is. In other words, what margin of error in the analysis should there be? After expenses are paid and the mortgage payment is made, what’s left? From the investor’s viewpoint this is his monthly profit, from the lenders standpoint this is the margin of error that allows the venture to absorb bumps in its cash flow without affecting the investor’s ability to make mortgage payments.

The Debt Coverage Ratio is nothing more than a relationship between the annual debt service and the NOI. Take the NOI you calculated and divide it by the monthly debt service. The type of property, the track record of the investor and the comfort level of the lender will determine what Debt Coverage Ratio will be set for the project. This ratio seldom is allowed to drop below 1.25. This actually means for every dollar of annual debt service, there is $1.25 of NOI available to pay it.

Cap Rate

The cap rate is a ratio of the NOI and the listing of purchase price. This rate in then compared to other similar properties in the area to see how it stacks up. If you just try to compare sale prices, as you would with single family homes, you run into the problem of differences in rent roll and operating expenses. These factors can vary greatly from one property to another making a sales comparison difficult or worse inaccurate. Since the cap rate is based off NOI, income and expense variations from property to property are already accounted for.

If the NOI of the property our investor is interested in is $50,000 and the cap rate for this type of property in the area is 10% then market value for the property should be $500,000. The $50,000 NOI divided by the cap rate of 10%. If our investor feels he can work the property and within the year can get his NOI up to $60,000, he can anticipate an increase in value from the $500,000 to $600,000.

Break-Even Ratio

When looking at the financing on a project, both the investor and his lender need to know what the minimum percentage of projected income is needed for the project to break even. The lower the percentage, the stronger the project is.

The calculation is straightforward. First you add your fixed and variable expenses to the debt service. In the variable expense total we had added a factor for replacement for reserves. For this calculation we need to subtract that factor back out. Once we’ve done that we then divide by the gross rental income. This gives us the percentage of income needed to break even.

Cash-on-Cash Return

Any investor, no matter how large or small, will need to know what yield he is getting on his investment. Take the annual NOI, subtract the annual debt service and then divide it by the cash investment of the investor. This is he Return on his Investment (ROI). His lender will also be interested in this number. If the return is not reasonable, the lender will question the investor’s commitment to the project.

Loan-to-Value (LTV)

This is the relationship between the appraised value and the loan amount. The LTV is used in conjunction with the other 5 variables in finalizing the feasibility of the project. If the investor is putting 25% down on the project and the debt coverage ratio or the break-even ratio is too low, than the price is too high. If we have strong ratios, it’s possible to find a source of funds that will consider a higher mortgage amount.

Example 3: Purchasing an Apartment Building

Our subject property is a 240-unit apartment complex in Brooklyn, currently fully rented and well maintained. The asking price is $13,800,00.00.

The annual income as presented is broken down this way:

Rental Income                    $2,250,000.00

Garage Space                         $39,000.00

Laundry Room                       $17,700.00

Storage Lockers                     $14,000.00

Total Annual Income        $2,320,700.00

Annual Expenses:

Management                           $58,400.00

Legal/Accounting                     $8,400.00

Payroll                                 $160,000.00

Union Fees                            $32,000.00

FICA & Unemployment         $15,000.00

Security                                 $43,000.00

Heating Oil                           $125,000.00

Electricity                             $134,300.00

Outside Maintenance            $110,000.00

Real Estate Taxes                $262,000.00

Water & Sewer Charges        $38,000.00

Insurance                              $25,600.00

Total Annual Expenses   $1,011,600.00

Let’s see how this property looks to a potential investor. The property is being represented as being well maintained, so until told otherwise by the engineer’s report we’ll work on the assumption that there are no major repairs needed at this time.

To start the analysis we need to calculate the EGI, the Effective Gross Income. We have a rent roll of $2,250,000.00 in a borough covered by rent stabilization. This means 2 things. On the one hand no apartment will remain vacant very long when a tenant moves out, but on the other hand any old time renters are likely to stay in their apartments for the rest of their lives due to the attractive rent they’re paying. We will use a 5% vacancy factor to be conservative.

Our EGI then looks like this: 95% of $2,250,000 plus $70,700 in miscellaneous income equals $2,208,200 annually. Our expenses totaled to $1,011,600 and we’ll add in a factor of 2% for the Replacement for Reserves yielding a total of  $1,056,600.

The NOI comes to $1,151,600. If we are driving for a Debt Coverage Ratio of 1.25, we need to divide our NOI by 1.25. This gives a total annual debt service of  $921,280 or a monthly mortgage payment of $76,773.33. We will assume that our investor has 8% fixed money on a 20-year amortization available to him, at an 8% annual rate with a 10-year balloon. This mortgage payment then calculates out to a $9,200,000 mortgage.

Our investor anticipates making a 25% down payment. A targeted sale price on this property is $9,200,000 divided by 75% yielding $12,300,000, not far off from the original asking price.

For this analysis we will assume that this particular section of Brooklyn has a cap rate of between 9 and 10%. $1,151,600 divided by .10 yields a value of $11,516,000 and dividing by .09 gives $12,796,000. This is a similar value to what the Debt Coverage Ratio came to. This confirms that we’re dealing with a reasonable asking price and that should a deal be made between by the seller and the investor that financing should be available.

Now let’s look at the Break-Even Ratio and see if it’s reasonable. The total annual expense, without the replacement for reserves, is $1,011,600 and our annual debt service is  $921,280. This totals to $1,932,880. The rental income is $2,250,000. Dividing this out comes to an 86% ratio. Superficially, this looks tight but we have additional ancillary income of $70,700 to increase the comfort level here.

Assume a sale price of $12,300,000. Our investor will be putting down $3,075,000 and will be incurring transaction/closing costs of roughly $550,000 (this is based on a closing cost factor of 6% of the mortgage amount). This brings the total cash invested to approximately $3,627,000. Our NOI was $1,151,600 the annual debt service is anticipated to be $921,280. Subtracting these numbers we’re left with $230,320 per year positive cash flow.  This works out to a 6.35% annual return, before considering the amortization portion of the debt service. In the first year, we’ve amortized approximately $194,500 because of the 20-year term of the mortgage. If we add this to the $230,320 we get $424,820. This brings gives a yield of 11.71%. So although our cash-on-cash return is on the low side, 6.35%, we have an aggressive amortization on this mortgage product to help offset the low cash-on-cash return.

Since our investor is working with a mortgage with a 10-year balloon, his analysis will be based on how much he can increase the value of this property over the next decade. At which point his goal will be either to sell the property and take his profits out or refinance the property to free up his cash for the next deal.

Real Estate Investment Trusts

The major hurdle a small investor needs to clear to move into the realm of the major players is cash. In order to move up to investing in major commercial ventures, an investor would need large sums of cash to work with. In an attempt to open the doors for smaller players to invest in major ventures, congress created the Real Estate Investment Trust (REIT) in 1960. Congress decided that the only way for the average investor to access investments in significant commercial properties was through pooling arrangements. Through REITs the capital of many investors could be united into a single economic enterprise. The enterprise is geared to the production of income through commercial real estate ownership and finance.

Congress designed REITs specifically to create taxable income on a regular basis, and did not permit REITs to pass losses through to shareholders. Paper looses were very important to real estate investors, until 1986. As mentioned earlier, the revamping of the tax code in 1986 restricted the use of passive losses. This meant that real estate investments had to be economic and income oriented.

The eighties caused most sources of real estate financing to dry up. Real estate financing became too risky a business. Real estate companies, needing financing to fuel their projects started to look at alternate financing vehicles. It turned out that he most efficient way to access capital was through the public marketplace using REITs.

Since REITs are publicly traded, they permit individuals to buy into a commercial real estate venture and at the same time have the liquidity of stock market investment. They can choose the type of property they are interested in, residential, senior housing, medical, etc. and the geographic location of the project through the selection of which REIT to invest in. They don’t need to stay invested any longer than they want to, they can simply sell their stock whenever they wish to. An investor can diversify a relative small investment thorough multiple property types and regions through buying onto several different REITs.

REITs are a secure avenue to invest in real estate. Most real estate investments run into trouble due to being over leveraged. The real cash flow numbers don’t come in as anticipated and then problems arise. Since REITs cannot pass on real estate losses through to the investors, they tend to carry very low levels of debt.

Real estate is a physical asset with a long life during which it has the potential to produce income. Because of this, investors were always attracted to it. REITs permit an investor to become part of a project he could never imagine being involved with. He is assured the managers are being held accountable for their actions since the investor is investing in a publicly traded entity. At the same time, he has the ability to liquidate any portion of his holdings on a moment’s notice.

Historically REIT market performance has been comparable to the overall stock market returns and at the same time has exceeded returns on fixed debt instruments. Because REITs annually pay out almost all of their taxable income, a significant component of total return reliability comes from dividends.

1031 Exchange

Overview:

Investments are made expressly for the purpose of making a profit. The ultimate goal is that at some point you will sell the asset for more money than you’ve invested. Real estate investing, no matter how large or small, affords several avenues to take your profit out of the deal. The tax consequence of each approach is quite different.

You could simply sell the property and pay tax on the gains. This is the most straightforward method of taking your profits, but is typically the most expensive.

Currently the Federal Capital Gains rate is 15%. If the property has been held for less than 12 months the rate is your ordinary income tax rate, which can be as high as 36%. In the case of depreciable property (such as rental or industrial property) there are additional taxes due. Over the period you have owned the property, you have taken a depreciation deduction each year against your ordinary income. Now that you are selling the property the Federal Government will be recapturing the revenue they didn’t receive from you over the years you had the property in service. This recapture is taxed basically at your ordinary income tax rate. In addition to what you will owe the Federal Government you will also have New York State income taxes to pay.

Depending how long you’ve held the property and the dollar amount of the improvements that have been added to your cost base, you could have a substantial exposure to capital gains tax. Obviously, the first thing that’s done when addressing the issue of taking your profit out of the deal is to have a long talk with your accountant. You should have an idea of your tax bill before considering selling the property.

If you feel this property is still a good investment but need money for other purposes, refinancing the property becomes a viable option. If you’ve owned the property for some time, you probably can net out the same amount of cash through refinancing as you could through selling it. You can safely refinance the property for 70% to 75% of the value of the property, take the proceeds, pay no capital gains tax since you didn’t sell it and still have the property in your portfolio. This is a sensible way of going if your are happy with the investment you’ve made in this property and see it increasing in value going forward. If you’re not happy with the property or have become negative to the prospects of continued appreciation, then refinancing would not be the best course of action.

There is a third option. If you plan on making another real estate investment and don’t want to hold on to this particular piece, you can execute a 1031 tax-deferred exchange. Section 1031 of the Internal Revenue Code allows property owners to exchange their property for other like-kind property.  This makes it possible to transfer the financial gain that is realized from the sale of a property into another property.

There are strict rules that need to be followed in order for the exchange to qualify for this preferential tax treatment. Before considering this approach you should continue your discussion with your accountant. If he agrees that this is the way to go, then work closely with him and your attorney to be sure your execution is properly done.

For a property to qualify for the exchange it first needs to show that it was being held for the productive use in a trade of business or was being held for investment. It can’t be your primary residence or your vacation home. The property you are trading off is called the relinquished property.

Your goal is to take the relinquished property and trade it for the replacement property or properties. The replacement property must be of like kind. All this means is that it must be a property that you will be using for business or investment purposes. You can exchange a residential property for a commercial property, a hotel for a shopping center, etc.

The sale must be executed through the use of a Qualified Intermediary, establishing special trusts or special security and guarantee arrangements. At no point during the transaction can any of the proceeds of sale get into the investor’s hands. The Qualified Intermediary can serve in no other capacity and must be completely independent from you. In other words, a family member would not be eligible to function in this capacity.

Section 1031 requires an actual exchange of properties.  If you simply sell your property and reinvest the money in another property, you will not qualify for exchange treatment, even if it is a simultaneous close.  This type of transaction will result in “Constructive Receipt”. 

Constructive receipt occurs when you have the funds in a position in which you may draw on them, direct their usage, or give notice of intention to withdraw.  In other words, you must not have control of the funds.  If you have any type of control on the funds or control over the person holding the funds, you will be considered to have constructive receipt. When the Qualified Intermediary is holding your funds you are not in constructive receipt because control over this money is subject to a substantial limitation or restriction. You are in constructive receipt at the time such limitations or restrictions lapse, expire, or are waived. The Qualified Intermediary is an independent organization whose only contract with you is to prepare the exchange documents and hold the cash proceeds from the sale of the relinquished property, nothing else. It cannot serve as your attorney, accountant or any other agent of yours.

The proper procedure you need to follow is this. You find a buyer for your property. You then close on the sale, but the proceeds of sale are given to the Qualified Intermediary not to you. You then have 45 days to identify the replacement property to the Intermediary. The Intermediary has 180 days from closing on the relinquished property to close on the replacement property unless the tax return is due for the investor first. Then that date becomes the deadline.

The replacement property must be of equal or greater value than the relinquished property. There can be more than one replacement property. You can:

·    identify up to 3 properties up to any value

·    identify any number of properties as long as the value doesn’t exceed twice the sale price of the relinquished    property. (Remember we are talking about the identifying stage; the sale price or prices have not been negotiated yet.)

·    identify any number of properties as long as you close and take title to 95% of the value of such properties.

All the proceeds of sale from the relinquished property need to be invested in the replacement property. Remember you are not being relieved of your tax bill, you are just deferring it. When the time comes and you finally sell the replacement property, without doing another 1031 exchange, the capital gains tax is calculated the same as in any other sale. You need to establish the cost basis on the new property at the time of sale.

The basis on the new property starts with the basis transferred from the old property. That is the original purchase price, plus the transaction costs at the time of purchase, plus the cost of any improvements, less any depreciation that was taken over the years. We then add in the difference between the sale price of the old relinquished property and the new replacement property, minus the deprecation on the new replacement property. It is on this number that the capital gains tax is calculated. 

History:

The origins of tax-deferred exchanges go back to The Revenue Act of 1918. This was the first income tax code and it did not specifically allow for any type of tax deferring exchange. To accommodate the needs of farmers, exceptions began to be granted so they could swap parcels of land among themselves to make their farms more productive. The Revenue Act of 1921 was the first time tax-deferred exchanges were formally authorized by the government. This was a much more liberal tax code than we have today. It allowed for exchanges of like-kind as well as non-like-kind assets. Even securities could be exchanged.

The exchange rules were cleaned up with the adoption of the Revenue Act of 1924. This act limited the use of tax-deferred exchanges to like-kind properties. In 1954 the tax code was amended moving the requirements for tax-deferred exchanges to Section 1031 and adopted the framework of our present day structure.

The Deficit Reduction Act of 1984 codified the rules governing a tax-deferred exchange adopting the 45 and 180 calendar day rules. The next significant revision to this section occurred in 1989. The Revenue Reconciliation Act of 1989 made 2 major revisions. First, it eliminated the ability to use a tax-deferred exchange between domestic and foreign properties. Second, it created a 2-year holding period requirement for 1031 exchanges involving related parties.

Major Guidelines:

The property that the owner is selling must qualify as business or investment property. Dealer property or property considered as inventory is not applicable. A property that is being “flipped” would not qualify for a 1031 exchange. Neither would a primary residence or a vacation home meet the requirement.

Only the gain on the net proceeds of sale needs to be reinvested in the replacement property. The net proceeds is defined as the sales price of the property less all transactional expenses paid by the seller at closing. If the replacement property is not of the same or greater value tax will be due on the shortfall. The IRS calls this “boot”.

The mortgage on the replacement property must be equal to or greater than the mortgage that was on the relinquished property at the time of the sale. If the mortgage taken out on the replacement property is greater than the existing mortgage that was on the relinquished property the difference is considered boot and taxes will be owed on that difference. If you are looking to take cash out of the transaction, the way to do it is to place a mortgage on the property after title is transferred from the Intermediary to you.

The same ownership entity that sold the relinquished property must become the owner of the replacement property. Whatever taxpayer id number was used for IRS filings on the relinquished property must be the same id number that is associated with the replacement property. This is why a tax-deferred exchange cannot be used when a partnership is breaking up. In order to take advantage of a 1031 exchange, a partnership would need to convert to a Tenancy in Common form of ownership, wait 2 years to conform with the holding period requirement of related parties, and then execute the 1031 exchange. Tenancy in Common is defined as an undivided fractional ownership of real estate. Each owner has his own deed and therefore an owner can pass through the exchange since he can now use the same tax id number.

Exchanges can be executed either through a forward exchange or a reverse exchange. Until now we have been addressing forward exchanges, where the relinquished property is sold prior to the purchase of the replacement property. It is possible to acquire the replacement property first. This is called a reverse exchange. In 2000 the IRS published Revenue Procedure 2000-37 in which they set the guidelines to properly execute a reverse exchange. This procedure details the requirements of a “Parking Arrangement”. That is a mechanism by which the Qualified Intermediary acquires the replacement property holding or “parking” it while waiting for the relinquished property transaction to close.

The procedure works like this. First, the Qualified Intermediary either creates an “Accommodation Titleholder” or takes title in its own name. This entity then takes title to the property. Second, a “qualified exchange accommodation agreement” must be entered into within 5 days. This agreement commits the Accommodation Titleholder to report to the IRS that it is the owner of the property and files tax returns reflecting all income and expenses related to the property. It specifies that the property be parked for the purpose of completing a 1031 exchange within 180 days of taking title. Third, the relinquished property must be identified to the Qualified Intermediary within 45 days of the Accommodation Titleholder taking ownership of the replacement property.

The Accommodation Titleholder is an independent entity of the principal in the transaction. This means that the principal can lend money to the Titleholder in order to purchase and or renovate the replacement property. He can lease the property from the Titleholder. He can be paid a management fee for managing the property for the Accommodation Titleholder. He can build on or renovate the property. Whatever the principal does, he needs to make sure that property is transferred to him within the 180 day window or he will not qualify for the exchange.

Construction Exchange:

A 1031 exchange can also be used to construct or substantially rehabilitate a property. The biggest obstacle however is that you need to comply with the 180 day timeframe. The procedure here is similar to the reverse exchange. The property is parked during the construction phase. Proceeds of the sale or the relinquished property is held by the Intermediary and released to the Titleholder to pay the contractors. Once all the proceeds of sale are spent, the property can now be transferred from the Titleholder to the principal completing the exchange.

The 1031 tax-deferred exchange allows the real estate investor the flexibility to modify his real estate holding to best suite his investment objectives without exposing himself to capital gains tax. It also has the effect of keeping real estate values strong. An investor has little incentive to sell off real estate holdings. If he does, he is obligated to share a substantial share of his profits with the IRS. This limits the number of properties that actually come to market. In addition there is another effect. When an investor starts the exchange process in motion, he is forced to move quickly. If he doesn’t complete the transaction within 180 days he loses all the benefits of the exchange. This forces him to be less aggressive in negotiating the purchase price on the replacement property. He will choose to pay a higher price in order to control the timing of the purchase transaction. He’s got too much to loose if he closes on the 181^st day.

Conclusion:

This seminar is not intended to make you an expert in analyzing the real estate market of New York. It was meant to give you a basic understanding of the driving forces of this market. With the national economy existing the longest growth period in the nation’s history on top of the regional effects of September 11, we are entering a time unlike any other in our history. With a general understanding of the marketplace you will be better equipped to develop your own opinion.

Each day you will be receiving new economic data, news reports and comments from various industry experts. Stay alert and prepared to modify your opinion as to where the market is headed. You will need to be flexible in your position or you will get into trouble.

This is truly an exciting time to be involved in real estate, but it is not for the faint of heart. Stay informed, don’t rush to conclusions and you will be in a stronger position to make your own investment decisions or to advise your clients.

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