Real Cashflow, Fake Cashflow – Part IV

For new readers: Do NOT APPLY … this was my 2009 April Fools Day Joke

Thanks everyone for your comments and support for the first money-making opportunity that I have ever announced on this blog! I wanted my loyal readers to have first opportunity. Sure, it’s a bit unusual (horse racing), but it comes from a trusted source … and, we never know where the next opportunity will come from

However, Expressions of Interest have now CLOSED!

But, stand by as there will be a follow up post announcing how The System works and what it means for you next Thursday …
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This is the fourth – and, final – installment of our series on the three types of Positive Cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

After introducing Tax Cashflow “cleverly designed to make Negatively Geared real-estate look like a good deal”) we spoke about manipulating the amount of deposit that you put into a property to ‘force’ it to produce a kind of ‘Fake’ Positive Cashflow.

This kind of cashflow comes at the expense of: (a) cash – you are typically forced to put in a lot – and, (b) returns: typically, the more cash you put into an investment, the lower its return.

So, what is the secret? Simple, it’s to look for a property that produces …

Real Cashflow

For some unknown/stupid reason, we look at property exactly the wrong way around:

We let the bank and public opinion of the day tell us how much capital (i.e. deposit) to put in; then we look for the greatest tax benefits; then …

… we buy!

Of course, there is no ‘secret’ to Positive Cashflow Real-Estate at all: we should simply ALWAYS treat ANY property acquisition as though it were a business … and, we would NEVER buy a business that needs to be manipulated in order to make money:

First, it must produce cash …

… then we can ‘tweak’ the income statement and balance sheet for greater tax benefits and return on capital.

It’s exactly the same with property; the problem is that we:

(a) Buy in the wrong market – we buy when everybody else is buying and property is too expensive, and

(b) Buy in the wrong sector – we buy what everybody else is buying – residential real-estate, which rarely produces positive cashflow … and, when it does, it’s usually a ‘dog’ when it comes to appreciation.

So, here is the real 7million7years Patented Positive Cashflow System:

1. Look for real-estate that will produce Real Positive Cashflow with a reasonable deposit (say, 10% – 35%); typically, this will be commercial real-estate … BUT, in the current market (low prices and low interest rates) you will probably find some residential real-estate nuggets if you look hard enough. Just don’t forget to lock in the interest rate, or you may find your diamond turning into a lump of coal as interest rates rise again.

2. Then, tweak the deposit that you actually put in according to the Fake Cashflow return that you want to get: in the Making Money 201 wealth accumulation phase, I recommend putting in ‘just enough’ deposit to break-even (perhaps with a buffer for contingencies, unless you have the spare income to cover these elsewhere) and then using you spare cash to buy another!

3. Then, take every tax deduction that you can get! Accumulate the extra Tax Cashflow that you get until you have enough accumulated to put down as a deposit on another property.

If you buy right … then manage your capital and tax right … you will have a large and Positive Cashflow real-estate portfolio before you can say “negative cashflow sucks lemons”.

If you can’t find one now, you ain’t looking hard enough

Real Cashflow, Fake Cashflow – Part III

This is the third installment of our series on the three types of Positive Cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

Last week we discussed the first of these (Tax Cashflow), cleverly designed to make Negatively Geared real-estate look like a good deal. As I said:

By allowing you to pay less personal income tax, the promoters of these schemes will show you that the property can pay it’s own way (Neutrally Cashflow or Neutrally Gear) or even Positive Cashflow!

Unfortunately, it’s all on paper … and, it relies on you earning a high income … and, will probably only work for one or two properties because you won’t have enough personal tax to ‘save’ for more properties than that.

Today, I will introduce you to a simple, but powerful concept that will allow you to take any piece of real-estate and create positive cashflow … it’s so simple, you’ll wonder why you didn’t think of it sooner But, you’ll quickly see why I call it …

Fake Cashflow

If you want a property to produce positive cashflow without doing a lot of work and research, use the 7million7years Patented Positive Cashflow Formula:

Pay Cash!

Now, this isn’t a stupid idea, it’s actually a valuable – and, under-appreciated [AJC: pun intended] – Making Money 301 wealth-preservation strategy … and, it works because it eliminates a (actually, usually THE) major expense on your investment property: mortgage interest.

Without interest, the chances are that your property will produce enough rental income to cover vacancies, repairs & maintenance and other typical costs, yet still produce a very healthy profit … perhaps even a livable income for a MM301 ‘retiree’.

The problem, of course, is that the rest of us – those still trying to accumulate wealth – (a) don’t have enough cash to buy much (any?) real-estate outright, and (b) real-estate’s growth is typically just around inflation-to-6.5% (depending upon who you believe) … hardly earth-shattering.

But, we don’t HAVE to pay cash for a property to produce this kind of positive cashflow return, we just have to decide how much cash to put in … as best explained by Shafer Fincancial in a comment to a recent post:

Here is how it works. Most folks, including myself, advise re investors to make their properties cash flow for safety (comparing your costs with the rents received). So if one person can get a loan for 7% and the other can only get a loan for 9% in order to make it cash flow, the later will have to put down more capital (down payment). If you are leveraged at 80% LTV and a property cash flows you only have to tie up that 20% capital. However, if you are having to put down 25% to make the property cash flow because of a high interest rate on the loan then you have 5% more capital tied up in the property for the same capital appreciation.

$100,000 property
Person A cash flows with $20,000 down payment
Person B cash flows with a $25,000 down payment

Think about it:

You put 0% down and you have a negatively-geared ‘dog’ … and, if enough people do it, a future real-estate crash (a.k.a. ‘credit crunch’)  on your hands.

You put 100% down and you have a positively-geared ‘retirement investment’ that ‘only’ grows with inflation (unlike CD’s – which ONLY provide some income).

… surely, there is a ‘break-even’ point somewhere between the two, where the property will cashflow positive, but you only have to put in a deposit and you can borrow the rest from a bank like a ‘normal person’?

Yes there is, and we ‘twist’ the Shafer Financial example (he was talking about the ‘cost’ of different interest rates) to illustrate the point very nicely: Property B may be a ‘dog’ with a 20% down payment @ 9% interest, but if you just up it to a 25% down payment also at 9% interest, you lower your monthly mortgage payment just enough to make it break-even on a monthly (or yearly) basis, or even cashflow positive.

So, fiddle the numbers on a spreadsheet (with the help of your accountant, if necessary – they LOVE this kind of stuff!) and you will find the break-even point (i.e. the point where the property JUST starts to cashflow positive) and if you can afford the deposit, perhaps you have a ‘winner’?!

But, it comes at a ‘cost’ or two:

1. You need to come up with a bigger deposit … which, means that you may not be able to buy as big/many properties as you like, and

2. The more money you put in, the lower your overall return (annual compound growth rate); again, Shafer Financial explains nicely:

The interest rate on mortgage debt on investment property does curtail capital appreciation …

$100,000 property
Person A cash flows with $20,000 down payment
Person B cash flows with a $25,000 down payment

Property appreciates 3% for five years. Aproximiate value of $116K.
For simplicity stake; No excess cash flow for five years (unlikely)
No tax advantages.

Person A ROI= 12.47%
Person B ROI= 10.4%

Having to put that extra $5K down to make the property cash flow cost you 2% in the return department. Note that the property only appreciated 3% per year, yet the rates of return were 10% and 12%!

Now in the real world you must account for the cash flow over time and the tax advantages to compute ROI. But this is a perfect example of how interest rates effect return. Also, note that the higher the leverage (above 75% LTV for most folks) the higher the interest rate is likely to go. So, there is usually a break even point for leverage/cash flow that takes into consideration the interest rate.

This is that ‘leverage’ thing that makes real-estate such a wonderful investment, producing returns (for well-selected / purchased real-estate) well above the naysayers moans that real-estate only grows “according to inflation” or “6.5% a year” (depending upon who you believe).

So, the problem with Fake Cashflow is that – while we can ‘force’ a Positive Cashflow out of almost any piece of real-estate by simply putting more of our own cash in it up front – it tends to reduce leverage, hence reduce our overall returns. This is why I call it ‘Fake Cashflow’ …

There has to be a solution … and there is: see you in the final installment in this series, where I show you how to find ‘Real Cashflow’

Where do all these rules come from?

I’m a maverick, yet I like rules … how do you figure that?

Well, the rules that I like are actually ‘rules of thumb’. You see, when I was $30k in debt, I was in the financial wasteland with no idea how do dig my way out …

… so, I did the only thing that I am really good at: I read books. A lot. All non-fiction. Mostly about how to make money.

I can read a 100-pager non-fiction book in the matter of an hour or so and absorb most of the salient points … I may then go back and work at snails pace through detailed explanations, if necessary.

And, I like to read books for instructions: do this, do that. Which I’m then pretty good at modifying for my own use.

So it was for my financial troubles; I started reading:

First Rich Dad, Poor Dad – the first book (and best, in terms of how it opened my eyes) on personal finance that I ever read.

Then The Richest Man In Babylon – which explained the power of compounding and reinvesting.

Then every other Robert Kiyosaki book that came out over the next four or five years.

And, I attended every financial spruiker seminar that came to town (Robert Kiyosaki, Peter Spann, Brad Sugars, and so on … )

… all the time looking for the ‘rules of the money game’.

What I found was that there was no ‘one size fits all’ set of financial rules that everybody should follow … but, there were various recommendations as to what you should do in this circumstance or that.

Over the years, by trial and error (largely a lot of trial – and tribulation – and plenty of error) I found various ‘rules of thumb’ that seemed to make sense to me, and some that I had been following without even realizing it, just like the rules that Jeff questions:

Where are all these rules coming from? Did I miss a bunch of information in the brochure?

If I understand correctly, we have the 20% rule for home equity vs. net worth, 25% rule for mortgage vs. income, and now the 5% rule for cars.

I had been following these rules, largely by coincidence, for most of my successful working life (i.e. during my 7 year journey), when I chanced upon a book that I had never heard of, written by a guy I had never heard of, who lived in a (now) bushfire ravaged area not far from my home in Melbourne, of all places!

Naturally, I had to read the book …

He worked from the premise – one that I happened to agree with – that at least 75% of your Net Worth should be in investments – OUTSIDE of your home, your car, your possessions, and basically anything else that is unlikely to yield you an income or be readily salable at a profit (where will you live if you sell your house?).

That leaves 25% of your Net Worth to spend on: houses, cars, possessions, as follows:

20% House

2.5% Cars

2.5% Possessions

Simple; except that I’m happy to blur the lines a little between cars and other possessions into one 5% ‘pool’.

Of course, this only helped to understand how much equity to hold in these items, and not how much you should finance on a house (that’s where the 25% Income Rule comes in) and cars/possessions [AJC: Easy ... buy used and pay cash!].

I have explained how these rules work in practice in these three posts (please follow any backlinks):

Your House

http://7million7years.com/2008/04/11/applying-the-20-rule-part-i-your-house/

http://7million7years.com/2009/01/12/how-much-house-can-you-afford/

Your Cars and Other Possessions

http://7million7years.com/2008/04/12/applying-the-20-rule-part-ii-your-possessions/

Real Cashflow, Fake Cashflow – Part II

Last week I told you that there are three types of positive cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

Today, I want to discuss the first of these … cleverly designed to make Negatively Geared real-estate look like a good deal!

Tax Cashflow

In the first installment, I explained that most real-estate (especially residential real-estate, and single family homes and condos in particular) has more costs (e.g. mortgage interest, vacancies, repairs & maintenance, provisions, etc.) than income (i.e. rents), forcing us dumb investors to gamble on the future appreciation of the property … and, we can see where that has lead us!?

So, those developers and promoters with lots of real-estate that costs way too much to buy found some money to help you cover your losses and turn them into a ‘profit’ … from this, comes our first opportunity for the Holy Grail of Real Estate: Positive Cashflow property i.e. one that puts money INTO your pocket each year.

Now, I said each year for a reason: tax.

Uncle Sam will help you to help these property promoters to become rich by encouraging you to buy their overpriced, under performing real-estate! Take Scott, for example:

My wife and I have been pondering this very same topic with our rental(which was our previous home). We are negatively geared by $250.00/month on that property, have great renters that have completed their 6 month lease and are continuing to rent month to month while they continue to try and get their home in Connecticut sold, then move on to purchase their own home here in Louisville.

Money seems to be tight for them from all that I can see, however they are able to make this rent each month, so I’m a bit afraid of raising rent on them, but it really troubles me to be negatively geared for the moment. This property (according to this years filing) has given us a pretty large tax deduction, which has certainly saved us money, perhaps enough to pay us back the monthly amount we have lost to make us break even. Not to mention, it is in one of the most premiere areas of the city and has enjoyed one of the highest appreciation rates this city can offer, but as your post suggests, we don’t want to get caught up in the hope of appreciation.

As Scott has discovered the ‘secret’ is in tax-deductions …

… naturally, almost all the expenses that you have on an INVESTMENT property are tax-deductible, not just including mortgage interest (as in your own home) but, also ‘business’ expenses like repairs and maintenance … even vacancies allow you to earn a little less income, so you pay a little less tax … but these will probably not make a property cash-flow positive on their own.

Actually, the real secret is in the ‘provisions’ … a provision is a fund that you build up over time to allow you to cover major costs later (e.g. an Emergency Fund is a kind of provision).

You see, Uncle Sam allows you to ‘build up’ a fund over time to replace the building that you have on the property, and all the things that you have inside the property (e.g. stoves, lights, carpets, curtains, etc., etc.). You probably borrowed the money to buy all these things – and, are tax deducting the mortgage interest – but, the nice people at the IRS allow you to take a ‘double deduction’ in the form of a Depreciation Allowance on these items, as well.

It becomes another expense that you can get a tax deduction on, and because the property may not have enough income (hey, it’s already Negatively Geared!) you can lower your personal tax bill instead.

By paying less personal income tax, the promoters of these schemes will show you that the property can pay it’s own way (Neutrally Cashflow or Neutrally Gear) or even Positive Cashflow!

Unfortunately, it’s all on paper … and, it relies on you earning a high income … and, will probably only work for one or two properties because you won’t have enough personal tax to ‘save’ for more properties than that.

When you ‘run out’ of personal tax deductions you can’t make any more properties Tax Cashflow Positive … it’s all smoke-and-mirrors.

So, when it comes to real-estate, you want tax deductions and you want tax cashflow, but you don’t want to buy a property that only has this kind of cashflow, if you can find something better.

In the next installment, we’ll look at something even more fun: Fake Cashflow.

Tempting deal … bad deal!

My last (not ever, but for a while) Reader Poll showed that most of you thought that my hypothetical real-estate transaction was a good deal, provided that it didn’t tie up your money for too long.

Thomas, who has all the hallmarks of becoming a great real-estate investor, liked the strong returns on cash invested:

I don’t have to invest the full 100k. I can finance most of it, secured by the real estate. So, let’s say I can finance 80% of it, which means I “only” need to come up with 20k myself. If I can finance it at 5%, the interest on the 80k would be $4k a year, which would leave me with $3500 left over each year. $3.5k annually for an investment of 20k is a return of 17.5% per year. In addition, any appreciation is also yours, so unless you need to average a very high annual compound rate, this sounds like a great deal.

I, too, think it’s a pretty tempting deal, but NOT for the reasons that many of you gave for liking it in the first place …

… to summarize; here’s what I like about the deal:

- very well-established commercial strip-mall in a great area

- fully rented, with long leases

- currently returning 9%, less contingencies … so, estimated yearly distribution is $7,500

So, on an investment of $100k, I get a 7.5% – 9% return each year … presumably, there’s some sort of ‘ratchet clause’ in the lease to ensure that rents at least keep pace with CPI and/or market. I would NOT invest until I knew the answer to this question, but it’s a reasonable assumption to give an ‘in principle’ OK to the deal … with the cost of funds at sub-6% these days (and, I can lock in for 5 to 10 years on a commercial loan), this is beginning to look quite good. The capital appreciation almost becomes a ‘bonus’ …

So, here’s what I don’t like about the deal:

- It’s a general partnership … luckily I am the general Partner and get to control the property, but the rest of you don’t

- There is a rental/return guarantee

Whoa … I DON’T like a guarantee??!! … what’s up with that?!

To me, the guarantee is  a risk – not an opportunity – because the real returns should meet or exceed the guarantee at all stages, anyway, except in two cases:

1. The value of market-place rents decline (a recession can cause deflation; tenants may leave or go broke and we may need to cut rents to retain new tenants),

2. Costs can go over budget (vacancies could cause protracted loss of income; hidden structural issues could cause major repair costs; etc.)

3. Both could happen at the same time

Rick agrees, sounding the following warning:

It really sounds too good to be true- if a lot of these businesses go out of business can the $9K/year really be guaranteed? Could you really find another buyer in the current economic environment?

If only one of these things happen, we may be able to dig into our contingency fund to ‘ride it out’ (remember, we retain roughly 1.5% on net income each year as a ‘contingency’), but if a number of things happen at once, such as in the current economic and real-estate ‘perfect storm’, then the fund may run ‘dry’ …

… if this were our only investment, we would simply not take much/any rent out of the deal until we covered these costs and rebuilt our fund (if the situation becomes dire, we may need to put more money in or even sell out … but, this should be extreme).

However, because this is a partnership with a guarantee, the General Partner (me) has to maintain a minimum 7.5% return to the partners (you); which only leaves me a few choices:

1. Dig even further into the contingency fund, or

2. Ask you ALL to agree to vary the contract and take less money this year OR sell the project (are you ALL going to agree?), or

3. Borrow more money to pay the guarantee and/or cover the costs (increasing the expenses on the project even more), or

4. Wait for the bank, a supplier, or an investor to foreclose (because we pay you and slow down the bank and/or suppliers, or we pay the bank and one of you initiates proceedings because we fail to pay you as ‘guaranteed’).

In all of these cases, the flaw is that the ‘guarantee’ is funded by the project itself and forces the General Partner to make decisions that he would NOT make if ‘the project’ didn’t have to pay the guarantee …

I like to think that the ‘managers’ on any project or business that I am involved in are always making the best commercial decisions, not acting artificially to enforce some sort of ‘forced distribution’ …

…. kind of like the board of directors of a business focusing on maintaining a certain level of dividend for investors, rather than growing the business’ long-term earnings (a.k.a. profits).

Can you now see that dividends and profits (businesses) or guarantees and net income (real-estate) are NOT the same thing?

So, for this project, if I were an outside investor, I would make a decision on the project and insist that there were NO guarantees … simple. Unfortunately, most investors don’t think past their noses (“what’s my return?”), hence the ‘guarantee’.

As to me, unless I was the General Partner and there was no guarantee, I would NOT invest …

What do you think?

Real Cashflow, Fake Cashflow

This is the first installment of a four part series on what I describe as the three types of cashflow (as it relates to Real-Estate) … feel free to weigh in!

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I think, by now, most of our readers no longer subscribe to the “buy property for the tax deductions and future appreciation” scams of the 90′s and 2,000′s that resulted in one of the biggest property busts that the USA has ever seen.

But, I fear a new mantra – not quite as dangerous, but one that can squash your future returns (hence, financial dreams) like a kink in a fireman’s hose [AJC: that's probably the worst simile that I have ever written] …

… it’s the ‘positive cashflow’ mantra.

You see, there are three types of positive cashflow, when it comes to Real Estate … and, I’m not sure that you will read about this anywhere else, but here it comes:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

… only one of which we are really looking for, although, any great property purchase will probably exhibit characteristics of all three.

First, though, let’s review the typical property; the one that doesn’t produce any cashflow at all and loses you money … it’s negatively geared!

Negative Cashflow

A property produces rents – hey, even your home produces a ‘rent’ … it’s just that you don’t bother to pay it to yourself, but you should – and those rents are offset by costs: e.g.

- Mortgage Interest

- Repairs and Maintenance

- Vacancies

- Provisions

And, there are many others …

… interestingly, the last two aren’t strictly a ‘cost’ but a lost opportunity to earn rent – it amounts to the same thing: more cash going out than going in.

If the property has more expenses going out than money coming in from rents it is said to be Negatively Geared; this simply means that you are losing money!

So, why do you do this? Well, the promoters of such property – and, there are many such ‘promoters’ (e.g. builders, developers, real-estate agents, etc.) – will say that you do it for the FUTURE APPRECIATION …

… definitely lose a little bit of money today for the chance to make a LOT of money in the future.

There’s a word for that: gambling. I prefer poker; you may prefer lotteries; let others gamble on this kind of real-estate.

In the next installment in this special 4-part series on real-estate, I will cover the first kind of ‘positive cashflow’ real-estate: Tax Cashflow.

Good deal or bad deal?

No, this is NOT another ‘Howie Mandel-style’ game show … I’m done with that series (aside from a couple of wrap-up posts, still to come)!

But, this will be my last reader Poll for a while, so I want you to sit down for 3 minutes and make a commercial decision with imperfect information:

[polldaddy poll=1327033]

Time for a fun ‘hypothetical’ … I’m not really asking you to invest with me [AJC: I want you to learn to invest with somebody far more capable: yourself!] …

I would like you, and a number of other people, to join me in a real estate project [remember: this is hypothetical].

It will be very low risk, because it’s a very well-established commercial strip-mall in a great area, pretty much fully rented with lots of good tenants with long leases left to run and for the last 10 years has produced a reasonable – perhaps not stellar, but certainly highly respectable – profit with very low maintenance costs, tenant turnover, etc., etc.

No catches, here, really … it will be a general partnership, I will be the managing partner and you can join the group of passive investors already committed.

So, let’s look at the deal a little:

Your share of the investment will cost $100,000 and for that you get 10% of the $1,000,000 project (incl. financing/closing costs) … it’s a very inexpensive strip mall

We expect reasonable capital appreciation over the life of the project (up to 10 years, although you can sell out anytime before then, and we will guarantee both a buyer and then-current market price for your share).

The property will return about $9,000 a year (net operating income per 10% share), but we think it’s best to keep aside some as a contingency against vacancies, maintenance, etc., etc.)

So, we will guarantee you (secured by the project itself) $7,500 income each year for at least the next 10 years indexed to 7.5% of the current value of the building (but, NO LESS than the $7,500 p.a. guarantee) v the $3,000 or 3% that a bank will currently give you, and which does not grow. Of course, you may have others ideas in mind for the money, but I hope you will invest with us … after all, here, your income is guaranteed!

In summary: an ultra-low-risk ‘bricks and mortar’ investment returning a MINIMUM 7.5% p.a. on your original investment (increasing in line with property value increase) … you will get your money back, just from the guaranteed distributions that the project will pay you, over 13 years and you STILL get 10% of any appreciation in the building!

Deal or no deal?

Investing is a business …

There was a craze that hit Australia in the 90′s and America in the 2000′s … we know the result, but what was the cause?

It was the ‘negative gearing’ craze …

… people were promoting real-estate purchases on the basis that you take a loss now and make a (hopefully, huge) capital gain in the future.

The benefits that used to be promoted by the real-estate gurus are stated very nicely in this comment on Andee Sellman’s blog:

You have forgotten tax benefits which can be substantial. Also, the actual equity needed to purchase his investment could have been minimal compared to the purchase price. Most importantly, over time the tenant and the tax man pay for the majority of his investment.

Now, I would understand this comment if it were from 2005 or even 2006, but it is from only a couple of months ago …

… if we don’t learn from our mistakes, we are doomed to repeat them!

When real-estate is going up in price, it is easy to get caught in the trap of buying on the basis of future capital appreciation, and use tax deductions on the mortgage and depreciation benefits on the building and improvements to help ‘soften the blow’ as running costs were typically higher than the income (in some places, severely so … yet we still bought!).

Given the current market we all KNOW the problems this causes, but real-estate – and sentiments – cycle every 7 to 10 years, so WHEN you forget what happened in 2007 and 2008 during the next boom, pull up this blog and remember:

Treat your real-estate investment as a BUSINESS.

A real business is bought (or started) because it does (or soon will) produce profits and free cash-flow year in and year out, and then MAY be sold at a future date for a speculative gain. At least, that’s what happened to me …

… I can’t understand why we shouldn’t look at any other investment, including property, exactly the same way?

Can you?!

Anatomy of a Commercial RE Investment – Part 3

Hopefully, my last post gave you the numbers, and today’s will explain the ‘deal’:

Summary

So, here is the crux of the deal:

1. I have a property with one good tenant (they are cashed up … because I just gave them the cash!) and an easily rentable smaller area for a second tenant.

2. If I borrow 75% at 6.5% fixed for 7 years, I get $63,000 cash (i.e. TOTAL INCOME – TOTAL EXPENSES) in Year 1 to spend (well, keep some in reserve against future repairs, vacancies, etc.).

3. My deposit is $700,000 so that $63,000 is a 9% return on my own money (subject to those unforeseen costs that I mentioned in 2.) … not a bad return on cash AND I get all the upside on the property.

4. If the second tenancy is vacant for any reason, I still almost break-even.

5. If the second tenancy rents at only $6 / sq. foot I still net $43k per year; if I get $10 / sq. foot I net $83k.

6. Properties in this area sold for $80k – $120k per sq. foot; even though the market has softened somewhat (commercial generally works on a slower up/down cycle than residential) I am buying it for $60 / sq. foot … clearly, if a condo. developer knocks on my door in 7 years and offers me $120 / sq. foot, I’ve doubled the whole $2.6 Mill. (not incl. Realtor’s commissions) purchase price!

Note: Think about that – when people say that RE only increases with inflation, therefore stocks are a better option: I make $63k a year less costs (est. 25% as a contingency), say, 6.75% net. The property then increases to $3.4 Mill. over the next 7 years (that’s only inflation):

I earn: $362k in rents (after the 25% contingency against, repairs, and with a 3% rent increase each year)

plus: I net $700k on the sale of the property (I’m expecting to make close to double that, but let’s just accept inflation for now).

I return: That’s a total of $1.362 against the $700,000 that I put in (the bank put up the rest, and they’ve already been paid interest and their money back in these numbers) or 11.5% on my money

I expect: But, that’s only if the building appreciates by inflation; I expect to net at least $1.5 Mill. on the sale of the property (if not $2.5 Mill.!) which brings the return up to 20% … secured by real-estate, no less!

7. If no purchaser does come along, I am earning a neat 9%+ on my $700k until somebody does buy it!

So, by all measures, this is a great deal … some common sense and some simple number-crunching tells me that, no ‘cap rates’, ‘proforma’s, or any other complex financial manipulations necessary.

BTW: I did a quick ‘drive by’ but haven’t even been inside, yet. It doesn’t matter … I won’t be ‘living there’

Next step: tell the broker to make the offer!

Anatomy of a Commercial RE Investment – Part 2

OK – close your eyes (actually, keep them open so you can keep reading!) and imagine the complexity of analyzing cashflows and proformas for a real-estate deal north of $2.5 million …

Daunting, huh?

Well, that may be how OTHERS analyze a deal, but not me … all of my deals are done on the backs of envelopes … well one clean sheet of paper. I have this one right in front of me, in my own scrawly handwriting.

On the strength of it, I have authorized my Realtor to make a written offer, with a $200k ‘earnest money’ deposit on the $2.7 Mill. office/warehouse. Sure, the proformas will come later, but I’ll get him to prepare those for the bank … while I’m at the beach or off skiing someplace!

Here’s what the piece of paper says:

Purchase Costs

$2.7 Million (incl. $100k broker commission)

$5k Building / Environmental inspections

$15k Closing Costs (legals, bank fees, appraisals, etc.)

Of these, the $5k for the inspections is my only financial risk, as I need to undertake these during ‘due diligence’ (we’ll talk about this in a future post if the deal gets that far).

Finance

$2.7 Million Purchase Price (incl. broker’s commission)

$ 2 Million to be financed

Note: this is approx. 75% of purchase price to be financed; this is high for commercial which can be as low as 60% being the maximum that the bank will fund.

$700k – so this leaves me 25% of the purchase price, or $700k, to find as a deposit.

Note: I’m sure that the owner’s won’t ‘carry back’ a note on this one, as the whole purpose of the sale is to raise cash to keep their business afloat or growing.

So, that’s the purchase / financing side of the equation, now let’s see if it can make me any money …

Income

$175k – Rent for Tenant 1 @ $8 / sq. foot

Note: the current owners will lease 2/3 of the property for the above fee (probably 5 years, with a 3% yearly increase)

$80k – Rent for Tenant 2 @ $8 / sq. foot (we need to find this smaller tenant)

Note: the property is street front with car park, so we feel is should be easy to find a second tenant in the $6 – $10 / sq. foot price range

$255k TOTAL INCOME

Expenses

Note: the GREAT thing about commercial properties is that most expenses (and in a ‘triple net property, all expenses – unfortunately, this is NOT one of those) are handled by the tenant, leaving me just …

$45k Taxes

$7k Building Insurance

$10k Management Fees

Note: Rental management fees can vary from 4% – 6% of the rent if you don’t want to deal with the tenants yourself; keep in mind that commercial property is very different to residential and you won’t have as many issues dealing directly with commercial tenants – they are responsible for all repairs & maintenance … but, if the roof springs a leak, you’ll be expected to act quick! I will use an agent ( my friend).

$130k – Bank Interest @ 6.5%

Note: this is the ‘biggie’ and I haven’t spoken to any banks, yet; obviously, that’s my next port of call but my Realtor friend tells me that I shouldn’t have any problem getting funding fixed for 7 years (or a 25 year P&I loan with a 7 year balloon) around these rates. Variable can be as low as 4%, but I prefer to ‘fix my costs’.

$192k TOTAL EXPENSES

In the final part [AJC: when I return from my 'winter break' on Jan 5], I’ll summarize this all for you and explain why I like the deal so much …