by Thomas Hall GRI ABR QSC, Broker Associate
So often when I speak to potential clients seeking investment property, I ask them to explain to me their process for evaluating income-producing property. A significant majority of these investors tell me they look solely at the capitalization rate of the property – the percentage of net income over the purchase price of a potential investment.
Cap rate is definitely a strong metric in measuring the value of an investment candidate, but it should not be the sole metric for measuring the strength of an investment. Evaluating an income producing investment property should not be one-dimensional.
Critical to evaluating any investment property’s fit in your overall investment strategy, it is important to understanding the four key criteria used to better understand the big picture. Solely relying on one financial metric does not provide an accurate picture of the viability of a particular investment property. Think of the four criteria as legs on a chair – the fewer the legs, the less stable the chair. By not evaluating one or more of the four criteria, you may not be making the most informed decision.
Ideally, the savvy investor evaluates all of the key criteria that make income producing investments attractive and evaluates the big picture – they determine how all of the above fit into their investment strategy.
When evaluating an income producing property, be sure to review the following criteria:
1. Cash flow
2. Principle Reduction
3. Tax Advantages
4. Appreciation
Cash Flow
Simply put cash flow measures the inflow of cash generated by an income producing property, i.e. rents less the outflow of cash, i.e. expenses generated by a property over a period of time. Ideally, cash flow is measured before taxes and depreciation.
Prior to identifying an investment property, it is important to understand what are your financial objectives. To some investors, cash is king – therefore their primary objective is to purchase property that provides a positive cash flow.
While positive cash flow sounds attractive, some investors may be looking to shield income, therefore, a positive cash flow may not be their primary objective – their search may be to seek income producing property with a cash neutral or even slightly negative cash flow for the attractive tax advantages.
Principal Reduction
One of the best advantages of holding income-producing property is that your tenant(s) are paying down a portion of the principal balance of your mortgage over time. In some cases, however, if your potential property has strong prospects of significant appreciation, it may make sense to explore financing with an interest only product – allowing the prospects of appreciation to offset the principal reduction paid by your tenants.
Tax Advantages
Depreciation is a non-cash expense, however, it has a significant impact on an income producing property’s cash flow. Because all assets lose value over time due to wear and tear and general obsolescence, depreciation accounts for the loss of value by lowering a property’s net income, hence lowering an investor’s tax liability as well.
As a current or future owner of investment and income producing investment property, here is some food for thought.
When you begin the process of completing your Schedule E, are you and/or your accountant depreciating just the value of your building, or do you bifurcate the value of the land, land improvements and personal property in your building(s)? If you are simply depreciating the value of your building, you may be losing enormous tax advantages.
IRS tax laws allow owners of residential income producing investment properties to depreciate the value of your building, land improvements (i.e. value of curbs, sidewalks, parking lots etc.) as well as the value of the personal property in the building (i.e. carpet, window treatments, lighting fixtures, appliances etc.). The cost recovery for personal property percentage in year one alone is 20% and can be depreciated over 5 years. The cost recovery percentage for land improvement is 5% in year one and can be depreciated over 15 years. You may even be able to file an amended tax return and perhaps get money back. Your potential refund can be reinvested in additional real estate. Consult a financial professional or call me, I can point you in the right direction.
Some addition thoughts as we close out the year: Do you and/or your accountant calculate the return on your equity in the property(s) you own on a year-to-year basis? If not, you may want to calculate your return in order to best understand whether or not your investment is providing the best return possible. As you begin to lose the tax advantages over time, your money may be better used in purchasing additional investment properties with better returns. You may not even need to sell your current investment. Perhaps borrowing against your equity may be a better solution. Either way, it’s important to understand how your money is working for you.
In order to best demonstrate the attractive tax advantages of income producing property, please see the following example:
Depreciation Illustration:
You purchase a building for $600,000 of which the land value is $100,000.
Your net income for the year is $24,800.
For purposes of a simplified illustration, the cost of debt service is not included in the calculations.
Building: Recovery Period for Residential Property = 27.5 years
Recovery Percentage for Residential Property for Year 1 = 3.48%
Land Improvements: Recovery Period for Land Improvements = 15 years
Recovery Percentage for Land Improvements for Year 1 = 5.00%
Personal Property: Recovery Period for Personal Property = 5 years
Recovery Percentage for Personal Property for Year 1 = 20.00%
Without bifurcation:
Purchase Price: $600,000
Building Value: $500,000
Land Value: $100,000
Total Depreciation = $500,000 x 0.0348 = $17,400
Net Income: $24,800
Depreciation: $17,400
Cash flow before tax = $24,700 - $17,400 = $7,400
With bifurcation:
Purchase Price: $600,000
Building Value: $400,000
Land Value: $100,000
Land Improvement: $50,000
Personal Property: $50,000
Total Depreciation:
= ($400,000 x 0.0348) $13,920 + ($50,000 x .05)$2,500 +($50,000 x 0.2)$10,000 = $26,420
Net Income: $24,800
Depreciation: $26,420
Cash flow before tax = $24,800 - $26,400 = -$1,620
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