Real Estate Investment - Case Study Example

Real Estate Investment Customer Insert His/Her Name Customer Insert Grades Course Customer Insert Tutors Name May 8, 2012. Outline 1. Introduction 2. Managing risks 3. Analysis of real estate 4. Conclusion and Recommendation 5. References Introduction Real estate investment in rental property is extremely attractive. Many investors turn to market of real estate because this category of investment is long-term in nature. Investment in real estate brings high income to the investor depending on the property location. Even if property is profitable not every landlord possesses qualities of a good landlord. But those who have these features can make fortune as a result of profit emerging from renting an apartment. For an investor to buy a good property, the investor should start looking for a superior property to invest in, which will take time doing research and connections (Jhonson, 2012). The investor should know his/her investment period and the longer the renting period the more rent will be earned freeing finances to further develop the property. It is desirable for investor to wait until they earn half of their initial investment and sell the property later when in good condition and when conditions in the market are more favourable. More investment risks can be encountered by the investor in case he invests for a short period. Even though, the rent will appreciate in the next 10 years, it may also reduce its value after 6 years, particularly if the property was bought in unstable market. Therefore, in such a case the investor needs higher potential return so as to cover potential risks that may possibly arise. Ownership of property is appropriate for small investors in case of long-term investment as this will avoid market perturbations with rental income substituting investor’s day job (Jhonson, 2012). Managing risks In property investment, the investor is exposed to a number of risks such as interest rates variations, housing prices, damages to property and tenant problems. Financial products like fixed loans and insurance can assist the investor to mitigate risks linked with these problems (Mills, 2007). Risks can also be mitigated using other methods that include; First, investor should purchase property with very high yield which has a possibility of staying strong in future at a low price, with possibility for improvement. Second, carrying out market research in order to make sure that no malicious surprises are hanging about like the main employer is leaving the town. Third, portfolio diversification by investing in various countries or in different assets, this prevents the investor from possible loss in one particular sector. Fourth, purchasing in relatively liquid section of property market makes property easy to sell as less people afford to buy more costly properties. This implies that inexpensive properties are the most liquid in this market. Finally, making sure that the ability to pay-off the mortgage is strong (Mills, 2007). In addition to common risks, there exists another type of risk which can be controlled by the investor which is the borrowing risks. The investor has power over the borrowing amount and the more money the investor borrows the higher the investment leverage or financial power. It implies that the investor is likely to earn more cash but also lose more money. High leverage should be avoided because if the market becomes unfavourable the investor may not be able to service the loan which may force the investor into liquidation (Mills, 2007). Lenders normally look at the amount invested as owner’s equity and proportion of disposable income when determining the borrowing capacity in order to establish whether the borrower is able to repay interest. Interest repayment is used to determine debt-financing ratios. Many financiers’ debt-financing ratios permit the investor to commit a maximum of 35% per month of gross income to debt repayment (Mills, 2007). Analysis of real estate Housing investment is at an unbelievable value this moment. The mortgage rates are at their record low and with the recent housing bubble housing or property is inexpensive. Right now is the best time to do so because the sellers are motivated, there is easy financing, tax benefits, government assistance, positive cash flow and undervalued property compared with overvalued property during the recent financial crisis (Jhonson, 2012). Rental property investment might be the top investment in 10 years time. In contrast to the recent financial crisis period, property purchased at right price may now earn positive cash flows to the investor. However, real estate investment is an investment of money and time. Therefore, the investor should analyse property’s cash flows and return rate as well as tax benefits. Some loan alternatives should be evaluated as well as different presumptions rates of vacancy and the price appreciation effect on return rate (Jhonson, 2012). This paper is going to analyse a Rental Income Property, the property to be analysed is described in the next section. Property 40-Appartments in a quiet Neighbourhood Price: $9,978,095.20 No. of units: 40 Building Size: 48,900 Square Feet Price/Unit: $249,452.38 Property Type: Multifamily Property Sub-type: Mid/High-Rise Property Use-type: Investment Gross Rent Multiplier: 6 Commission Split: 4% Occupancy: 98% No. of Floors: 5 Bedrooms: 3 Built Year: 0 to 2 years ago Property Description The property is a four-storey walk-up building with 40 apartments, consisting of three bedrooms and three bathrooms units. The property owner offers hot water and heat to tenants and tenants are responsible for own electricity bill for lighting and their stoves. The building requires approximately $15,000 in repairs before buying. This property is located in Rio De Janeiro, Brazil. Extra features are as shown on Table 1 below. Table 1: Extra Features General Lot Elevator Balcony Power Back-up Basement   Park Facing   Private Garden     Exterior Security Visitor Parking Intercom Facility Reserved parking Fire Alarm   Security guards     Interior Recreation Mable Flooring Park Modular Kitchen Fitness Centre Laundry Facility Swimming Pool     Financing The investors have traditionally been financing real estate investment through credit unions, home mortgage firms and banks. Presently 15-year Mortgage fixed rate is at 5.75% while a 30-year mortgage loan has a fixed rate of 6.25%. But as a result of the recent sub-prime housing crisis, lenders have made their lending criteria tighter as many ask for a credit score of 680 or superior for approval. In addition to that, they ask for complete documentation of the income as well as loan for approval. After qualification most lenders ask for approximately 10% down payment and others may ask for less (Oakey, 2012). In paper we are going to analyze real estate investment of the above property. The Table 2 indicates financial data that will be used in the analysis. Table 2: Cost and financing Cost   Purchase Price $9,978,095.20 Down payment $1,995,619.04 Improvements $15,000.00 Closing costs (2% of purchase price) $199,561.90 Total cost $10,192,657.10 Cash Outlay $2,210,180.94     Financing   Down payment 20% Finance Amount (80% of purchase price) $7,982,476.16 Down payment amount $1,995,619.04 Interest Rate 3.673% Mortgage (Years) 30 Mortgage Payment $36,620.18 Net Operating Income (NOI) Net Operating Income (NOI) is normally used in real estate analysis. NOI is total income generated by the property after expenses are deducted, excluding interest rates or financing costs. NOI is equal to total income minus total expenses incurred in management of property (Scott, 2010). NOI = Total Income – Total Expenses Generally, NOI is a monthly figure determined using monthly expense, income data and may be converted to yearly data by multiplying it by 12. The income and expense for our property is determined as shown below. Income The total income received from property investment is termed as gross income, including rent from tenant, other income generated from activities like laundry facilities and storage together with any other revenue that the property may generate on regular basis. Our property has 40 units renting for $1,750 per month as shown below. Table 3: Income Unit count Monthly rent Annual Rent 1 $1,750.00 $21,000.00 2 $1,750.00 $21,000.00 3 $1,750.00 $21,000.00 4 $1,750.00 $21,000.00 5 $1,750.00 $21,000.00 6 $1,750.00 $21,000.00 7 $1,750.00 $21,000.00 8 $1,750.00 $21,000.00 9 $1,750.00 $21,000.00 10 $1,750.00 $21,000.00 11 $1,750.00 $21,000.00 12 $1,750.00 $21,000.00 13 $1,750.00 $21,000.00 14 $1,750.00 $21,000.00 15 $1,750.00 $21,000.00 16 $1,750.00 $21,000.00 17 $1,750.00 $21,000.00 18 $1,750.00 $21,000.00 19 $1,750.00 $21,000.00 20 $1,750.00 $21,000.00 21 $1,750.00 $21,000.00 22 $1,750.00 $21,000.00 23 $1,750.00 $21,000.00 24 $1,750.00 $21,000.00 25 $1,750.00 $21,000.00 26 $1,750.00 $21,000.00 27 $1,750.00 $21,000.00 28 $1,750.00 $21,000.00 29 $1,750.00 $21,000.00 30 $1,750.00 $21,000.00 31 $1,750.00 $21,000.00 32 $1,750.00 $21,000.00 33 $1,750.00 $21,000.00 34 $1,750.00 $21,000.00 35 $1,750.00 $21,000.00 36 $1,750.00 $21,000.00 37 $1,750.00 $21,000.00 38 $1,750.00 $21,000.00 39 $1,750.00 $21,000.00 40 $1,750.00 $21,000.00 Gross Scheduled income $70,000.00 $840,000.00       Other Income Laundry Facilities $1,200.00 $14,400.00 Storage $400.00 $4,800.00 Other $210.00 $2,520.00 Total $1,810.00 $21,720.00       Gross Operating Income $71,810.00 $861,720.00       Vacancy Rate (2%) $1,400.00 $16,800.00 The rental income totals to $840,000 for the first one year, while other income generated from other sources totalled $21,720 and in total the Gross Operating Income was $861,720. Most of the income is generated from rent collected from tenant thus it is important that income reported should account for rent that will not be collected as a result of some vacant units. Our property has an occupancy rate of 98% this implies that only 2% of total units are vacant. Thus, the vacancy rate is determined by multiplying rental income with vacancy rate (2%) which amount to $16,800 per year or $1,400 per month. To obtain total property income, the amount that will not be received as a result of vacant units is subtracted from rental income. In our analysis only 2% of the units are vacant. Thus our monthly and yearly income will be as shown below. Table 4: Gross Income Revenues Monthly Yearly Rental Income $70,000.00 $840,000.00 Vacancy Rate $1,400.00 $16,800.00 Net Rental Income $68,600.00 $823,200.00 Other Income $1,810.00 $21,720.00 Gross Income $70,410.00 $844,920.00 With a monthly income of $70,410 then yearly gross income will be $844,920. Table 5: Income Assumptions Assumptions   Rent increase per annual 4% Other income increase per annum 4% Rate of property appreciation per year 3% Assume that rent and other income will increase by 4% each per annum while the property will appreciate by 3% per annum as shown on Table 5 above. Expenses In this section we will determine expenses for this property. Generally, expenses are categorised as property taxes, repairs/maintenance, insurance, management fee, advertising, utilities, landscaping, and water/sewer among others. Table 6: Expenses   Method 1 Annual $ Method 2 % of Gross Operating Income Annual $ Property taxes $126,000.00   $126,000.00 Repairs/Maintenance   6% $51,703.20 Management fee   5% $43,086.00 Insurance $24,000.00   $24,000.00 Advertising $500.00   $500.00 Utilities $7,000.00   $7,000.00 Landscaping $2,500.00   $2,500.00 Others $2,100.00   $2,100.00 Total Expenses     $256,889.20 The total operating expenses for the first year is $141,389.20, assume that these expenses will increase by 4% per annum while vacancy/collection losses will be 2% per annum and sales commission will be 11%. Table 7: Expenses Assumptions Expenses: Assumptions   Increase in expenses per year 4% Collection/Vacancy losses 2% Sales Commission 11% We now have annual expenses and income generated by the property and we can determine NOI by subtracting expenses from income. NOI = $844,920.00 - $256,889.20 = $588,030.80 Therefore, the property generates $588,030.80 per annum, but NOI does not show the complete picture, it cannot be used solely to make investment decision as it is the basis of determining most of vital metrics in this evaluation. The following section will evaluate other metrics that are important in investment decision such as cash flow analysis, rate of return and capitalization rate among others. Performance measurements Up to this point we have necessary information to establish whether this property is good to add to our investment portfolio. In this section we will deal with cash flow, rate of return, capitalization rate and Cash-on-Cash returns among others. In the previous section we have dealt with NOI as income earned by the property excluding financing costs. Thus, in this section financing costs will be included in our analysis. Table 8 below indicates the value of the house and the land, in which the house represent 70% of the purchase price. Also assume the property will have a remaining useful life of 58 years with a salvage value of zero then yearly depreciation is $120,425.29. It is also assumed that the investor is in the 28% tax bracket. Table 8: Depreciation and assumptions Improvement Ratio 70% No. of Years of depreciation 58 Land Value $2,993,428.56 House value $6,984,666.64 Annual Depreciation $120,425.29     Assumptions   Investor's Tax bracket 28% Capital Gain Tax Rate 15% CGTR on Recaptured Depreciation 25% With the use of all of the above information we are able to summarize and find cash flow and Return on Equity for this investment as shown on Table 9 below. Table 9: Investment summary First Year Property Investment Summary Property Information Financing Purchase Price   $9,978,095.20 Finance Amount   $7,982,476.16 Number of units   40 Monthly payment   $36,620.18 Price per unit   $249,452.38 Yearly payment   $439,442.20 Appreciation/Basis           Appreciation @ 3% $299,342.86       Depreciable basis @ 70% $6,984,666.64                   Income Initial investment Gross Scheduled Income   $840,000.00 Down payment   $1,995,619.04 Vacancy @ 2% $16,800.00 Improvements   $15,000.00 Laundry Facilities   $14,400.00 Closing costs (2% of purchase price)   $199,561.90 Storage   $4,800.00 Initial investment   $2,210,180.94 Other   $2,520.00       Gross Operating Income   $844,920.00 Tax Benefits       Taxable Income   $844,920.00 Operating Expenses Deducted Expenses   $256,889.20 Total Expenses   $256,889.20 Mortgage Interest   $290,709.07       Depreciation   $120,425.29 Cash Flow Before Tax Taxable Income   $176,896.44 Gross Operating Income   $844,920.00 Tax Benefits (loss) @ 28% $49,531.00 Operating Expenses   $256,889.20       NOI   $588,030.80 Return on Equity Debt Service   $439,442.20 Appreciation   $299,342.86 Improvements   $15,000.00 Cash Flow Before Tax   $133,588.60 Cash Flow Before Tax   $133,588.60 Principal Reduction   $148,733.09       Tax Benefit (loss)   $49,531.00 Cash Flow After tax Total Profit   $631,195.55 Cash Flow before tax   $133,588.60 Initial Investment   $2,210,180.94 Tax Benefit (Loss)   $49,531.00 Return on Equity (ROE)   28.56% Cash Flow After tax   $84,057.59       Table 9 above indicates Cash flow and Return on Equity (ROE) that will be earned from the property in the first year of investment. The ROE and Cash Flow are positive. Financing costs are not included in NOI calculation because NOI shows income level that will be generated by property without investor’s financing model. Thus, if financing costs are included in NOI, this implies that NOI will be meaningful in a certain financing plan (Scott, 2010). This is because various investors will surely have various financing plan, thus it is vital to have income metric which is particular to that property and not the investor. The cash flow for the first year will be $133,588.60 before tax and $84,057.59 after tax. Thus, paying all the cash available will reduce the debt service to zero, which may maximize cash flow. However, cash flow is not the only vital factor during real estate analysis. Similar to NOI that is independent from financing details, Capitalization Rate (Cap Rate) is independent from investor and financing details. Cap Rate is determined by dividing NOI with purchase price (Scott, 2010). Cap Rate is significant when carrying out real estate analysis because it is independent of financing and investor’s details, thus it indicates pure return that will be generated from property. Cap Rate = NOI / Purchase price = $588,030.80/ $10,192,657.10 = 5.77% 5.77% is the return that would be earned if the entire purchase price was paid. Contrary to cash flow that is maximized when entire cash is paid, Cap Rate is necessarily not the maximum return from the property. But it assumes it is the maximum investment amount but the rate of return increases when initial investment drops. According to Rapoza (2012) GTIS is offering Cap Rate above 16% for investment in Brazil. This means that Cap Rate of 5.77% is very low; thus the investors should look for an investment that has Cap Rate of about 16% in Brazil. But the higher the Cap Rate the higher the risk and the lower the demand while the lower the Cap Rate the lower the risk and the more stable the income is (Seddiq, 2012). Therefore Cap Rate of 5.77% is not bad if the income will be stable since it will give the investor guarantee that he/she is going to repay debt and earn some returns. Another measure of performance is Cash-on-Cash Return (COC) which is real return rate because it is directly linked to cash invested in the property (initial investment). It is thus determined by dividing cash flow with initial investment as shown below. COC = $133,588.60/ $2,210,180.94 = 6.04% (before tax) COC = $84,057.59/ $2,210,180.94 = 3.80% (after tax) The rate of return depends on investor’s investment objective, but it must be obvious that if the investor is obtaining less than 10% as property return, it’s likely that such investment is not worth the investor’s money and time. It is therefore wise to take such money in stock market where little effort is required. However, before using COC to make final decisions remember that cash flows from the property are not the only items that affect investor’s bottom line. Rate of return is important than cash flow, rates of return is amount received by investor relative to investment cost. ROE is higher when there is higher cash flow or lower initial investment. The property ROE is 28.56%, this implies that for every $2,210,180.94 you invest you obtain 28.56% as ROE. ROE takes in the total impact of property appreciation, equity accrued and tax impacts. Unlike COC that considers cash flow impact on return, ROE considers factors affecting the investor’s bottom line. A figure of 28.56% is not bad return for this investment. Financial Analysis Based on Table 10 (10-year return in the spreadsheet) the Return on Initial Investment for the property has increased from 28.56% in Year 1 to 50.89% in Year 10. However, Return on Total Equity had decreased from 31.39% in Year 1 to 17.09% in Year 10; the decrease was as a result of increase in Total Equity with constant amount of initial investment. The cash flows from the property throughout the 10 years are positive and on an increasing trend. In the first four years the investor will gain negative capital gains if the property is sold. Therefore, in order to gain positive capital gains the investor should sell the property from the fifth year, in the tenth year when the property will be sold the investor will be able to make $1,756,999 as real capital gains. The total income to the investor will be the income generated during the 10-year period and capital gains in the tenth year when the property will be sold. Conclusion and Recommendation Rental property investment is a huge opportunity to an investor willing to put his/her savings in a real estate asset that earn regular income. And this is the best time to do so because; first, the houses are cheap to buy and the best one are three-bedroom, multifamily, two-baths houses and single-family. These types of property have a big market. Second, mortgage rates currently are at their all-time lows. The 30-year fixed mortgage can be obtained from an utmost rate of 4.5%. While a 15-year fixed loan can be obtained by an utmost rate of 3.5%. Finally, many people are in financial trouble, and are renting property in large number than ever before. Banks have constricted lending policies making many people with good income to lack mortgage and thus the market is full of people looking for house to rent. The three factors create opportunity favourable for investors to invest in this market. Another reason to own a property is because of the dollar value decline and high inflation which may set in the future. So the $1,750 rent the investor will be receiving as rent income will increase in the future through inflation. That is to say, when the dollar value decreases the debt becomes inexpensive in actual or real terms. Therefore, as a result of inflation the property value may double in 10-years time. In conclusion, the investor should purchase the 40-units multi-storey building as it will generate positive cash flows and will have high ROE starting from 28.56% which is good for the investor for the 10 years and above. The property also generates positive capital gains in the fifth year indicating that it has potential to generate more income to the investor. Therefore, the investor should carry out various analysis of the property as shown above before making any decision.           References Jhonson, C. 2012. Property Investment Risks and Gains. Viewed May 7 2012, Scott, J. 2010. Introduction to Real Estate Investment Deal Analysis, viewed May 7, 2012, Rapoza, K. 2012. U.S. Investors commit nearly $1 billion to Brazilian Real Estate in new fund, viewed May 7 2012, Seddiq, R. 2012. Valuation methods for commercial property, viewed May 7 2012, Mills, S. 2007. Property investing: managing risk, viewed May 7 2012, Oakey, B. 2012. 5 ways to finance a real estate investment, viewed May 7 2012, Read More