Small Business Taxes & Management^TM--Copyright 2014, A/N Group, Inc.

Introduction

This is the second of a two-part article on investing in real estate with suggestions, tips, and cautions on various types of properties. Go to Investing in Rental Real Estate--Part I for the first part.

Leases and Tenants

Tenant types. The type of tenant can make a difference in both your cash flow and the valuation of the property. A professional building filled with doctors or attorneys usually commands the highest valuation. Many professionals stay in the same space for an extended period of time, are generally good credit risks and cause few problems. Other professionals such as accountants, brokers can also be quality tenants. For general businesses, national or regional firms are preferable to local firms. They are less likely to go out of business and usually are better credit risks. The disadvantage with larger firms is that they generally are tougher negotiators when it comes to rents and lease terms.

Retail tenants tend to be relatively stable, if their business and finances are doing well. For them, staying in a good location can be critical. On the other hand, if the area is changing a they may be looking to move. Office tenants are often more flexible; they can hang their hat almost anywhere. And moving can be relatively inexpensive for them.

Lease length. A building with tenants with long leases can be advantageous. If a tenant leaves on the expiration of his lease, the space could be vacant for some time and that means lost revenue. In addition, you may incur legal fees, broker commissions, have to pay for alterations, etc. on the turnover. On a renewal you may incur some of the same costs, but most likely at a reduced amount and you won't have to deal with lost rent. On the other hand, if rents in the area have gone up faster than any rent step-ups in the lease you want to negotiate a higher rent--or you want to change the tenant mix to doctors from regular office space. If that's the case you'd like the lease to expire as soon as possible.

Lease terms. Before buying a property you want to check other terms in the lease. You should also be aware of the terms in your market. In some areas you may have to offer a certain amount of free rent to a new or renewing tenant. Same for alterations. That is, you'll have to pay to move the interior walls, put down new carpeting, repaint, etc.

Escalations. Leases in rural areas may not include an escalation, or rent increase, clause. But you should build in rent increases for real estate taxes, utilities, and operating expenses if the lease term is longer than a year. In many cases rent increases are based on a fixed dollar amount per square foot or a percentage of rent for commercial leases. In some areas they're based on consumer price increases (CPI). Residential rentals are usually simply and provide for a dollar increase in the monthly rent. In urban areas a commercial lease can contain escalations based on expenses such as real estate taxes and utilities, as well as general rent increases.

Age of building. An old building may be cheap to buy, but expensive to run. In addition to refitting to the local code, heating and cooling may be more expensive, the property is likely to be less attractive to prime tenants, and the economic life of the building may be limited. The only option at the end of 15 years may be to tear down and rebuild or sell the land. That will limit your return.

Buying a Property

The market.Real estate is often called a very local market. The recent downturn made that evident. Prices fell in most markets, but some fell by 20%; some by 50%. Some are still soft. Some have already recovered; for some it could be years yet. In some areas selling a properly priced house takes 2 to 6 months; in some it can be 6 months to more than 2 years. There's no question you need an appreciation for the market before venturing into any transaction. A vibrant suburban market is far different than a rust-belt urban or a rural area. Not only is the rent and property cost different, so is the cost structure.

Some markets are much more volatile than others. In some areas of Florida prices were rising at more than 25% per year just before the bust. They dropped almost as fast after the peak. Frequently (but not always) fast rises are followed by fast declines and then fairly rapid recoveries (but the peak before the bust may not be reached for a number of years). More modest rises usually are followed by less precipitous drops. Unless you can live through a sustained period of lower prices (i.e., you're in it for the long term), it may be prudent to avoid volatile areas. Ideally you should invest in an area where real estate prices are increasing or, at a minimum, stable. You definitely want to avoid an area that's in a long-term economic decline. That could impact both building valuations and rents.

Fortunately, rents aren't nearly as volatile. In fact they usually decrease very little unless the area is in significant decline. On the other hand, they usually increase slowly unless there's excessive demand for space.

Leverage. It's the financial term for borrowing to finance an investment. The advantage of using debt to finance a property is that if your return on the investment is more than the interest rate on the mortgage or other loan, your overall return can be significant. A simple example will make it clearer. Fred buys some land for $100,000 cash. He sells it a year later for $110,000. He's made 10% on his investment. Sue bought an adjoining tract for the same price at the same time Fred did. But Sue only put down $20,000 and financed the rest with a $80,000 loan. After paying $4,000 in interest her profit was $6,000. Her return on her $20,000 investment was 30%. That's often how the big money is made in real estate. And it's generally easy to borrow on real estate. Sue could have made more money by buying five similar properties with the same cash that Fred used and had $30,000 in profits. But the term is leverage. And it works both ways. If the price of the property falls by $16,000, Sue's investment would be wiped out ($16,000 decline in property price plus $4,000 in interest expense equals $20,000). Borrowing allows you to make more money, but with greater risk of losing it all. Judicious use of leverage can improve your returns while maintaining an acceptable level of risk.

Municipal environment. Some towns have laws stricter than others. Building codes, licensing requirements for contractors and associated professionals such as landscapers, excavators, etc., zoning, etc. can add to the headache and expense of owning and managing a property. These can cut both ways. They can restrict your ability to develop a property and increase the cost of improving and operating it. On the other hand, they can protect your investment from nearby development that can lower the value of the property. You should understand the local rules before investing. One town allows you to abandon an in-ground oil tank by filling it with foam or sand--a relatively inexpensive procedure. A neighboring town requires multiple tests on the soil and that the tank be removed necessitating the state Department of Environmental Protection and a fire truck to standby. The first may cost about $3,000; the second procedure nearly three times that amount. Sticking to your home turf can make this easier. If you're investing in an unknown area, get professional assistance.

Engineering reports and appraisals. Even if not required by the lender, you should secure an engineer's report and an appraisal on the property. Both are relatively cheap and add little in cost to the property but will provide valuable information.

Valuation. Income properties are generally valued quite differently than a personal residence. A residence value is based on comparable sales. For commercial properties, while that method is used, in part, to arrive at final value, an income approach is the most important part of the valuation. That is, how much income will the property generate and what are other investors looking for in return on investment. The computations can be done on a spreadsheet for a property with only a few tenants, but using a dedicated analysis program is preferred. The process involves discounting the cash flow for the property during a holding period and capitalizing the net income from the property in the final year to compute a residual value for the assumed sale. A "rule of thumb" called the cap rate is often used as a quick and dirty method. Go to our Business and Tax Formulas page for a complete description of the cap rate.

Cash flow analysis. Buying an investment property isn't that much different than buying a business. While a single family rental property is fairly straight forward, a multi-tenant building requires a rigorous analysis. You've got to project the income, which is likely to vary by year, the debt service (principal and interest payments on any loans), future capital expenditures, etc. If all the leases expire in four years you've got to be prepared for a loss in income when some of the tenants leave (some are likely to renew; some are not) and the cost of real estate commissions and potential alterations. Because most properties are heavily leveraged--80% or so of the purchase price usually consists of debt--debt service can represent a significant monthly cash outflow. You should always maintain a cash budget and a multi-year capital budget.

Cash cushion. You should either have a cash cushion or be able to get funds quickly for emergency repairs, unforseen capital expenditures, etc. Commercial properties are not like houses. Paving a portion of the parking lot can run $20,000. Snowplowing can start at $4,000 for the season.

Take a partner. If you're venturing into real estate for the first time or taking on a big project, it can make sense to take on a partner, for both operating and financial reasons. It's even more important if you're unavailable at times to handle an emergency. The downside is the possibility of a dispute between partners. Instead of simple co-ownership you should consider an LLC. That allows you flexibility in operation and also allows you to clearly define the nature of the obligations and rewards of the parties. Talk to an attorney; any dollars expended here well worth it in the long run.

Taxes. The tax benefits of renting property may be limited as a result of a number of number of provisions in the tax law. There are a number of factors that affect the tax benefits. While taxes aren't going to turn a good investment bad, they aren't going to turn a bad or mediocre investment good. The investment should provide the return you're looking for without the tax benefits. And special rules can apply to certain properties such as vacation homes and short-term rentals. We'll discuss the tax effects in an upcoming article.

--Last Update 10/28/14