All Forum Posts by: Dave Toelkes

You have all made good TO DO lists, but IMHO you have not set goals.

Setting a goal is not quite so simple. Goals are measurable, specific, and have a timeline.

To become rich is not a goal. It is a dream. How do you measure "rich", how long will it take to get rich?

To have a net worth of $1 million by the end of 2015 is a goal. It is specific, measurable, and has a definite timeline.

Buying a course, buying a property, taking a class, and joining a club are examples of action steps that may lead to achieving a goal. We just don't know what that goal is.

Now, what is your goal?

I have gotten this question from telemarketers offering me a "can't miss" stock market investment strategy, a short sale promotor, and a foreclosure investment promotor.

I have short and long term goals all geared toward maintaining financial independence and increasing my net worth. The actions I am taking to meet those goals work for me. Before those phone calls, it never occurred to me that there is a "next" level that I NEED to attain..

Since I am financially independent, what more do I need? I don't need another million $. I don't need to double the size of my real estate portfolio. I don't need more excess cash flow.

I don't need to spend more more money to flaunt my success. I don't need a big mansion, the newest imported luxury car, or a fancy vacation home. None of those things will make me any happier than I already am. None of these things will improve my health, make me live longer, or look better.

The bottom line for me is I don't need to work any harder to maintain my lifestyle and my financial independence. So why should I "get to the next level"? If there is a next level, I will let someone else try to get there.

I think that the only level anyone ever needs to attain is financial independence. Since you are also already there, Mike, I don't think there is a next level that you "need" to get to, either.

Originally posted by Dave Versch:

I understand I can depreciate the property value to offset capital gains I might have in stocks (not this year :cry: ), and that I can deduct the interest on my HELOC. Anything else?

Your understanding is imperfect. Rental property depreciation does not offset capital gains, at least not directly. Instead, depreciation offsets your taxable rental income. If the total of your operating expenses and depreciation is greater than your rental income, then you have a net passive loss which you can then use to offset other ordinary income. You are allowed to use your net passive losses to offset up to $25K in other ordinary income Since your other ordinary income is taxed at your ordinary income tax bracket, you would hope to use the net passive loss allowance to reduce your taxable ordinary income rather than capital gains which is taxed at a lower rate.

Although the HELOC is on your primary residence, you deduct the HELOC loan interest as mortgage interest on the Schedule E for the rental property. You can take this Schedule E mortgage interest deduction even if you don't itemize your deductions on Schedule A.

As I see it, there are three reasons an investor owns rental property.

1. Cash Flow
2. Appreciation
3. Tax Benefits

Rental property investors buy the cash flow. You need a positive cash flow to sustain the property while you wait for appreciation. If there is a positive cash flow, then your tenants are buying the property for you, and paying all your costs of ownership and rental operation. Eventually, your tenants pay off your debt and you own the property free and clear. Can't get there without positive cash flow.

Appreciation does not happen every year, nor does it happen at a constant rate. Indeed, over the short haul, appreciation is not guaranteed. Hold the property long enough, and the property usually does appreciate. Now, appreciation does not help you if you bought during a market peak and are forced to sell at a market bottom. Most of us are not forced to sell when the market is soft. If we sell, we nearly always sell at a profit -- so, appreciation is usually a payoff for the rental property owner.

Tax Benefits come in several forms. The largest immediate benefit is the depreciation expense. Depreciation does not cost me anything, does not take any money out of my pocket, yet it does reduce my taxable rental income. Even if I have a negative income, depreciation makes that tax loss even greater so my net passive loss allowance is larger. Either way, I have a lower tax bill than I might have otherwise without the depreciation expense.

I agree that after a certain number of years, the depreciation expense goes away. But by then, I will own the property free and clear, and will have added other depreciable properties to my portfolio with the excess cash flow..

If I am in the 25% tax bracket, then when the property is fully depreciated, Uncle Sam will have "paid" me 25% of the cost of my rental dwelling structure through income tax savings, while letting me keep 100% of the title.

There are other tax benefits too. Rental property owners enjoy capital gains tax treatment when their property is sold in a taxable event. The capital gains rate is a preferred rate that is always lower than the rate charged on your ordinary income, including your taxable rental income.

Rental property investors can defer capital gains taxes indefinitely with a 1031 exchange.

None of these reasons should be the single deciding factor in deciding to become a landlord. If you have one, you usually get all three.

That said, if you are going to pick a single reason to NOT buy a rental property, it should be a negative cash flow. Even a negative cash flow property has tax benefits and may appreciate over time, but it is not generally an efficient use of your investment capital. If I don't have a positive cash flow, I don't even bother with the property regardless of the potential tax benefits or potential for future appreciation.

Originally posted by Rich Weese:

I'm here to eat crow. It appears that ALL real estate is 27.5 years for depr.

Rich,

All RESIDENTAL dwellings are depreciated over 27.5 years, even the 100+ unit apartment complex.

The buildings that house your business, your warehouse, your shopping center, and your manufacturing plant are all examples of commerical use real estate and depreciated over 39 years.,

Here is how I look at it. Once you have acquired a property, how will you make money? The answer to that question is your exit strategy. The more ways you can answer that question, the more exit contingincies you have available to you

Originally posted by cucaloco:

So using this logic, a true 12 cap rate with a 1million dollar 10 year fully amortized note that has $10,000 cash flow a month is worse then a true 8 cap rate with 5 year interest only balloon payment loan with $11,000 cash flow a month?

You are comparing apples to oranges. Cap rate calculations are done with the premise that the property is owned free and clear. When the property is owned free and clear, the NOI is the pre-tax cash flow, and the cap rate is your return on investment. When you are comparing investments, the one with the higher rate of return is also a more efficient use of your money.

In practice, cap rate is used to determine the value of a property when there are no comps. If you are looking at large multi-plex properties, chances are there are no recently sold comparable properties to establish market value. After all, how many 100 unit apartment complexes get sold every day?

When comps are not readily available, investors resort to a cap rate analysis to establish the value of a property -- that is, the value to the investor.

If financing is to be used then the Debt Coverage Ratio (DCR) is the first consideration. If the Debt Coverage Ratio is at least 1.25 a property will usually sustain itself. That is to say, the cash flow will usually be large enough to take care of whatever unscheduled repairs may come up.

Let's say you are looking at a small apartment complex that has a $100K NOI. Let's say that my commercial lender requires 20% down and a DCR of 1.3 for a 7% loan, 25 year amortization, 5 year balloon.

A $100K NOI gives me $8333 per month to cover debt service. A 1.3 DCR means that my debt service can not exceed $6410 per month. So, the maximum loan amount this debt service will support on the terms offered by the lender is about $907K. Since I had to put 20% down, then the maximum I can afford to pay for this property is $1.125 million.

Dividing the $100000 by $1125000 gives you an 8.9% cap rate.

At this purchase price under these financing terms, your first year pre-tax cash flow is just $1923 per month for a 6.7% return on invested capital.

If this is good enough for you, then for this property you will REQUIRE an 8.9% cap rate. A lower cap rate and you won't meet your cash flow requirements. A lower cap rate and this property might even negative cash flow.

You had to do some work to determine the maximum amount you could afford to pay for the property, and that work did not start with cap rate. The outcome of your "cash flow" analysis determined the lowest cap rate that you could accept. Now, you have a number to start negotiating from. Offer the seller a price based upon a 14% cap and negotiate down to a 9% cap. If the seller can't meet YOUR cap rate requirements, then walk away from the deal.

I have to side with Mike on this one. You can't use the cap rate as the sole evaluation factor to make your buying decision if you are using financing. You use the cash flow to determine the minimum acceptable Cap Rate you REQUIRE, and consequently the maximum price you are willing to pay for the property. From this point forward, the cap rate the seller is offering is irrelevant for this property since you already know the maximum price you are willing to pay. The maximum price you are willing to pay is the Value of the property to you.