All Forum Posts by: James Storey

@Kevin Barry seems pretty solid from a financial perspective. Being in a college town is a great upside as well assuming it's near a popular university. Don't know this market but $600/month per unit seems low for walking distance from a university which is a good sign if it is truly below market. Can't prove it from just the forum but depending on your market you might have some upside on the rent as well as moving the utilities to tenants. Unleveraged returns appear to be around 8.5% and could be well over 10% after rent increases and utilities being moved to tenant responsibility. Given the large spread between unleveraged returns and your cost of capital (4.75%) is a great sign from a financial risk view. Looks nice on the financials. Assuming market, site, and location is solid are good, seems like a solid investment.

James Storey, CCIM

@Lorenzo Martinez looks pretty good. Those CoC returns looks so good with you putting so little down in the deal comparative to what you are cash flowing. Are there any renovations or major repairs that need to be done right off the bat? That could change you capital into the deal and thus change the ratios. Once you rent out the space you live in, that CAP rate should jump up to about a 9% CAP. If all else has been included, seems like a very nice house hack investment from a financial perspective.

James Storey, CCIM

Great to hear you are getting into Robert Kiyosaki books. Once you get past Cash Flow Quadrants, look into Robert Kiyosakis The Real Book of Real Estate. It goes over many topics including real estate investing, business management, property management, development, etc. It basically has a chapter written by various different Rich Dad Advisors that specialize on their topic. 

Also, I don't know if it is exactly what you are looking for in business systems, but I started to re-read Dave Ramsey EnterLeadership and reading it was like a nice breath of fresh air with my business. I highly recommend it.

@Dan Nad in my experience, there has never been a set in place cancellation standard unless it is specifically written out in the lease. Some tenants will negotiate a lease cancellation clause up front to limit their expenses if something were to go wrong and they were to buy out their lease.

If there is nothing in the lease that states how the lease is to be paid in the event of a cancellation, then it's up to the landlord and the tenant to negotiate how much the tenant should pay for the landlord to remove the lease obligation. This can be costly in legal fees to write up a lease cancellation agreement and negotiating it back and forth, especially if you are dealing with a large corporation as a tenant.

In my experience, the best and most reasonable way of calculating the fee the tenant should pay to buy out their lease is to run a Present Value calculation on the remaining lease obligation at a specified discount rate. You would do this by running out the remaining lease obligation (rent, CAM, reimbursed expenses, etc), and discount it back at a specified discount rate. The discount rate is determined by the landlord based on his/hers expected return on the lease. The higher the discount rate (higher expected return), the lower the buy out fee is, the lower the discount rate (lower expected return), the higher the buy out fee. This is similar to the way a bank will determine the prepayment penalty if you pay your mortgage off prior to the end of maturity. Keep in mind, this is very simplified.

EXAMPLE:

Lets assume a tenant has $100M in lease obligation left over 5 years, like in your question. And that leaves the tenant paying $20M a year on their lease. Let's also assume that the landlord determines that he can make a 9% return (discount rate) on his money today. Plugging this into a discounted cash flow calculator would determine the lease buyout would be about $77M in Net Present Value. 

This is not set in stone in the way to negotiate this but it's a great starting point. The tenant get's a discount on their lease liability and the landlord can take the $77M and recoup their investment and reinvest at 9% to replace their lease value. However, I will be up front, if you are dealing with a large corporation that has a ton of legal backing, expect to get thrown around in the ring because it can be a tough and costly negotiation.

Hope this helps.

James Storey, CCIM

@Nick Liu first off, I want to say that you have done a great job with the investment you have made so far, being able to own two properties worth a total of $900k free and clear is not easy and takes patience. As you have determined, now that you have gotten to this point, now is a perfect opportunity to look forward on what to do next.

Based on what I am hearing, you have two properties worth about $450,000 each cash flowing around 3.22% as is ($29,000 NOI/($450,000 X 2 properties))= 3.22%. And you can make renovations and get an additional $50,000 for each property. First off, unless the renovations will cost less then $25,000 per rental, then I wouldn't do it. In the end, you want to make money on the money you put into your properties and if the cost were $50,000 and the net gain from said renovations were $50,000, you would be wasting a lot of energy. Now on the other hand, if you feel like you will need to renovate to simply sell the properties, then obviously I would think about doing the renovations.

As far as your options are concerned, here are my thoughts.

Option 1. Selling and taking a capital gain hit would be very costly in this situation. Since you owned the property since 1997, you have likely depreciated a majority of these properties and the gain on unrecaptured property (top tax rate of 25%) will really eat up your proceeds. Not to mention the actual gains on appreciation that you will likely pay (top tax rate of 20% dependent on AGI), net investment tax (typically 3.8% for some sellers), and state capital gain tax (varies by state). That being said, my first inclination would be tying to do some sort of 1031 exchange if your goal is to continue to build your portfolio. Again, this is without going into in depth analysis of your tax situation, but from experience, this has typically been my suggestion for my clients historically.

Option 2. You mentioned doing a 1031 exchange into some multi family property that are running at CAP rates of 4-5%. Based on you scenario, if you took your net proceeds (selling price minus closing costs and brokers fees) from the sale of the two properties into an investment that had a CAP rate of 4-5%, assuming your net proceeds were $850,000, then your new unleveraged cash flow should be close to $38,250 ($850,000 X 4.5% = $38,250) which is about $9,250 more in annual cash flow then what your investments are producing today. If you want to know my opinion, I think you can find a much better return then 4-5%. Just as an example, I recently worked on a SFH portfolio here in Indianapolis worth of about $1M that had unleveraged cash flows around 10% and rents were below market and the properties were in great locations. I have even worked on single tenant triple net commercial properties that had 10 years leases, no landlord responsibility, and sold for 7% CAPs. Long story short, I think you can find a better returning property but you might have to look a little out of state. You have a really good opportunity to double or even triple your cash flow.

Option 3. You mentioned to refinance the properties and reinvest the proceeds into new properties. Typically, this has been the best choice for investors that love leverage and intend to build their wealth through leverage, which is not right or wrong just a matter of preference. However, I hear two things in your situation, 1) you don't like the idea of more debt and 2) the cash flow return would need to be significant enough to cover the new debt liability. If your situation, with a 3.22% CAP, your cost of capital (interest) will likely be a lot more. If your interest runs at 6%, it will significantly erode at your current in place cash flow at 3.22%. In order to use leverage in a positive way, you would need to have an investment that has a net return (cap rate) greater then your cost of capital (interest). Based on my calculations, if you refinanced on a 30 year fixed mortgage at 6%, you would only be able to pull out $400,000 (about 44% LTV) before it completely eliminated your cash flow, let alone banks typically only let you pull out at a 1.2X-1.25X DSR (debt service coverage). I just don't see this as a viable option in this scenario even without running IRR projections.

Recommendation. The good news is that you currently have a very safe investment with very reliable tenants. The downside to that is that it sounds like you don't have much upside. My recommendation would be to look more into a 1031 Exchange and really consider looking into something with higher yield. If you truly like the multi family value add aspect, then it might be hard to find something in OR.

James Storey, CCIM

@David M.

Yes depreciation recaptured gain on Section 1250 is limited to depreciation above the MCRS straight line method and is taxed as ordinary income. On the other hand unrecaptured gain (in this seller finance example) on section 1250 permits a maximum 25% tax on depreciation taken on the life of the property. This article has a good explanation in more detail.

https://www.taxcpe.com/blogs/news/recaptured-and-unrecaptured-real-estate-rental-section-1250-gain

@Terone Johnson yikes! Sound like you might have a very conservative accountant. Hopefully he is not confusing bonus depreciation with Section 179 expensing which is only applicable to commercial property. As the tax code states:

"For bonus depreciation purposes, eligible property is in one of the classes described in § 168(k)(2): MACRS property with a recovery period of 20 years or less, depreciable computer software, water utility property, or qualified leasehold improvement property."

Anything that is not part of the structure, roof, foundation, driveway, and framing is considered an improvement or fixtures which have 15 year recovery period and/or 7/5 years. 

Wish you the best of luck on this.

James Storey, CCIM

@Jeremy Hawkinson yes, the seller financing doesn't eliminate any capital gains tax at all. It simply defers the capital gains payments over the life of the seller financed structure.

The capital gains percentage is not determined buy how much gain is collected, it is determined based on how much the owners earn as earned income in the form of adjusted gross income. So if their is adjusted gross income put's them in the 20% tax bracket for long term capital gains, then that is how much they would pay on their net gain compared to their original basis in the property (how much they paid for the property originally).

Check out bank rate for examples of this: 

https://www.bankrate.com/investing/long-term-capital-gains-tax/

Keep in mind, this isn't the only capital gains they would pay, the tax code also permits a gain on recapture tax which is a flat 25% rate regardless of anyone income earned. This 25% rate is paid on all of the depreciation the owners took on the property since they owned it.

For example, Let's say for simplicity purposes, they purchased the property for $100,000 30 years ago and they are selling it today for $200,000. They would pay 20% on the difference between the two ($200,000 - $100,000 = $100,000 long term gain on appreciation X 20% = $20,000 tax on appreciation) assuming they are in the 20% tax bracket. Let's also say that since the owned the property for 30 years they fully depreciated the property from $100,000 to $0. They would pay the 25% on depreciation as well ($100,000 - $0.00 = $100,000 gain from depreciation X 25% = $25,000 tax on depreciation). Therefor their total capital gains tax would be $45,000 ($20,000 + $25,000 = $45,000). This however, does not include any net investment tax (typically 3.8% if they meet an income threshold) and state capital gain tax (varies by state).

In the case of seller financing, they would owe the $45,000 over the course of how long  you amortize the seller financing terms.To keep it simple, if you amortize the $200,000 over 10 years without interest (again for simplicity) then you would pay them $20,000 every year and they would pay $4,500 in capital gain every year ($45,000/10 years = $4,500). Keep in mind, they would also pay taxes on any interest they collect as well.

Hope this helps.

James Storey, CCIM

CCIM is one of the best commercial real estate training when it comes to analysis. Also, it creates a great network for referrals and gives you great credibility when talking about commercial investments. It's worth every penny, in my opinion.

James Storey, CCIM

@Terone Johnson both myself and my clients bonus depreciate anything that has an expected life of 15 years (i.e. improvements and furniture/fixture) or less even on smaller multi family units. This can be done by two ways.

1. Have a cost segregation study done to determine the value of improvements and furniture and fixtures and bonus depreciate that amount.

2. If you are making renovations, make good records of all the items you use in the property so they can be classified as one of the bonuses depreciate asset classification.

The 27.5 years time span you are hearing is in connection to the actual structure and roof itself. I have heard of accountants using an average of the cost of improvements and furniture/fixtures on new purchases on clients who have had cost seg studies done in the past but it is technically not correct in practice. Be cautious and as always, consult with your accountant.

James Storey, CCIM