All Forum Posts by: Christopher Perez

Hi Chris.  I'm on the lending side of things.  You should check out www.11capitalfinance.com.  Product sheet on the site.  10,000 loan variations plus a net branch system where you can learn the lending side of things and earn on both sides of the fence, doing your own real estate deals and the ones you don't offering financing.  Every real estate investor should be earning on real estate AND finance since they are all out here originating, but only earning on 1 out of 20 deals they see.  Adding finance means you can potentially earn on 20 our of 20 deals.  Pretty cool stuff. CP

lol  I'm sure you would...we will send you you some local business for sure.  

What is IAP Membership?

IAP is an EXCLUSIVE by INVITATION ONLY MEMBERSHIP training program that allows anyone the ability to “Earn while you Learn” to get into the extremely lucrative $500 billion dollar a year commercial real estate lending industry. No matter your background you can have your own business, with training, processing, support & guidance for far less than almost any other franchise opportunity.Join Today All Bigger Pockets Members are Pre-Sponsored

March 1, 2018 “I want to thank everyone for their hard work on getting this file to the closing table and getting the file closed. I look forward to more deals coming your way soon.” Donald T, Chicago

February 22, 2018 “Thank you so very much! I really appreciate all your hard work and patience with my learning curve. I wish I was buying more property now, as I enjoyed the experience and felt very supported and respected. Beyond excellent customer service and extremely knowledgeable! I also felt you were on my side and worked in my best interest. I am looking forward to our next transaction.” Linda S, Philadelphia 

And David W, natural is closing loans everyday with happy customers which are available to speak to upon request, so thanks for chiming in.  Feedback is always appreciated.  I see your in Philadelphia.  We should grab coffee.  

Hi Harrison.  The product sheet is on the web site which is great guide, but they have over 10,000 loan variations so if you have a need simple 3 minute online application and multiple offers come back within 24hrs or less, sometimes within 1hr.  They are full service brokerage.  

Hi Ray.  During hold periods the spread is vita i.e. income vs. expense. This comes down to thee Golden Rule.  You make your money on the buy price.  Always.  Unexpected things always come up so the thinner the margins the less room investors have for speed bumps along the way.  Do your homework when buying, look at the trends in the area, and always have an exit plan with cash reserves.  Living through market swings and a total collapse teaches frugality and caution.  The wild west has been tamed, somewhat...lol

Thanks all! Im on the finance side 20+ years so please feel free to use me as resource but keep in mind we are stupid busy printing money. Lol. If you are investor please reach out because you are leaving mountains of cash on table. I'll show you in 1 minute regardless of if we do business. CRE investors are inheriting our business and its awesome and just plain ole makes sense. Already in our business...just not earning. CP

Terms in CRE lending that everyone should know...

Adjustable Rate Mortgage: Mortgage where the interest rate adjusts periodically up or down through a set index. Also called a floating rate mortgage.

Adjusted Gross Income: Gross income of a building if fully rented, less an allowance for estimated vacancies.

Adjustment Interval: The period of time between changes in the interest rate for an adjustable-rate mortgage. Typical adjustment intervals are one year, three years, and five years.

Amortization: The process of paying the principal and interest on a loan through regularly scheduled installments.

Annual Percentage Rate (APR): This is the actual rate of interest your loan would be if you included all of the other associated costs, such as closing costs and points.

Apartment Conversion: When a rental apartment building is converted to individually owned units.

Apartment Rehabilitation: Extensive remodeling of an older apartment building.

Appraisal: An estimate of the value of a property, made by a qualified professional called an appraiser.

ARM: See Adjustable Rate Mortgage.

Assumable Loans: Loans that can be transferred to a new owner if a home is sold.

Balloon (Payment) Mortgage: Usually a short-term, fixed-rate loan that involves small payments for a certain period of time, and one large payment for the remaining principal balance, due at a time specified in the contract.

Basis Points (BP): 1/100th of 1% added or deducted to the current index rate in order to accomplish a pricing goal or option.

B, C, and D” Lenders or Loans: The letters “B, C, and D” refer to the rating of the lender or loan. We refer to “B, C, and D” credit as “problem or troubled credit,” rather than using these letters with a borrower.

Bond Financing: Type of financing that includes a promise to repay the principal along with interest by a specified date.

Buy down: The process of paying additional points on the loan to reduce the monthly mortgage. There are typically two specific types: a Permanent Buy down, and a Temporary Buy down.

a) In a Permanent Buy down, a sufficient amount of interest is prepaid to lower the rate permanently. b) In a Temporary Buydown, only a sufficient interest is paid to lower the payment for the first three years.

1) The reason to temporarily “buydown” a loan is to lower the current payments, thereby more easily qualifying for the loan. This usually makes sense because income will usually continue to increase as the interest increases.

2) The most common Temporary Buydown is called “3-2-1,” meaning three percent lower the first year, two percent lower the second year, and one percent lower the third year.

Bridge Loan: Financing which is expected to be paid-back relatively quickly, such as by a subsequent longer-term loan; also called a “swing loan.”

CMBS: Commercial Mortgage-Backed Security: Wall Street-speak for a low interest rate loan product.

Cap: The maximum which an adjustable-rate mortgage may increase, regardless of index changes. An interest-rate cap limits the amount the interest can change, while a payment cap limits the increase in monthly payment to a specific dollar amount.

Cap Rate: A net yield set by an investor to determine the value of an income-producing property.

Capital Expenditures: Line items on a profit and loss statement that would not be expensed on an annual basis. This category would include replacement of major building systems, such as roofs, driveways, etc.

Capitalization Rate: A method used to estimate the value of a property based on the rate of return on investment.

Closing: The meeting between the buyer, seller, and lender (or their agents), where the property and funds legally change hands. Also referred to as “settlement.”

Closing Costs: The cost and fees associated with the official change in ownership of the property and with obtaining the mortgage, which are assessed at closing or settlement.

Commercial Conduit: Direct link to an institutional lending source.

Comparative Market Analysis: An estimate of the value of a property based on an analysis of sales of properties with similar characteristics.

Conduit: The financial intermediary that sponsors the conduit between the lender(s) originating loans and the ultimate investor. The conduit makes or purchases loans from third-party correspondents under standardized terms, underwriting and documents. When sufficient volume has been obtained, the conduit pools the loans for sale to investors in the CMBS markets.

Convertible: An option available on some adjustable rate mortgages (ARMs) that allows the loan to be converted to fixed-rate mortgage. Conversion usually involves paying a one-time fee, and conversion may be limited to within a certain time-frame.

Cosigner: Someone who is willing to sign the mortgage loan obligation with the borrower, in case she defaults on her monthly payments. Normally, the cosigner is required to go through the same application and approval process as the original signer of the loan.

Credit Company: A lending organization that obtains its source of funds from the commercial market.

Credit Enhancements: A loan to provide improvements to the property.

Credit Report: A search through your existing credit history by a qualified credit bureau to determine if and how often you may have been delinquent making monthly payments on previous debts. Even when a credit report is, for the most part, positive, many lenders require a written explanation for any negative comments contained therein. This type of report is usually required to obtain a mortgage loan.

Debt Service Coverage Ratio (DSCR): A DSCR of 1.0 means break-even. The ratio is calculated by taking the net operating income (NOI) and dividing it by the mortgage payments. Most lenders look for a ratio of 1.25 or higher. See "Net Operating Income."

Debt Service: The periodic payments (principal and interest) made on a loan.

Debt Ratio: One of several financial calculations performed by your lender to determine if you can afford a particular monthly payment. The debt ratio (also known as the obligations ratio) is the sum of all your monthly debt payments (including your total monthly mortgage payment) divided by your total monthly income. Typically acceptable debt ratios for conventional loans are 36-38%, FHA loans are 41-43%, and VA loans are 41%.

Discount Rate: Many lenders may offer you a lower “teaser” rate on an adjustable rate mortgage for the first adjustment period. After this period is over, the lender will adjust your loan according to the normal lender’s margin rate.

Down Payment: The amount of money you initially invest to purchase a property, normally anywhere from 5% to 25%.

Due Diligence: The legal definition: a measure of prudence, activity or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent person under the particular circumstances. In CMBS: due diligence is the foundation of the process because of the reliance securities investors must place on the specific expertise of the professionals involved in the transaction.

Engineering Report: Report generated by an architect or engineer describing the current physical condition of the property and its major building systems (i.e., HVAC, parking lot, roof, etc.). The report also determines an amount for calculating replacement reserves, if needed.

Environmental Report: Report generated by a qualified environmental firm to determine potential environmental hazards in a building's region or within the building itself.

Environmental Risk: Risk of loss of collateral value and of lender liability due to the presence of hazardous materials, such as asbestos, PCB's, radon, or leaking underground storage tanks on a property.

Equity: 1.) The difference between the fair market value and current indebtedness also referred to as “owner's interest.” 2.) The difference between the amount owed on the loan and the current purchase price of the home or property.

Equity Capital: Capital raised from owners. In a commercial real estate case, a lender will also provide equity capital for a percentage of ownership.

Escrow: 1.) A special account set-up by the lender in which money is held to pay for taxes and insurance. 2.) A third-party who carries out the instructions of both the buyer and seller to handle the paperwork at the settlement.

Fair Market Value: An appraisal term for the price for which a property would sell in a competitive market, given a willing seller and willing buyer, each having a reasonable knowledge of all pertinent facts, with neither being under any compulsion to buy or sell.

Fannie Mae (FNMA): A congressionally-chartered corporation that buys mortgages on the secondary market from banks, savings and loans, etc. They then pool them and sell them as mortgage-backed securities to investors on the open market. Monthly principal and interest payments are guaranteed by FNMA but not by the U.S. Government.

FHA: Federal Housing Administration, a government agency.

Fixed-rate Mortgage: A mortgage with an interest rate that remains constant for the life of the loan. The most common fixed-rate mortgage is repaid over a period of 30 years. There are 15-year fixedrate mortgages are also available.

Floating Rate Mortgage: See Adjustable Rate Mortgage.

Floor-To-Area Ratio (FAR): The relationship between the total amount of floor space in a multistory building to the base of that building. FARs are dictated by zoning laws and vary from one neighborhood to another. In effect, they stipulate the maximum number of stories a building may have.

Foreclosure: The process by which a lender takes back a property on which the mortgagee had defaulted. A servicer may take over a property from a borrower on behalf of a lender. A property usually goes into the process of foreclosure if payments are more than 90 days past due.

Forward Commitment: A written promise from a lender to provide a loan at a future time.

Freddie Mac (Federal Home Loan Mortgage Corporation): An entity that buys loans from conventional lenders and packages them for sale to investors as securities.

Government Loans: One of two loan types called FHA or VA loan. These loans are partially backed by the government and can help veterans and low-to-moderate income families afford homes. The advantages of these types of loans in that they often have a lower interest rate, are easier for which to qualify, have lower down-payment requirements, and can be assumed by someone else if the home is sold. Many mortgage bankers can obtain these types of loans for you.

Graduated Payment Mortgages: A type of mortgage where the monthly payments start low, but increase by a fixed amount each year for the first five years. The payment shortfall, or negative amortization, is added to the principal balance due on the loan. The major advantage of this type of loan is a lower monthly payment at the beginning of the loan term. The disadvantages, typically, are a slightly higher rate than traditional fixed- rate mortgage loans, and a larger down payment is required by lenders. In addition, the negative amortized amount increases the balance due on the total loan, which can be a problem if the value of the home declines.

Gross Income: Total income, before deducting taxes and expenses. The scheduled (total) income, either actual or estimated, derived from a business or property.

Growing Equity Mortgage: A type of mortgage where the monthly payments start low, but increase by a fixed amount each year for the entire life of the loan (as compared to five years with a Graduate Payment Mortgage.) The advantage of this type of loan is that the loan can usually be paid-off in a shorter duration than a traditional fixed-rate loan. The disadvantage of this loan is that the payment continues to go up regardless of the income of the borrower.

Hard Equity: High interest rate financing.

Housing Ratio: One of several financial calculations performed by your lender when applying for a conventional loan to determine if you can afford a particular monthly payment. The housing ratio (also known as the income ratio) is your total monthly payment (including taxes and insurance), divided by your total monthly income. Typically acceptable housing ratios for conventional loans are 28% to 33%, and FHA Loans are 29% to 31%.

HUD: Housing and Urban Development, a federal government agency.

Index: An economic indicator, usually a published interest rate, that determines changes in the interest rate of an Adjustable-Rate Mortgage (ARM). ARM rates are adjusted to reflect changes in the index. The margin is the amount that a lender adds to the index to establish the actual interest rate on an ARM.

Interest: The sum paid for borrowing money, which pays for the lender's costs of doing business.

Interest Rate: The sum charged for borrowing money, expressed as a percentage.

Interest Rate Cap: Limits the interest rate or the interest rate adjustment to a specified maximum. This protects the borrower from increasing rates.

Interest Shortfall: An aggregate amount of interest payments from borrowers that is less than the accrued interest on the certificate.

Investment Banker: An individual or institution that acts as an underwriter or agent for corporations and municipalities issuing securities, but that does not accept deposits nor make loans. Most also maintain broker/dealer operations, maintain markets for previously issued securities, and offer advisory services to investors.

Jumbo (Non-Conforming) Loans: A mortgage loan that exceeds the amount that is acceptable by the government if the loan were to be resold (on the secondary market) to Fannie Mae and Freddie Mac.

Lease Assignment: An agreement between the commercial property owner and the lender that assigns lease payments directly to the lender.

Leasehold Improvements: The cost of improvements for a leased property, often paid by the tenant.

Lender Margin: This is simply the profit the lender expects to receive from the loan. You can ask your lender what the margin is on an adjustable rate mortgage. Typically, lenders use a discount rate initially as a “teaser” rate. You must be sure to verify the normal margin after the discount period is over.

Lines of Credit: An arrangement in which a bank or vendor extends a specified amount of unsecured credit to a specified borrower for a specified time period.

Loan Origination Fee: The fee charged by a lender to prepare all the documents associated with your mortgage.

Lock-In: The process of fixing the interest rate for a specific period of time regardless of future or impending economical changes to the interest rate. This process may require a fee or premium, since it reduces the risk that the monthly payments will change while the loan paperwork is filed.

Lock-Out Period: A specified period of time after the loan funds, during which a borrower cannot prepay the mortgage loan without incurring very significant penalties.

London Interbank Offered Rate (LIBOR): The short-term rate (one year or less) at which banks will lend to each other in London. Commonly used as a benchmark for adjustable-rate financing.

LTV or Loan to Value: Proposed loan amount divided by the value of the property.

Margin: The amount that is added to an index rate to determine the total interest rate.

Maturity: 1.) The termination period of a note (i.e., a 30-year mortgage has maturity of 30 years). 2.) In sales law, the date a note becomes due.

Mezzanine: Late-stage venture capital financing.

Miniperm: Short term, permanent financing, usually three to five years.

Mortgage Banker: An entity that makes loans with its own money and then sells the loan to other lenders.

Mortgage Broker: An entity that arranges loans for borrowers.

Mortgage Insurance: A type of insurance charged by most lenders to offset the risk of a loan when the down payment is less than 20% of the value of the home.

Mortgage Reduction Programs: A type of accelerated payment program whereby payments are made more frequently, usually bi-weekly or weekly schedule, rather than the traditional monthly payment. Making more frequent and accelerated payments reduces the amount of principal more quickly, which interest accumulation is based on. The net effect can be a savings on the total interest paid.

Multi-Family Property Class A: Properties that are above-average in terms of design, construction, and finish; command the highest rental rates; have a superior location in terms of desirability and/or accessibility; and are usually managed professionally by a national or large, regional management company.

Multi-Family Property Class B: Properties that frequently do not possess a design and finish reflective of current standards and preferences; construction is adequate; command average rental rates; generally are well maintained by national or regional management companies; and unit sizes are usually larger than current standards.

Multi-Family Property Class C: Properties that provide functional housing; exhibit some level of deferred maintenance; command below-average rental rates; usually located in less desirable areas; generally managed by smaller, local property management companies; and tenants provide a lessstable income stream to property owners than Class A and B tenants.

Negative Amortization: This occurs when interest accrued during a payment period is greater that the scheduled payment, and the excess amount is added to the outstanding loan balance. For example, if the interest rate on the ARM exceeds the interest rate cap, then the borrower's payment will be sufficient to cover the interest accrued during the billing period. The unpaid interest is then added to the outstanding loan balance.

Net Effective Rent: Rental rate adjusted for lease concessions.

Net Operating Income (NOI): Total income less operating expenses, adjustments, etc., but before mortgage payments, tenant improvements and leasing commissions.

Net-Net Lease (NN): Usually requires the tenant to pay for property taxes and insurance in addition to the rent.

Notice of Default (NOD): To initiate a non-judicial foreclosure proceeding involving a public sale of the real property securing the deed of trust. The trustee under the deed of trust records a Notice of Default and Election to Sell ("NOD") the real property collateral in the public records.

Non-Recourse: A finance term: a mortgage or deed of trust securing a note without recourse allows the lender to look only to the security (property) for repayment in the event of default, and not personally to the borrower. This loan does not allow for a deficiency judgment. The lender's only recourse in the event of a default is to possess the security (property), and the borrower is not personally liable.

Operating Expense: Periodic expenses necessary to the operation and maintenance of an enterprise (e.g., taxes, salaries, insurance, maintenance). Often used as a basis for rent increases.

Participation: A type of mortgage where the lender receives a percentage of the gross revenue in addition to the mortgage payments.

Percentage Lease: Commonly used for large retail stores. Rent payments include a minimum or “base rent” plus a percentage of the gross sales “overage.” Percentages generally vary from 1% to 6% of the gross sales, depending on the type of store and its sales volume.

Phase I: An assessment and report prepared by a professional environmental consultant who reviews the property, both land and improvements, to ascertain the presence or potential presence of environmental hazards at the property, such as underground water contamination, PCB's, abandoned disposal of paints and other chemicals, asbestos, and a wide range of other potentially damaging materials. This Environmental Site Assessment (ESA) provides a review and makes a recommendation as to whether further investigation is warranted (i.e.,, a Phase II Environmental Site Assessment). This latter report would confirm or disavow the presence of any mitigation efforts that should be undertaken.

PITI: Principal, Interest, Taxes and Insurance. Your calculated estimate of monthly payments.

Points: Loan fees paid by the borrower. One point equals 1% of the loan amount.

Pre-payment Penalty: A charge for paying-off a loan before it is due.

Pre-qualification: The process of determining the amount of money a particular lender will let you borrow. You should strive to obtain pre-qualification with at least two or three lenders.

Prime Rate: An artificial rate set by commercial bankers. Many banks will use the Wall Street Prime Rate, which is a rate set by the top lending banks in the country.

Principal: 1.) The amount of debt, not including interest, left on a loan. 2.) The face amount of the mortgage.

Property Appraisal: A report showing exactly how much the particular building or structure is worth, based on comparisons of like properties in the local community. A commercial appraisal is much more in-depth than a residential appraisal. It takes longer, costs more, and suitable comparison properties are much harder to find.

Property Classification: Most lenders will classify a property by its age and it’s needed maintenance. For example, many insurance companies will only loan on properties that are Class A, meaning that the property is ten years old or less and is not in need of repair.

Property Tax: Taxes based on the market value of a property. Property taxes vary from state to state.

Rate Index: An index used to adjust the interest rate of an adjustable mortgage loan (i.e., the changes in U.S. Treasury securities, or “T-bills,” with a one-year maturity). The weekly average yield on said securities, adjustable to a constant maturity of 1 year, which is the result of weekly sales, may be obtained weekly from the Federal Reserve Statistical Release H.15 (519). The change in the T-bill’s interest rate is the “index” for the change in a specific Adjustable Mortgage Loan.

Recourse: A loan for which the borrower is personally liable if he or she defaults.

REIT (Real Estate Investment Trust): Pooled funds that are used to purchase and hold commercial real estate.

Refinance: The renewal of an existing loan by the borrower.

Rent Step-Up: A lease agreement in which the rent increases every period for a fixed amount of time or for the life of the lease.

Replacement Reserves: Monthly deposits that a lender may require a borrower to reserve in an account, along with principal and interest payments, for future capital improvements of major building systems (i.e., , HVAC, parking lot, carpets, roof, etc.)

Reserve Funds: A portion of the bond proceeds that are retained to cover losses on the mortgage pool. A form of credit enhancement (also referred to as “reserve accounts”).

Residual Income: The amount of money left-over after you have paid all of your ordinary and necessary debts including the mortgage. This calculation is typically used with VA loans.

Sale/Lease Back: When a lender buys a property and leases it back to the seller for an extended period of time.

Savings & Loan: A state- or federally-charted financial institution that takes deposits from individuals, funds mortgages, and pays dividends.

SBA: Small Business Administration, a federal government agency.

Second Mortgage: A mortgage on real estate that has already been pledged as collateral for an earlier mortgage. The second mortgage carries rights that are subordinate to those of the first.

Secondary Financing: A loan secured by a mortgage or trust deed, in which the lien is junior, or secondary, to another mortgage or trust deed.

Secondary Mortgage Market: The buying and selling of first mortgages or trust deeds by banks, insurance companies, government agencies, and other mortgagees. This enables lenders to keep an adequate supply of money for new loans. The mortgages may be sold at full value (“par”) or above, but are usually sold at a discount. The secondary mortgage market should not be confused with a “second mortgage.”

Spread: Number of basis points over a base rate index.

Standby Commitment: A formal offer by a lender making explicit the terms under which it agrees to lend money to a borrower over a certain period of time.

Structural Report: (see Engineering Report)

Tax and Insurance Impound: Monthly deposits that a lender may require to be included with principal and interest payments for the payment of taxes and insurance.

Tenant Improvements (TI): The expense to physically improve the property in order to attract new tenants to new or vacated space. These may include new improvements or remodeling, and may be paid by the tenant, landlord, or both. Typically, tenants are provided with a market rate TI allowance ($/square ft.) that the owner will contribute toward improvements. The tenant must pay for any cost over and above the TI allowance.

Term: The length of a mortgage.

Title: The actual legal document conferring ownership of a piece of real estate.

Title Insurance: An insurance policy that insures you against errors in the title search, essentially guaranteeing both your and your lender's financial interest in the property.

Triple-Net Lease: A lease that requires the tenant to pay for property taxes, insurance and maintenance in addition to the rent (also referred to as a “Net Net Net” Lease).

Underwriting: The process of deciding whether to make a loan based on credit, employment, assets and/or other factors.

Uniform Residential Loan Application (1003): This application, also called a URL- 1003, is the standard loan application used by all lenders.

Underwriter: The underwriter is the lender or company who actually provides the money for your loan. A mortgage broker “brokers” and represents several different underwriters. Depending on your situation, they choose the best underwriter for you and your lender.

Upfront Fees: Generally refer to fees charged to pay for third-party costs like appraisals.

VA (Veterans Administration) Loan: A type of government loan administered by the Veterans Administration. Eligibility for VA loan is restricted and limited to qualifying veterans, and to certain home types. You need to check with the VA to determine if you qualify. The maximum VA Loan is $184,000.

Workouts: Attempts to resolve a problematic situation, such as a bad loan.

Yield Maintenance: A prepayment premium that allows investors to attain the same yield as if the borrower made all scheduled mortgage payments until maturity. Yield maintenance premiums are designed to make investors indifferent to prepayments and to make refinancing unattractive and uneconomical to borrowers.

Yield To Average Life: A yield calculation used in lieu of “Yield to Maturity” or “Yield to Call,” where books are retired systematically during the life of the issue, as in the case of a “Sinking Fund” with contractual requirements. The issuer will buy its own bonds on the open market to satisfy its sinking fund requirement if the bonds are trading below Par. There is, to that extent, automatic price support for such bonds. Therefore, they tend to trade on a yield-to-average-life basis.

Yield to Maturity (YTM): Concept used to determine the rate of return an investor will receive if a long-term, interest-bearing investment, such as a bond, is held to its maturity date. It takes into account purchase price, redemption value, time to maturity, coupon yield, and the time between interest payments. Recognizing the time value of money, it is the discount rate at which the present value of all future payments would equal the present price of the bond (also referred to as “internal rate of return”). It is implicitly assumed that coupons are reinvested at the YTM rate. The YTM can be approximated using a bond value table (also referred as a “bond yield table”), or it can be determined using a programmable calculator equipped for bond mathematics calculations.

Stock market investors are often so focused on growth that many do not realize how the leverage, cash flow, and tax-deferral of real estate investing can combine to produce potent returns. And when mixed with the power of compounding, real wealth can be generated from a relatively modest investment.

The real return on real estate is not always easy to see, which is perhaps why investors do not pursue it as actively as investments in equities or fixed-income instruments. Also, professionals do not always agree on the best way to calculate the ultimate return on real estate. Below is an approach that takes into account cash flow, tax-equivalent yields, and depreciation, both combined and separately, and can make the case for why you might consider investing in real estate. Throughout this example, we’ll take some shortcuts that make our numbers more conservative. If this case study was real, the actual return would likely be higher than what is presented here. These shortcuts will be pointed-out as we go along:

Now let us consider our happy, fictional couple, the Smiths, who purchase a four- unit apartment building in their hometown for $292,500. Their down payment is $75,500 (or 25%), and their closing costs are another $6,822, for a total cash investment of $82,322. Their total mortgage balance (with one point on top) is $219,170, financed with a 6.26%, 30-year mortgage.

During the first year of ownership, the Smith’s building delivers the following financial performance:

Total Rental Income $ 40,780 Less Mortgage Payments $ 16,210 Gross Income $ 24,570 Less Operating Expenses $19,836 Net Cash flow $ 4,734

(Here is the first of the shortcuts: the above mortgage payments of $16,210 include the principal as well as the interest. The interest expense alone is less than the $16,210, meaning the net income and the investor’s return is actually higher than what we will shortly calculate. We will revisit this later.)

At the most fundamental level, the investor’s return is 5.75%, (consisting of $4,734 cash flow divided by the $82,322 total equity investment). Scholars might quibble over whether or not closing costs ought to be part of this calculation. If not, the return goes up to 6.27%. However, for those who actually had to come up with the cash to get to the closing table, it’s easy to look at these expenses as part of your equity in the property.

True, a return of 5.77% is not such a bad thing, but at the same time it is not a very compelling return. Yes, it will double in 12 years, but that’s a very long time. However, 5.77% is not the end of the story. If we consider depreciation, 5.77% is only the beginning.

Most rental property can be depreciated over a lifespan of 27.5 years. Therefore, the $292,500, net of the land value of $5,100, carries an annual depreciation expense of $10,451. This is a non-cash expense, which is the best kind to have, since it will significantly boost the Smith’s return. Why? Because on an economic basis, the Smith’s property actually lost $5,717 ($4,734 operating income minus $10,451 depreciation). Therefore, the $4,734 that went into the Smith’s pocket is sheltered from taxes by the depreciation on the property.

For the Smith’s to put $4,734 in their pocket from wages, tips and salary, they would have to earn $7,283 in a 35% tax bracket. Therefore, the so-called tax equivalent return is 8.85%. ($7,283 divided by $82,322). Now the Smiths are getting somewhere! And once again, this figure understates the return because it does not take into account the sheltering of income against state and local taxes which might occur.

But there’s more: the Smith’s still have an economic loss of $5,717, which is the depreciation expense net of the operating cash flow ($4,734 minus $10,451). This loss will help the Smith’s shelter $5,716 of other income. Specifically, if the Smiths are in the 35% tax bracket, the $5,716 loss on their property will result in $2,001 of avoided federal income taxes. If this avoided expense is viewed as income, it represents an additional 2.43% return ($2,000 divided by $82,322) in addition to state and local taxes which may have been avoided as well.

As an aside, the opportunity to avoid taxes through real estate investments can be tricky. Specifically, if you are not a real estate professional (i.e., it is not your career), the federal government places a limitation on how much of your passive loss from an investment on something such as real estate can be deducted against your ordinary income. Specifically, a married couple filing jointly may offset up to $25,000 of passive losses against their “active” income (i.e., wages and salary). Furthermore, the deduction is phased out for adjusted gross incomes between $100,000 and $200,000.

And while we are on the subject of taxes, it is worth noting that some of the deferred income taxes will come out in the wash in the form of higher capital gains taxes, if and when the property is sold. This will happen because the depreciation expense decreases the owners’ basis in the property, which will increase their gain upon sale.

In the case of the Smiths, neither limitation applies. Accordingly, the Smiths’ return is 11.28%, which is comprised of their 8.85% taxable equivalent yield plus the 2.43% yield from avoided taxes. While this figure takes some work to arrive at, there’s nothing illusory about it. You would have to generate interest income of $9,286 on an investment of $82,322 to come out the same after taxes.

There is one other element to the return worth taking into account: the monthly mortgage payments consist of both interest and principal. During the first year of operation, the Smiths pay $13,647 of interest while making $2,563 in principal payments. There are several ways of looking at this $2,563. One way would be to add it to the equity base of $82,322, since principal payments add to owner’s equity. This has the effect of decreasing percentage returns, since additions to equity increase the denominator of return calculations.

But this, however, is not the appropriate way to consider this new sliver of equity. The reason has to do with pockets. Specifically, since the mortgage is a self- liquidating liability, funded by tenants’ rental payments (assuming, of course, at least “break-even” cash flow), this new equity never came from the owner’s pocket. It came from the tenant’s. Therefore, it’s not unreasonable to think of this $2,563 as a gift, which at 3.11% of the initial $82,322 investment, is not an insignificant one at all. If it could be efficiently extracted from the property, this $2,563 could also be viewed as a return of principal, which reduces the owner’s equity investment from $82,322 to $79,759. This, in turn, will increase the effective return to 11.28%.

If there has been any appreciation in the value of the property, the owner’s equity will increase even faster than the rate at which principal is “gifted” to the owners by the tenants.

Of course, real estate investing is not as cut and dried as this article would make it appear. Owning a building where others live is a real responsibility. Things do go wrong, and maintenance is required. But if you’ve got the temperament for it, the very real return on real estate can be well worth your time and attention.

Perhaps the most striking feature about the money made by homeowners from their house was how little of it was intentional. For many, their mortgage payment was simply a substitute for their monthly rent payment. But over time, loan balances went down, values went up, and suddenly there’s a half a million in equity sitting on the table.

Although a similar opportunity exists for small businesses, fewer entrepreneurs take that leap. Running a business is challenging enough; why add the headache of owning additional property? While this may be true, buying real estate to house your business, as opposed to renting, can have a significant material impact on your return from the business and on your overall wealth.

To see this concept in action, consider the performance our hypothetical retailer: the Speed Shop. They sell automotive products. We will evaluate their business both before and after the purchase of real estate:

For years, the Speed Shop provided a nice living for its owner. Located in the suburb of a major metropolitan area, the business, a subchapter S corporation, consistently generated $750,000 in sales and distributed net profits of 5%, or about $37,500 after the payment of a $60,000 salary to the owner. Since the business was stable, the owner typically took the net profits out of the business in the form of a cash payment.

Suddenly, the owner receives a call one day. The building owner has died. The executor of the estate would like to know if our business owner would be interested in buying the building for $750,000. Because the owner had invested his bonuses wisely over the past 10 years, there was no question he had the cash to make a 40% down payment of $300,000.

The important question became this: would the purchase of the building have a positive or negative effect on the financials of the Speed Shop’s owner? Let’s assume the owner buys the building personally, and rents it to the business. How far out ahead might he come after 10 years, versus continuing to rent?

If the $450,000 balance was financed with a 6.25% adjustable rate mortgage, the monthly principal and interest payment would be $2,770, if amortized on a 30-year basis. Including the annual taxes of $7,200 increases the monthly payment to $3,370. This is less than the monthly rent of $6,500 that the company currently pays, so the transaction is off to a good start. But let’s be conservative and assume that the Speed Shop’s owner spends $37,500 annually on maintenance and operating expenses for the building. This $37,500 equals the annual difference between the old rental payments and the new mortgage and tax payments.

Now we need to make two adjustments to account for depreciation and principal contributions: let’s take principal first. The mortgage payments of $2,770 per month (which total $33,240 annually) contain about $5,300 in principal payments in the first year. These principal payments cannot be expensed.

On the other hand, there’s depreciation to consider. Net of land, which cannot be depreciated, the value of the building is $675,000 (which is $750,000, less an assignment to the value of the land at about $75,000, or 10% of the total value of the property). The useful life prescribed by the IRS for non-residential, commercial real estate is 39 years. Therefore, the annual depreciation expense for the property is $17,308, which is the $675,000 basis divided by the 39-year useful life.

The Speed Shop’s income statement for the first year would look like this:

Income $78,000 Expenses Mortgage Payments Net of Principal -$27,940

Taxes -$ 7,200 Operating Expenses -$37,500 Depreciation -$17,308 Total Expenses $89,948 Net Loss $11,948

The landlord feels none of this net loss, because it is delivered in large measure by the non-cash depreciation expense. On the down side, however, he also doesn’t really feel the increase in equity of $5,300, because despite the lower mortgage balance, the mortgage payment does not change.

Regardless, what’s important is the ability of the landlord to take this loss and net it against the profits he receives from his retail business. This is what will ultimately have a material impact on his wealth.

Remember the 5% (or $37,500) in distributed net profits? Thanks to the loss on the building, the owner will pay taxes on just $25,553 ($37,500 profit minus $11,948 loss from real estate). In a 35% tax bracket, this means avoided taxes of $4,181.

Let’s put it another way: the Speed Shop’s net margin would have to increase to 5.86% to leave its owner with the same amount of cash after taxes. This represents an astounding 17.2% (0.86%/5.00%) increase in net realized profits to the owner.

It is important to keep in mind, however, that the Feds as a general rule do not like to see passive income (i.e., income from a real estate investment) offsetting active income (i.e., income from running a retail operation). There are rules that govern limits to the offsets over certain amounts. And if you try to convince the Internal Revenue Service that your ownership and management of the building is active, you may very well be unable to get them to see your point of view.

Now let’s project 10 years into the future and assume that rather than selling the business, our owner simply shuts it down and sells the building. Let’s also assume that after the first year, he replaced the 6.25% adjustable rate mortgage with 9.87% permanent financing. How did he do? At the end of ten years, he owes the bank $410,000. However, because real estate values went up by an average of 7% per year, he is able to sell the building for $1.47 million. After paying off the mortgage, the Speed Shop’s owner is left with $1.06 million.

True, he doesn’t get to pocket this; he must pay long-term capital gains taxes. And all that depreciation he claimed for so many years finally catches up with him; it lowers the cost of the building, and in-turn increases the capital gains tax owed. In this case, the $17,308 in annual depreciation reduces the owner’s cost basis by $173,080 over ten years. Said differently, the owner must now pay taxes on this so-called “unrecaptured” depreciation at a rate of 25%. The balance of the gain will be taxed at the recently enacted, long-term capital gains rate of 15%.

However, this must be weighed against the avoided taxes of $4,181 in the first year, and $9,800 in years two through ten (as a result of a mortgage with a higher interest rate). But more importantly, it must also be weighed against the $634,692 ($1.06 million in proceeds, minus $125,308 in capital gains taxes, minus $300,000 initial investment) earned on the real estate investment after the payment of all long-term capital gains taxes.

The average after-tax gain of $63,469 per year ($634,692/10 years) is the equivalent of $97,644 pre-tax income in a 35% tax bracket. Adding this to the owner’s salary and profit distribution of $97,500 means that diverting the cash flow (which normally went into rent) toward ownership of real estate has effectively DOUBLED his income. It is as if he made the business twice as big, but he never added a single square foot to the operation. Yes, it’s safe to say that adding real estate into one’s business equation can have a very material effect on one’s wealth.