Lauren Herlich

People are often confused about investing in real estate for investment purposes. When I am speaking of "investment purposes", I am talking about a long term investment where the subject property is a rental property. People know if the mortgage payment per month is $600.00 and the rent is $800.00, they are making money. Or are they?

The best way to analyze a property's potential is to use the income approach and the capitalization rate. What is it? It is how the property will pay for itself or cash flow. Often you will hear people talk about "cap rate". Again, what is it? It is a measure of how fast an investment will pay for itself. Thus, if your "cap rate" is 10% , the investment will pay for itself in ten years. And again, if the cap rate is 5%, the investment will pay for itself in 20 years.

How do you calculate the "cap rate"? It is a ratio between the net income and the price or cost of the asset. So, how do you calculate net income? The example below will give you an idea of how this calculation works. I will use a $1000 rent for the example. I am also assuming this is a 1200 square foot, single family house.

Gross Income (Rents x 12) $12,000
Real Estate Taxes $ 1,000
Utilities (Paid by landlord) $ 500 (Assuming in Philadelphia landlord is paying Water and Sewer - typical)
Insurance $ 1,000
Management Fees $ 720 (6% - could be higher)
Maintenance & Repair $ 600 ($0.50/ft - using 1200 square feet)
Replacement Reserves $ 420 ($0.35/ft - using 1200 square feet)
Snow Removal & Misc $ 400 (estimated)
Vacancy & Collection $ 600 (5%)

Net Income $ 6,760


Now you know what your net income looks like. However, some of these expenses listed above could be different in reality. For example, management fees could be more. In Philadelphia, it is likely that the insurance and taxes could be lower. Also, I have built into this formula that the property is in good condition when rented. I am assuming the roof, systems, kitchen and bathroom are reasonably up to date and functioning.

Now, you need to address the Capital Cost or Asset Price. See the example below.

Purchase price $60,000
Closing Costs $ 4,500 (7.5% - Philadelphia typically 6-9%)
Improvements $10,000 (Estimated)
Asset Price $74,500

The next step would be to take a look at the ratio.

Net Income/Capital Cost = Capitalization Rate

$6,760/$74,500 = 9.07%

Thus, the investment would pay itself off in a little more than 11 years. This is a very good capitalization rate.

Conversely, you may be looking at properties where you know the price. You can quickly calculate a number on gross figures to know whether it is worth even looking any further. I am seeing a lot of properties, currently, that are multi-family. They are collecting, let us say for this example, about $1800/month and asking $500,000 for the building. So, if I want an 6% cap rate, I don't have to go through great calculations to see what is what.

Gross Income/Capital Cost = Cap Rate

$21,600/$500,000 = 4.32%

STOP HERE! We have not used the net income nor have we added closing costs and improvements, and we are at a 4.32% Capitalization Rate. When we add and subtract the rest, the rate will only go down.

If you want to see what you should pay, let us assume that there are 3 units each paying $600 per month. Let us also assume that the building is 2000 square feet.

Gross Income (Rents x 12) $21,600
Real Estate Taxes $ 1,200
Utilities (Paid by landlord) $ 1,000 (Assuming in Philadelphia landlord is paying Water and Sewer - typical)
Insurance $ 1,200
Management Fees $ 1,296 (6% - could be higher)
Maintenance & Repair $ 1,000 ($0.50/ft - using 1200 square feet)
Replacement Reserves $ 700 ($0.35/ft - using 1200 square feet)
Snow Removal & Misc $ 400 (estimated)
Vacancy & Collection $ 1,800 (5%)

Net Income $13,004

So, if our net income is $13,004 and we want an 6% cap rate, which is the average for apartments, what should we pay for the asset?

Net Income/Cap Rate = Cost of Asset (What should be paid including closing cost and improvements)

$13,004/6% = $216,733

If you are trying to achieve a higher cap rate, be aware that many properties allowing for higher cap rates, will usually have higher vacancy rates.

Now, of course, there are other factors to consider when purchasing the property. Will the rents increase? Will the expenses increase? I could go on and on, but the questions may blur the idea of what I have explained herein. Thus, when considering purchasing and investment property, consider how the property will cash flow to see if you are making a good investment or not.

I don't know how it works in other parts of the country, but in Philadelphia, there are multiple types of Grants for which a buyer can qualify. Most of them are income related. Some come from the City of Philadelphia, Some from the State of Pennsylvania, and some from lenders.

What a buyer must be aware of is that the ones from the State and City require credit counseling. In fact, the counseling must be done before an offer is submitted. Thus, if you are low income or moderate income and pursuing one of these grants for closing costs, you must be very proactive and get in to meet with a credit counselor. The lenders may also require credit counseling, however, that must be determined on a grant by grant basis. In Philadelphia, there are many of these groups, which provide the counseling. There are too many to list here. Some are quite good and responsive, and some are not. Either way, be pushy and get in to see the counselor so that you can get on with buying real estate.

An agent in my office recently submitted an offer without realizing the counseling had to be done. So far, they are okay. Her buyer is on top of everything and the two have been scurrying to get everything done. They called all over to get the counseling done. They finally found a counselor who would meet with them Saturday night. She had to drive her client to the appointment so she ended up in attendance.

She said the Credit Counselor was very bright, but spent a good deal of time bashing Realtors. Misrepresented what we make. In fact, doubled it (what we make). Told the buyer not to tell the Realtor if they really liked a property. Told the buyer not to use a home inspector recommended by the Realtor, because they would just pass the house in order to get the sale pushed through. Also, told the buyer not to sign a buyer broker agreement. I have so many issues with what this man said and I was not there! I will address these issues in separate entries!

We had a discussion today in the office as to what "AS IS" means. We agreed, as per our discussion, that it could have a couple of different meanings in a real estate transaction.

First, it could mean that what you see at "offer time" is what you are buying. Therefore, make sure you make a good visual survey of the property before making an offer, or perhaps, do a property inspection prior to making an offer, or bring a trusted, licensed and insured general contractor through for a good look at property and get his/her estimate for needed items and improvements wanted.

Or Second, it could mean that you still have the right to do inspections, but no ability to negotiate price based on the findings on the inspection(s). In this case, you would include a contingency or contingencies in the contract, which allows you to either accept, or decline as a result of the inspection and get your deposit monies back. So, you would hire a home inspector to inspect the property. When the report(s) comes back, you have a chance to review it/them and sign an acceptance or declination of the contract. If you decline, you are to get your deposit money back. If you accept, you will not be allowed to negotiate the price or assist based on the results of the home inspection.



Thus, if "AS IS" is presented to you, the buyer, in contractual form, make sure you have a contingency to get out of the contract if the "AS IS" condition turns out to be above what you have budgeted for improvements, or future improvements, or in other words the condition is worse than anticipated.

If the seller will not allow you to have inspection contingencies then do it before making an offer or find another property. Of course, there is an expense involved in doing inspections, so make sure you are serious about the property before either entering into a contract or have lots of extra cash on hand to do multiple inspections on multiple properties.

It is best to address all of them immediately.

Most people will need to do the following:

• Make a mortgage application
• Make sure the property is insurable
• Schedule inspections
• Make a second deposit
• Perhaps, review leases or condominium documents
  

None of these items are based on one another. All of their contingency periods run simultaneously. Thus, a second deposit is not based on the result of the home inspection, etc.. Generally, it is due earlier. Thus, make sure your Realtor gives you a list of deadlines and begin making the phone calls as soon as you have the contract in your hand. You want to make sure you meet all deadlines and protect your deposit and not accidentally default.

There is a great incentive for FIRST TIME HOME BUYERS and/or people who have not owned a home in the last three years in the form of a Tax Credit provided by the Housing and Economic Recovery Act of 2008.

How does it work? I will try to make it as simple as possible

1. House must be purchased between 4-9-2008 and 7-1-2009
2. The house must be a primary residence
3. House ownership of spouse will affect your qualification
4. Income: Single: up to $75,000; Joint Filers: up to $150,000 (Singles earning up to $95,000 and Joint Filers earning up to $170,000 can get a partial credit)
5. The credit for Singles is $3,750 and Joint Filers is $7,500. The credit cannot exceed more than 10% of the sales price of the home.
   
6. The credit may be deducted on the 2008 or 2009 return depending on when the house is purchased
7. This credit is deducted from TAXES OWED and not from GROSS INCOME
8. If the credit is more than taxes due, you will get a refund of the credit amount
   
9. This credit is not a gift
10. The credit must be repaid, interest free over 15 years beginning two years after purchase of house
11. If the house is sold, the full balance of the credit must be paid off at the time of settlement

Anyone, who qualifies, should take this credit even if they are going to put the money into savings account. It is interest free and payable over 15 years.