A 1031 tax deferred exchange is a type of real estate transaction defined in the Internal Revenue Code (Section 1031).
Opportunity: For a long-term real estate investor, it is possible to: 1. sell a rental property; 2. at closing have the sale proceeds assigned to and held by an exchange facilitator; then 3. use those proceeds to acquire like-kind replacement investment property that is of equal or greater value and has equal or greater debt.
Benefit: If done exactly by the Sec. 1031 rules, the investor will pay no capital gains taxes on that sale. The investor gets to keep and use the entire net sale proceeds to buy the replacement property.
Advantage to Exchanger: 1. By legally deferring the payment of capital gains taxes, more money is available to the replacement property. 2. Buy more property or have less debt; and, 3. You get to select the time in the future when you would prefer to pay the capital gains tax.
Concern: The Sec. 1031 rules are very specific and unforgiving if you make an error. Recommendation: Consult with a CPA who specializes in real estate or a tax attorney. Also consult with a very experienced commercial – investment real estate broker on the more specific procedures to be taken to avoid what could be a very costly tax issue. I know of such specialists that I can recommend. Email or call me at (541) 912-6583.
The “cap rate” is used by informed real estate investors to estimate the value of an income producing property. It shows the productivity of an income producing property.
How Calculated: The cap rate is the relationship between Net Operating Income and the value of the income producing property. The Net Operating Income of recently sold income property is compared to their sale price.
Components: 1. The Net Operating Income is the amount of cash that a property is capable of generating annually if owned free and clear of debt, and before income tax payments. 2. The sale price is the price paid by an informed investor for the right to receive that amount of Net Operating Income in the future.
Calculation: Divided the Net Operating Income by the sale price. The resulting number is the “cap” or “capitalization” rate.
How Used: Knowing the applicable cap rate for the type of property to be acquired, an informed investor can then divide the Net Operating Income of the property being evaluated to determine a reasonable investment value of that property.
What You Need To Know About Cap Rates:
1. Cap rates vary with each type of income property will usually have a unique and similar cap rate (apartment complexes vs office buildings vs medical buildings vs retail buildings – each property type will have a different cap rate)
2. Cap rates vary with each market and submarket. The cap rate for an apartment complex in Seattle will vary from the cap rate of a very similar apartment complex in San Francisco or Eugene, Oregon. The perceived risk inherent in each market and each submarket will influence the cap rate of highly similar property types.
3. If you carefully study the typical commercial real estate transaction, you will find that the seller is trying to sell for the highest price (which will produce a low cap rate); and, the buyer is trying to buy the property at the lowest price (which translates into a higher cap rate for the available income stream). For the same income stream to the investor, the lower the sales price, the higher will be the cap rate.
4. Market cap rates can vary with the level of motivation of the seller and the eagerness of the buyer.
Where Can I Find a Reasonable Cap Rate:
1. Call a local real estate appraiser who is very experienced in appraising the type of income property that you seek to buy or sell. Ask for a range of reasonable cap rates for that specific type of property.
2. Call a real estate investment broker who is dominant in the market area which interest you, and who is most experienced with brokering transactions for your specific type of property. Email or call me (541) 912-6583 for further recommendations.
Debt Coverage Ratio (DCR)
The Debt Coverage Ratio or DCR is the lender’s primary way of generating lender safety when making a loan on an income property. The DCR will specifically calculate the maximum amount of loan that the lender should make for any given income stream.
Why Lenders Think This Way: All lenders are absolutely aware of the risk of lending too much money on a property. If the lender is the only one with “skin in the game” the borrower may find it both easy and convenient to simply hand a bag of keys to the lender and given them the tenant rent roll, and walk off from a property that is generating too much negative cash flow.
In order to assure that an income property can safely service the monthly payments, the lender makes a loan that forces the property to generate a positive cash flow. “Never lend so much money that there will be negative cash flow”… the mantra of the commercial mortgage lender.
How the DCR Is Applied:
1. Determine a conservative estimate of the property’s Net Operating Income
Example: NOI = $150,000 per year
2. Divide the Net Operating Income by the lender’s selected DCR (e.g. 1.30)
Example: $150,000 / 1.30 = $115,385 in annual debt service (PI only)
3. Divide the annual debt service to determine allowed monthly debt service
Example: $115,384 / 12 = $9,615 PI per month
4. Calculate the size of loan that would be amortized by the allowed monthly payment (use a present value calculator such as a HP10BII)
Example: if the interest rate is 6.5% and the allowed amortization term is 30 years, then the maximum sized loan that $9,615 per month would amortize is $1,424,000
The lender now knows that if the maximum allowed loan is $1,424,000 on a property that can safely generate $150,000 in annual NOI or $12,500 in monthly NOI, the investor will receive the “left-overs” after making the mortgage payment.
Restated (Investor’s View): $12,500 in monthly NOI – $9,615 in monthly payment = $2,885 in monthly cash flow to the investor.
Restated (Lender’s View): The property would have to slip at least $2,885 in lost income or increased expenses before the lender would fear a late payment or worst yet a missed payment. Force the investor to have positive cash flow, and you will have little chance of getting the property given back to the lender.
My Opinion: The “good old days” of low Debt Coverage Ratios is over! Lenders understand that there is no glory in foreclosing on a property, only to discover a visit from a bank auditor can force them to “mark the asset to market”, thus forcing the lender to show a loss on their balance sheet
Contact me, and I will suggest several names of lenders who could give you hints on current Debt Coverage Ratios for the type of property that is of interest to you. Tuition is just too high to learn this information through the School of Hard Knocks. Amateur Night should only play in the evening at the local TaTa bar.
Email René or call (541) 912-6583