Student Manual REAL ESTATE · 2021. 2. 26. · TEST YOUR INVESTMENT REAL ESTATE IQ Test your knowledge of investment real estate. Mark the best answer. 1. The depreciation period

Build Wealth Representing Investors

and Becoming One Yourself

S t u d e n t M a n u a l

REAL ESTATEINVESTING

© Copyright 2016, 2019, Center for Specialized REALTOR® Education

Version 2.0

Published by the Center for Specialized REALTOR® Education, a wholly-owned subsidiary of the National Association of REALTORS®. All rights reserved. The National Association of REALTORS® owns these materials or have been granted permission from the copyright owners to distribute and reproduce them. Authorization is limited to view, store or print these materials for personal and non-commercial use only. No part of these materials may be reproduced, in any form or by any means, without permission in writing from the National Association of REALTORS®. Important

Note: The National Association of REALTORS®, and its wholly-owned subsidiary, the Center for Specialized REALTOR® Education, its faculty, agents, and employees are not engaged in rendering legal, accounting, financial, tax, or other professional services through these course materials. If legal advice or other expert assistance is required, the student should seek competent professional advice.

National Association of REALTORS®

Center for Specialized REALTOR® Education 430 North Michigan Avenue Chicago, Illinois 60611

Real Estate Buyer’s Agent Council (REBAC) 800-648-6224 [email protected] www.rebac.net

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TABLE OF CONTENTSINTRODUCTION ...............................................................................1

Course Goal and Learning Objectives ...............................................................1Exam .......................................................................................................................3Test Your Investment Real Estate IQ ..................................................................3

MODULE 1: WHY INVEST IN REAL ESTATE?................................5

Why Work With Investors? .................................................................................5Skills and Knowledge for Working with Investors ...........................................7Advantages of Investing in Real Estate ............................................................10Disadvantages of Investing in Real Estate .......................................................12Investing as a Real Estate Professional .............................................................13Practitioner Perspective .....................................................................................14

MODULE 2: MAKING THE PURCHASE DECISION ....................17

Location—the Big Picture .................................................................................17Location—the Close-Up Picture ......................................................................18Absorbtion Rate ..................................................................................................20Choosing a Property Type .................................................................................21Valuation—How Much is This Property Worth? ...........................................25Market Value .......................................................................................................26Highest and Best Use .........................................................................................27Investment Value ................................................................................................28Using Cap Rate to Estimate Market Value ......................................................32Cash Flow and Net Operating Income ...........................................................34Cash Flow Analysis Worksheet .........................................................................35Annual Property Operating Data .....................................................................37RPR® Tools for Investors and Appraisers ........................................................39The REALTOR® Code of Ethics ........................................................................40SEC Guidelines on Investment Advice ............................................................41Making an Offer ..................................................................................................41Contingencies .....................................................................................................42Practitioner Perspective .....................................................................................44Exercise: Neighborhood Analysis ....................................................................46

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MODULE 3: WORKING WITH INVESTOR CLIENTS..................49

Characteristics of Investors ...............................................................................49Prospecting for Investor-Clients .......................................................................52First Meetings with Clients ...............................................................................55Getting to Know the Investment Client: The A-I-R Model ..........................57Goal Setting for Real Estate Investors ..............................................................59Understanding and Managing Risk ................................................................61Exercise: Determining Investor Goals and Tolerance for Risk .....................63Building a Team ..................................................................................................64Practitioner Perspective .....................................................................................66Exercise: Role Playing Prospective Investors ..................................................68

MODULE 4: FINANCING OPTIONS AND TAX ISSUES ..............69

Forms of Ownership ..........................................................................................69Financing an Investment Property ...................................................................73Qualifying For a Loan ........................................................................................80Leverage ...............................................................................................................83Equations .............................................................................................................85Tax Considerations for Real Estate Investors ..................................................87Income Classification .........................................................................................87Income Tax Deductions ....................................................................................89Cost Recovery (Depreciation) .........................................................................90Capital Gains .......................................................................................................91Net Investment Income Tax ..............................................................................92Tax-Deferred 1031 Exchanges ..........................................................................92Basic Rules for Tax-Deferred 1031 Exchanges ...............................................94Foreign Investors ................................................................................................95Foreign Investment in Real Property Tax Act (FIRPTA) ..............................972018 TAX CUTS AND JOBS ACT (TCJA) .....................................................99Exercise: Putting It All Together .....................................................................101Practitioner Perspective ...................................................................................103

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MODULE 5: OWNING THE PROPERTY .....................................105

Property Management: Self-Managers ..........................................................106Property Management: Property Manager ...................................................107Property Management for Others ..................................................................109Property Maintenance .....................................................................................111Risk Management .............................................................................................113Setting Rents .....................................................................................................114Screening and Selecting Tenants ....................................................................115Tenant’s Rights and Responsibilities .............................................................117Landlord’s Responsibilities and Rights ..........................................................119Fair Housing .....................................................................................................121Exit Strategy ......................................................................................................123Exercise: Tenant Selection ...............................................................................125Practitioner Perspective ...................................................................................126

MODULE 6: INVESTING AS A REAL ESTATE PROFESSION ...129

Invest in the Product You Believe In ..............................................................129Consider Your Goals ........................................................................................131Strategy: Short-Term or Long-Term? ............................................................132Use the Tools You Already Have .....................................................................133Managing Your Properties ..............................................................................134Real Estate Professionals—Material Participants .........................................135Complying with the REALTOR® Code of Ethics ..........................................136Avoiding Bad Deals and Conflicts of Interest ..............................................138Practitioner Perspective ...................................................................................140

RESOURCES ....................................................................................143

NAR Code of Ethics, Article 11 ......................................................................143Sample Rental Agreement with Provisions and Attachments ....................147Checklist for Making an Insurance Claim ....................................................153Sample Apartment Interior Inspection Report ............................................155Websites ............................................................................................................161Glossary .............................................................................................................163

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ACKNOWLEDGMENTSIn practice and in spirit, the development of this program has been a collaborative journey with the goal of providing advanced training and resources for real estate professionals. The Center for Specialized REALTOR® Education would like to express appreciation to:

Todd Beckstrom, ABR®, PSA, CRS The Todd Beckstrom All-Star Team Chapin, South Carolina

Omar Capellan, ABR®, GRI, SRS, RENE Semper Realty & Property Mgmt. Cape Canaveral, Florida

Vince Malta Malta & Co. San Francisco, California

Axay Parekh, CRS AxTulsa Realty Group Tulsa, Oklahoma

Ron Phipps, ABR®, CIPS, CRS, GRI, GREEN Phipps Realty East Greenwich, Rhode Island

Sher Powers, CRS Urbane Residential Specialists Nashville, Tennessee

Jay Rinehart, GRI, CRS Rinehart Realty Rock Hill, South Carolina

Reveille Schaeffer, GRI, CRS Arizona Focus Realty Gilbert, Arizona

Vicky Silvano, ABR® Century 21 SGR Chicago, Illinois

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Introduction

COURSE GOAL AND LEARNING OBJECTIVESReal Estate Investing: Build Wealth Representing Investors and Becoming One Yourself covers the fundamentals of real estate investment that practitioners need to know to expand their business services. The one-day course looks at how practitioners can adapt core real estate skills and learn new skills to serve clients who want to invest in single-family homes, condos, townhomes, and small multi-family properties. You will learn how to work with investors as they goal set, plan, evaluate, and acquire properties, as well as, manage them. You will also learn how to “walk the talk” and become a real estate investor yourself.

1. WHY INVEST IN REAL ESTATE? f Recognize the advantages of expanding business services for clients

and customers to include investment real estate.

f Adapt core real estate business skills to work with investor-clients and customers.

f Describe the pros and cons and risk/reward potential of investing in real estate.

2. MAKING THE PURCHASE DECISION f Help investors identify and evaluate property types and locations and

other value considerations and select those that meet investment goals.

Real Estate Investing: Build Wealth Representing Investors and Becoming One Yourself

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f Comply with the REALTOR Code of Ethics and SEC guidelines for providing advice to clients and customers.

f Use comparable sales data and other methods to help clients and customers evaluate financial aspects of a property investment.

3. WORKING WITH INVESTOR-CLIENTS f Use statistical data on investor profiles and preferences to plan

business strategy.

f Identify and make contacts with clients and customers who need investment real estate services and help them refine their investment goals.

f Identify other professionals who can provide ancillary services for purchasing, managing, and maintaining real estate investment properties.

4. FINANCING OPTIONS AND TAX ISSUES f Identify types of ownership and help clients and customers find

sources for financing and choose appropriate financing for achieving investment goals.

f Describe the measurement and impact of positive and negative leverage on real estate investment.

f Alert investors to tax considerations for various investment strategies and transactions, and recommend that they seek advice from tax experts.

5. OWNING THE PROPERTY f Help investors consider pros and cons of managing their own

investment properties versus hiring a property manager.

f Describe techniques for developing and managing tenant relationships, including tenant and manager rights.

f Suggest exit strategies for owners who want to divest of investment properties.

6. THE REAL ESTATE PROFESSIONAL AS INVESTOR f Apply investment techniques presented in the course to build your

own portfolio of real estate investments.

Introduction

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f Take advantage of favorable tax treatment for real estate professionals who invest in real estate properties.

f Avoid conflicts of interest between your own real estate investment activities and those of your clients and customers.

EXAMA 30-question multiple-choice exam concludes the course. The use of this exam is optional and no longer required by NAR. It is to be used at the discretion of the instructor and/or the state in which the course is conducted

TEST YOUR INVESTMENT REAL ESTATE IQTest your knowledge of investment real estate. Mark the best answer.

1. The depreciation period for residential real estate is 5 years. True False

2. A high cap rate is better than a low one. True False

3. 1031 exchanges cancel taxes on capital gains when exchange properties qualify as a “like kind.”

True False

4. Real estate is less liquid than other types of investments. True False

5. Income-producing real estate has three types of value: market value, investment value, and replacement value.

True False


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6. When supply is less than demand, absorption is negative. True False

7. In non-disclosure states public records report sales transactions but not the purchase prices.

True False

8. Many small investors begin by purchasing bare land. True False

9. An IRA can own investment real estate. True False

10. Positive leverage occurs when the property generates a higher return with the use of debt.

True False

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module

1Why Invest In Real Estate?

AFTER COMPLETING THIS MODULE, YOU WILL BE ABLE TO:

f Recognize the advantages of expanding business services for clients and customers to include investment real estate.

f Adapt core real estate business skills to work with investor-clients and customers.

f Describe the pros and cons and risk/reward potential of investing in real estate.

WHY WORK WITH INVESTORS?As a real estate professional, you invest a lot of time, effort, and resources in building client-for-life relationships with home buyers and sellers. But what happens when your home-buyer client is ready to become a real estate investor? Do you have the skills, knowledge base, and contacts to work with real estate investors? Or, do you refer your client to another agent or firm and wave goodbye to the stream of future business?

Why would you want to leave your comfort zone to start working with investors? Beyond the obvious answer of “helping your bottom line,” there are many reasons why a real estate professional might want to broaden their client base to work with investors.


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Fast Facts About the U.S. Real Estate Investment Market1

f 19%: Percentage of homes sales to investors

f 59%: Percentage of purchases that are single-family homes; 34% are in suburban locations

f 47%: Percentage of investors who purchased the property through a real estate professional

f 28%: Percentage of investors who say they are very likely to purchase another property within the next two years, 39% say they are somewhat likely

f 76%: Percentage of investors who say now is a good time to purchase real estate as an investment property

f SIZE OF THE MARKET As the above statistics show, the potential market—about one in five transactions—is a sizeable stream of business that is currently going to your competitors. You can capture a share of this active, lucrative market by expanding your business services to work with investors.

f REPEAT DEALS Investors tend to buy more than one property, sometimes several per year. Establishing relationships with investors and demonstrating the value-your services add will make you an important team member and produce a stream of future business.

f MORE FREQUENT TRANSACTIONS Homeowners tend to sell or buy a home about every five to seven years or more. Investors, depending on their objectives, may buy and sell properties frequently resulting in more transactions and commission income for you.

f COMFORT LEVEL If you work with experienced investors (and novice investors who gain experience), you will spend less time handholding and explaining the basics. Because experienced investors know what they want, you can spend more time helping them find the properties that meet their goals, and less time worrying about their emotional needs.

1 2017 Investment and Vacation Home Buyer’s Survey, National Association of REALTORS® Research, www.nar.realtor/links/investment-vacation-home-buyers-report

Module 1: Why Invest In Real Estate?

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f SAVE TIME You may be able to automate processes to inform investor-clients about properties of interest as the listings appear on the MLS or other websites. Automated reply forms save time exchanging email and telephone messages.

f MORE LEADS Investors tend to be well-connected in their communities and have extensive networks of contacts who may be looking for a knowledgeable real estate professional. If you provide excellent service, your investor-clients will likely refer other prospective investors to you.

The business service needs of real estate investors differ greatly from those of home buyers and sellers. Insight as to how investors think, strategize, and plan is essential for growing this part of your business. Real estate professionals who want to capture a portion of the investment market need to recognize the differences, adapt their skill sets, and broaden their knowledge base.

SKILLS AND KNOWLEDGE FOR WORKING WITH INVESTORSThe core skills and knowledge you have acquired through working with home buyers and sellers provides a good foundation for broadening your business mix to include investors. Let’s take a look at how you can adapt your current skills and add to your knowledge base.

PRODUCT AND MARKET KNOWLEDGEA typical residential real estate salesperson focuses on listing and selling homes for owner occupancy. Working with investors, however, requires knowledge of the range of property types available for sale and rent in the market and the ability to help clients evaluate investment values. Real estate professionals must have a rich knowledge of all aspects of the market, community, demographics, local culture, and municipal ordinances in order to credibly represent the area and amenities. In particular, foreign investors and out-of-town second-home buyers may be unfamiliar with the area and rely on the practitioner for market knowledge and expertise.

UNDERSTAND FINANCINGDown payment and underwriting standards for financing an investment property differ from that of a primary residence. Practitioners need a thorough understanding of financing options and the process in order to help investors make the most effective choices. The structure of a deal may be as important to the return on the investment as the choice of the property itself.


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Investors have more options than traditional lending sources including private money, self-directed IRAs, and regional banks that specialize in short-term renovation loans.

NEGOTIATIONWin-win negotiation skills are an integral part of a real estate professional’s job. Successful practitioners must be able to represent themselves and the transaction in a professional and non-adversarial manner, as well as, provide a neutral sounding board to facilitate strategizing and decision-making. Effective negotiation strategies are even more important with investment deals, and creativity, problem solving, and the ability to present alternative solutions are essential skills.

Practitioners can expect to write many offers and counter-offers on investment properties to close a deal. A boilerplate offer contract that includes items clients usually want and an electronic signing program can speed up the back and forth of offers and counter-offers.

REPUTATIONReputation is critical when it comes to the brokerage of investment properties. A track record for fair dealing is more likely to earn the cooperation of an adversarial seller and that cooperation may just be what is needed to close a complicated transaction. Additionally, when representing renovated properties, a reputation for offering quality products helps sell properties faster at higher prices, so your client can move quickly to make the next investment.

COMMUNICATION AND LISTENINGThe biggest complaint clients have about real estate professionals is that they don’t keep them informed during transactions. Communication approaches must be systematic and adaptable for a range of clients. If you’re working with remote clients, it is important to learn how to “listen between the lines.”

In the case of a group of investors or an international buyer, contact and communication with the buyer may be through an intermediary. Although intermediaries are seldom the decision maker, they are very influential. Learning to work effectively with these gatekeepers and help them fulfill their roles will bring the transaction to a satisfactory conclusion and earn future business.


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PATIENCEPatience is a requirement for both investors and their clients. The purchase of an investment property is discretionary and involves detailed analysis, so it may not be a speedy process. Of course, some deals will require quick action, but it can take several years for a buyer to make a decision about purchasing an investment property. The type of property and pace of the market dictates the speed at which investors will move. An impatient investor should be a red flag to an agent. Impatient investors are likely to expect quicker and higher returns than are feasible, and may bring their frustration back to the person who brokered the deal.

CLIENT SERVICEReal estate professionals should be prepared to provide a wide range of client services and handle a range of aspects of the transaction that residential buyers or sellers would ordinarily handle on their own. In fact, client service often creates market distinction and wins valuable future referral business.

MINDSETLike their investor-clients, real estate professionals who work with them need to have a decisive attitude. Investment deals may require more negotiation and concessions than home purchases, and sometimes go awry, so real estate professionals need to be comfortable with uncertainty and disappointment. Part of that mindset is the ability to stay focused and organized.

REGULATORY KNOWLEDGE Real estate professionals should know the state and federal laws and regulations, as well as, local codes, covenants, restrictions, and their impact on the purchase decision, ownership, and investment strategy. These include laws and regulations at all governing levels that concern ownership rights, tax laws, building codes, water or mineral rights, lease issues, environmental issues, zoning, foreign and out-of-state ownership, and others. Although practitioners do not need to discuss or explain these laws and regulations in detail, they should know their potential impact on transactions so they can alert investor-clients and encourage them to seek legal advice when needed.

Real estate professionals must always be careful not to stray into the unauthorized practice of law in violation of state laws as well as NAR’s Code of Ethics, Article 13.


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TYPES OF OWNERSHIPPractitioners should be familiar with the many different types of ownership entities that are possible and the tax considerations and liabilities of each of them. Determining the most advantageous form of ownership may require the advice of legal and tax experts.

REPRESENTATION DUTIESState agency regulations and guidelines for residential real estate also apply for investor-clients. It may be necessary to educate prospective clients on the state’s agency laws, particularly out-of-state and foreign investors.

TAX ISSUESBecause tax strategy often figures into investment decisions, the real estate professional must know about taxation of investment and rental properties. Important areas of federal taxation, discussed in detail later in the course, include passive income and loss rules, capital gains, and tax-deferred 1031 exchanges.

A basic understanding of these tax issues is important so that the real estate professional can alert investor-clients to potential tax impact and recommend they seek the guidance of a tax expert. Real estate professionals can provide a valuable service by offering an investor-client a list of tax professionals with specifics of their specialties and experience.

ADVANTAGES OF INVESTING IN REAL ESTATEAs a real estate professional, you understand the value of home ownership, but if you have never worked with investor-clients or invested yourself, you may not have considered the advantages that real estate as an investment can offer.

f INCOME STREAM Unlike other types of investments, such as stocks and bonds, rental real estate generates a regular income stream. After paying the operating expenses for a property, the investor receives a monthly cash net return. In some properties, there may be sources of revenue in addition to rent, such as laundry equipment, parking, or access to fitness equipment.

f LOW VOLATILITY Fluctuations in financial markets tend to have less impact on real estate than other investments. Rents and capitalization rates change


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slowly over time, so cash flows stay relatively stable. This is particularly true with commercial real estate, because leases may run for five years or more.

f SAFETY OF A TANGIBLE ASSET Real estate is safer than other investments because the investor owns a tangible, brick-and-mortar asset. In fact, residential real estate may be safer than other types of properties because people always need somewhere to live. Even if a building is damaged, the land beneath it has value. As the saying goes, “Buy land, they’re not making any more!”

f ABILITY TO INFLUENCE PERFORMANCE Because real estate is a tangible asset, long-term investors can increase the value of their asset by making improvements that make it more attractive to tenants, thus increasing rents, cash flow, and overall value. A short-term fix-and-flip investor adds value by quickly renovating and reselling the property for a profit; in other words, buying low and selling high.

f INFLATION PROTECTION Real estate provides a natural hedge against inflation because with economic growth, which tends to fuel inflation, comes increases in rents. Rent growth generally leads to increased net income—assuming that operating expense inflation is less than revenue growth—and increases value.

f LEVERAGE Unlike other investments, with real estate an investor can borrow against the value of the property to purchase it. Therefore, as the value of the property increases over time, the investor makes money not only on the initial investment, but also on the funds that were available for other investments because the buyer used OPM (other people’s money).

f APPRECIATION The value of real estate tends to increase over time. An investor who buys and holds a property can almost always sell it for more than the purchase price.

f DEPRECIATION (COST RECOVERY) Because buildings and equipment wear out over time, the IRS allows an annual tax deduction for depreciation. The depreciation period for residential real estate is 27.5 years. This tax advantage reduces an investment property owner’s annual income tax bill.


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f TAX ADVANTAGES In addition to depreciation, there are other tax advantages to investment real estate. For example, a 1031 exchange defers taxes on capital gains as long as another like-kind property is purchased with the profit gained by the sale of the first property. Tax deductions are allowed for the costs of owning and operating the property, including interest payments, management, advertising, maintenance, insurance, and property taxes. Additionally, self-directed IRAs can own property, and defer taxes to retirement or use before-tax dollars in a self-directed IRA to purchase property. Selling property within a land contract can also offer tax advantages as capital gains are spread out over the life of the contract.

f MARKET CONDITIONS The real estate market is subject to the same fluctuations that affect the larger economy. As GDP grows and the market expands, demand increases and rental prices go up accordingly. Eventually, the economy moves towards recession, demand reduces and so do prices.

DISADVANTAGES OF INVESTING IN REAL ESTATESo far, we’ve looked at the advantages of investing in real estate. But it also has some disadvantages.

f LACK OF LIQUIDITY Perhaps the greatest disadvantage is its lack of liquidity compared to other types of investments. Depending on the type of property, property condition, and market climate, it may take considerable time to sell a property. In a down market, the investor who needs to sell a property quickly will most likely be forced to discount the price. Because of the large pool of potential buyers, single-family homes actually have more liquidity than other property types.

f RISK Like all investments, real estate involves a certain level of risk. Properties can decrease in value or be damaged or destroyed and investors can lose some or all of their initial capital investment, even on a leveraged property. Risks can be minimized by doing careful advance analysis of the property and locale and purchasing adequate insurance coverage. Holding the property for a long time—seven years or longer—can help minimize risk too.


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f EXPENSES Investing in a tangible asset, like real property, comes with costs of ownership and operation. Ownership cost is one reason why the IRS allows tax deductions for operating expenses and depreciation on real estate investments. Costs include managing the day-to-day operations of the property, from marketing and leasing to tenants, to maintaining the physical asset. Even a self-managed property requires considerable investment of time and resources.

f MARKET CONDITIONS Market conditions can also present a disadvantage: as demand falls and vacancies increase, rents and resale value are pressured downward. Understanding where specific target markets are in the overall business cycle is a key to making sound investment decisions. Attractive investment opportunities may exist at any point in the cycle, but recognizing where the market is in that cycle is critical for assessing potential investments.

INVESTING AS A REAL ESTATE PROFESSIONALIn addition to working with investor-clients, real estate professionals are uniquely positioned to become investors themselves. First and foremost, by investing yourself, you learn first-hand the motivations, strategies, and tactics that successful investing requires, and you can share those with clients. As a real estate professional, you have the advantage of being able to identify desirable investment properties as soon as, or even before, they are listed because of your connections in the real estate community. Plus, your local market knowledge can help you better spot the best deals. If real estate is your primary job, the IRS allows more liberal tax deductions than other investors. Property investing for real estate professionals will be covered in more detail later in the course.


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PRACTITIONER PERSPECTIVE

Vince Malta Malta & Co. San Francisco, California www.maltaandcompany.com

ADVICE FOR NOVICE INVESTORS

I WOULD ASK THEM TO ANSWER TWO QUESTIONS:

1. What is your long-term plan?

2. How will you manage your assets?

The answer to those questions will tell you what kind of investor you want to be. When making your long-term plan, have you considered the risks? Have you considered the costs involved? Have you considered the tax implications? If you don’t want to manage your property, have you looked at alternatives, like syndication or partnerships?

WHAT REAL ESTATE PRACTITIONERS NEED TO KNOW f KNOW YOUR MARKET.

New York is very different from Peoria, and investors in those two places are looking for very different things. If you know your market, you’ll know the government regulations that affect investments. For example, in my market we have a very stringent rent control ordinance. Know your market and you know what is needed in the way of capital, or when an investment will start to break even with cash flow.

f KNOW YOUR COMPANY. Is investing part of your company culture? Commercial and even residential investment properties may not be listed in the MLS. Do you have access to the kinds of databases and other sources for those properties? If you can, affiliate yourself with the team in your company that does these kinds of transactions, so you can learn about what’s involved.


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f BROADEN YOUR SPHERE OF INFLUENCE. You’ve got to branch out and you’ve got to announce to the world that this is the kind of work you do or that you’re interested in doing, or that you’re a buyer.

f SPECIALIZE IN SOMETHING. Figure out what it is you want to do. I became a specialist in rent-controlled properties, because I had to have knowledge of that in my market. I don’t do commercial properties. That’s a different world, with its own complexities.

f TAKE STOCK OF YOUR PERSONALITY. The two most important qualities you can have are being personable and driven. Of course, you also have to know your goals and decide what you want to achieve and how you are going to get there.


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module

2Making the Purchase Decision


f Help investors identify and evaluate property types and locations and other value considerations and select those that meet investment goals.

f Comply with the REALTOR Code of Ethics and SEC guidelines for providing advice to clients and customers.

f Use comparable sales data and other methods to help clients and customers evaluate financial aspects of a property investment.

LOCATION—THE BIG PICTUREProviding an overview of the market is an important part of a first-meeting consultation with a prospective investor-client. What are the forces and trends that create the real estate investment market in any particular region or area?

The big-picture view of a location begins with looking at the economic conditions there and likely future trends. The factors that shape the economic health, good or bad, and consequently the investment market of a location—region, city, neighborhood—include population trends, employment and income levels, overall housing market, vacancies, and home sales. Investors who want to stay close to home probably have a good idea of the economic vitality of the area, but investors who venture farther afield may not.1 Real

1 NAR’s 2017 Investment and Vacation Home Buyer’s Survey shows the median distance of an investment property from the investor’s primary residence of 20 miles; the other 50 percent of investors look farther away from home, with 15 percent of investors buying properties 250 miles or more away from home.


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estate professionals who work with investors should be able to present information on the economic health of an area and refer their clients to sources for additional information.

f POPULATION TRENDS Is the current level of population increasing or decreasing? Population growth affects current and future demand for rental properties. If the population decreases, the pool of renters is reduced and the economy of the area will suffer. If the population is growing, it is important to identify the causes. Ideally, there is a net positive migration—more people moving in than moving out—indicating an area in which people are choosing to live, work, and shop.

f EMPLOYMENT AND INCOME LEVELS Job growth is a good indicator of the economic health of an area: but it’s important to look beyond the current unemployment rate and consider overall trends and employment projections. Increasing unemployment signals a problem. On the other hand, if the unemployment rate has been dropping and projections are positive, it could mean that area property values will trend upward too. Take a look at the employers in the area, whether those industries are strong, and if there are any plans to expand or relocate. Employment figures don’t tell the whole story. Consider the quality of the jobs. Look at per capita and median household incomes. Areas that are prospering have rising incomes and higher wage jobs. If the number of people employed is rising but average incomes are declining, it means that mostly low-wage jobs are being added.

f HOME SALES Decreasing days on the market and dropping inventory of homes for sale indicate strengthening demand for the area; the downside, however, is usually increasing property prices and fewer bargains for investors. Housing inventory and days on market are good leading indicators of the health of the market and overall economic vigor of the area.

f OVERALL HOUSING MARKET Investors should consider the overall housing market of an area, particularly the rental market. Obviously, areas with more renters provide a larger pool of potential tenants. However, too many renters in a neighborhood creates an undesirable transient atmosphere. A mix of tenants and owners is generally more desirable.

Module 2: Making the Purchase Decision

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LOCATION—THE CLOSE-UP PICTUREWhen a client is choosing a property to invest in, the first thing to consider is the location. The same factors that a home buyer considers when choosing a location are relevant for residential investment properties, since they are just as important to renters as homeowners. Choosing the right neighborhood is the most important decision a buyer can make; the physical condition of a property and operation of a property can be changed, but its location cannot. Lenders look favorably on a good location because it offers the potential for greater liquidity and higher appreciation. What are the factors investors should consider?

f IS IT CLOSE TO HOME? First-time investors, particularly those who plan to manage properties themselves, should begin looking in the neighborhoods near where they live. Investors are likely to have a better understanding of the conditions in an area close to home. Self-management involves maintenance, showing units, and tenant relations, which require frequent visits to the property. A location that requires longer trips increases overhead and reduces revenues.

f ARE THERE REGULATORY OR TAX ISSUES? Municipal officials control issues that affect real estate investment such as property taxes, zoning ordinances, business regulations, building codes, traffic control, and health codes. Investors should thoroughly investigate all the relevant local ordinances and taxes related to the areas they are considering.

f HOW ARE THE SCHOOLS? Schools are as an important factor for renters as for home buyers. School ratings and test scores are available online, but it is worth taking the time to talk to community members. Check out local news coverage to determine if there are any particular issues, positive or negative.

f WHAT ELSE IS NEARBY? Parks, recreational facilities, medical facilities, supermarkets, restaurants, and public transportation hubs are all desirable amenities that attract renters. Industrial facilities, sewage and waste disposal units, airports, and energy plants tend to discourage would-be tenants.

f IS IT WALKABLE? The walkability of a community has a positive impact on both residential and commercial property values. Walk Score® uses Google Maps to rate neighborhood walkability on a scale of 0 to 100. The site also provides information about distances to stores, restaurants, post


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offices, libraries, distance to transit, and other community services. For objective, numerical ratings that can be featured in property listings and marketing materials, go to www.walkscore.com.

f IS IT SAFE? Crime statistics and databases of registered sex offenders are easily obtained online or from local police departments. Tenants prefer to live where they feel safe. Investors who plan to be on-site on a regular basis should consider their personal safety too. Rental and renovation properties in areas with higher crime rates may come with challenges, but they also may be more affordable. Dropping crime rates could be an indication of gentrification and potential investment properties.

f IS THERE A FLOOD RISK? If a property is in a designated flood zone, the risks and insurance costs must be factored into the purchase decision. The Federal Emergency Management Agency maintains an online database of flood maps at https://msc.fema.gov/portal. Properties in designated flood zones are insured through the National Flood Insurance Program (NFIP) which currently provides up to $350,000 of coverage where required for a federally-backed mortgage in 22,000 communities nationwide and sets premium rates based on location and risk. NAR supports a more strengthened NFIP that offers choices and provides flood insurance in all markets at all times. As of June 2019, a revised flood bill was sent to the U.S. House of Representatives for consideration. For more information on the NFIP, go to https://www.fema.gov /national-flood-insurance-program.

ABSORPTION RATEAbsorption is the amount of space or units leased within a market or submarket over a given period of time (usually one year). It represents the demand over a specified period, contrasted with supply. When supply is less than demand, vacancy decreases and absorption is positive. When supply is greater than demand, vacancy increases and absorption is negative. A negative absorption can reflect changes, such as a sudden lack of jobs due to a company closing.

A simplistic model of the absorption rate would be if a city had 1,000 homes currently for sale on the market and 100 homes are sold per month. In this case, the absorption rate would be 10% and supply would be exhausted within 10 months.


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HOW IS ABSORPTION CALCULATED?Units/SF vacant at beginning of period

+ Units/SF constructed new during period – Units/SF demolished during period

– Units/SF vacant at end of period = Units/SF absorbed during period

Absorption should be disaggregated by type and class of property and tabulated over the past three to five years. Emerging patterns enable forecasts of future absorption for each year of the holding period. Past absorption and vacancy information can be gathered from industry research firms and trade associations.

ABSORPTION EXAMPLE

f Subject property: 62,500 rentable square feet

f Total office square footage available in region: 2,950,000

f Subject property market share: 62,500/2,950,000 = 2.12%

Absorption Rates (Square Feet)Year 5: 50,000 Year 4: 55,000 Year 3: 63,250 Year 2: 69,575

Last Year: 77,924

Absorption from Year 5 to Year 4 was 10% (50,000 + 10% = 55,000). From Year 4 to Year 3, absorption was 15%; from Year 3 to Year 2, absorption was 10%; and from Year 2 to last year, absorption was 12%. A conservative estimate of absorption could be 10% for next year. Therefore, in this market you could predict that 10% x 77,924, or roughly 85,716 rentable square feet of space could be absorbed. If the subject property’s estimated market share is 2.12%, then the subject property could have 2.12% x 85,716, or 1,817 rentable square feet in absorption.2

2 Calculating Absorption, Institute of Real Estate Management. www.irem.org/education/learning-toolbox/calculating-absorption.


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CHOOSING A PROPERTY TYPEMost investors have some idea of the type of property they want to invest in, but may not have considered the specific characteristics and ramifications of choosing one type over another. The type of property will impact the type and source of financing available, the amount of cash flow expected, management costs, appreciation and depreciation, tax considerations, and even the character and number of potential tenants.

SINGLE-FAMILY HOMESMany small investors begin by purchasing single family homes, either to renovate and flip or to rent. Single-family homes make excellent investments because of the demand: over 40 percent of renters live in single-family properties.3 Another key advantage is that single-family homeowners are often motivated sellers. Factors like employment relocation, job loss, changes in family size, or inheritance can create the need to sell a home quickly, which can mean bargains for an investor.

Although single-family homes have many advantages, there are also downsides. Owners who intend to self-manage need to consider the costs of maintenance, supervising contractors, and the need for frequent visits to the property. Particularly when owning an individual property, it is important to have sufficient reserves, because whenever the property is vacant, there is no income. Even though single-family properties tend to appreciate in value over time, growth may be slow, unless the property is improved or an area becomes trendy.

CONDOMINIUMS AND TOWNHOMESWhile a single-family is the most common type of home for all buyer types, the most recent NAR Investment and Home Buyer’s survey shows that higher shares of vacation buyers and investors purchased condos and townhouses. Compared to single-family homes, condominiums and townhomes have advantages as investments because they have lower maintenance costs. The association deals with common areas like hallways, roofs, grounds, elevators, HVAC, and plumbing systems. (Owners are still responsible for maintenance of the interior of unit.) This advantage has a downside, however, because it means that the unit owner does not have direct control over costs. The association sets the fees and can levy special assessments as needed.

3 Quick Facts: Resident Demographics, National Multifamily Housing Council. https://nmhc.org. 2017 American Community Survey, 1-Year Estimates, US Census Bureau. Updated 9/2018


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Condominiums tend to appreciate less than single-family homes, and come with additional constraints, particularly for investors who intend to rent their units. Condominium owners must abide by the Covenants, Conditions, and Restrictions (CC&Rs), and bylaws of the association. The bylaws or other governing documents may contain restrictions on the number of units that may be rented at one time to comply with FHA guidelines. Condos may be good investments for parents of college students, who can live in the unit rent-free, and take in roommates to offset mortgage payments and association fees.

Townhomes tend to physically resemble single-family homes, with more than one story and individual yards, but share similarities with condominiums because of shared physical space (connected walls and roofs) and collective governance. As with condos, it is important to review the governing documents to determine exact ownership rights and restriction on rentals.

MULTIFAMILY HOUSINGSmall multifamily properties are usually defined as having four or fewer units, while larger complexes tend to be treated as commercial property. Financing tends to be easier with smaller rental properties, because they are treated like other residential properties, and because they provide multiple sources of rental revenue.

VACATION PROPERTIES AND SHORT-TERM RENTALSVacation properties are a desirable option for investors, especially those who live in popular tourist destinations. While traditional states like California, Florida, and Arizona remain popular, investors are also finding success in Tennessee, Colorado, and other family-focused areas. To learn more about vacation property investing, you can earn the Resort and Second-Home Property Specialist Certification (RSPS) through NAR. Visit the website for more information, www.nar.realtor/education/designations-and-certifications/rsps-certification.


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THE AIRBNB INVESTMENTMore and more travelers are including Airbnb in their search for lodging when traveling. The prospect of having a larger space at a relative cost is inviting to renters. Is it equally as inviting to investors? Short-term rentals can provide investors with more money than long-term rentals. However, this fairly new marketplace still includes uncertainties that investors need to take into account.4

1. CHECK THE LOCAL REGULATIONS. Don’t assume that every city has the same guidelines regarding short-term rentals. Some cities don’t allow short-term rentals in certain parts of the city, but do allow them in others. Homeowner’s association rules might be in place. Are property taxes and insurance coverage different for the rental market? Do you need a license to rent property?

2. BE READY TO FACE UNEXPECTED EXPENSES. The owner of an Airbnb faces the same issues as if the property were their own home, but since they don’t live there, they have to pay someone else to get the jobs done. That includes a cleaning service and landscaping service. There will also be utility bills, including Internet and cable television costs. While these expenses are normal, if the unit isn’t rented for a few months, there is no rental income but there are still monthly expenses. There is also the possibility of liability costs resulting from someone being injured on your property or theft. Remember also that Airbnb takes a 3% host service fee (may be higher in certain countries or for properties with very strict cancellation policies.)

3. REMEMBER THIS IS A COMPETITIVE MARKET. The market is becoming saturated with more and more properties, which means your rental has to stand out from all the rest. Consumers are becoming more particular in their selection and look for outstanding reviews from previous renters. The best way to generate these reviews is by providing quality service – high-end bedding and bath accessories, a listing of local attractions, pristine clean rental. Professional photos and an enticing description generate interest.

4 Forbes, 10 Things to Consider Before Buying an Airbnb Investment, April 4, 2017, https://www.forbes.com/sites/omribarzilay/2017/04/04/things-to-consider-before-buying-an-airb-nb-investment/


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4. TAKE TIME TO LEARN BEFORE YOU INVEST. Investors need to understand the risks before committing. Start small – perhaps rent out a room in your home and see what you learn from that. Learn as much as you can about the communities you are considering for property investments. Are they conducive to the rental market? You need to understand where the market is headed. Do your homework and put together a business plan prior to that first investment.

FORECLOSURES AND SHORT SALESForeclosures and short sale properties are very popular with bargain-hunting investors. About 35 percent of investors purchase a distressed (foreclosure or short sale) property.5 Foreclosures and short sales are desirable for investors because they are generally sold below market value. According to a report by RealtyTrac, there are more than 413,000 properties in the U.S. that are in some stage of foreclosure and the number of homes listed for sale is just over 925,000.6

Real estate owned (REO) or bank-owned homes are popular with fix-and-flip buyers since many of the properties are in substandard condition. If the property is sold at auction, however, there may be no opportunity to assess the degree of damage to the property or estimate the cost of repairs. Many foreclosures and short sales are sold “As Is” and some require forfeit of earnest money if buyers withdraw. Depending on the amount of renovation needed, and the character of the neighborhood, there may be more value in holding and renting the property than in trying to quickly resell. Short sales may be better options than foreclosures because the properties have been occupied and tend to be in better condition. However, short sales may take a long time to close and there may also be liens or other constraints that can affect the sale. Find practitioners who specialize in short sales and foreclosure and get on their coming-soon lists. Most of these properties sell quickly, and an advance warning can provide some time to see the property and make an offer before another investor snaps it up. Find foreclosure and shortsale specialists at http://realtorsfr.org/sfr-directory.

5 NAR Investment and Vacation Home Buyers Survey 2017, National Association of REAL-TORS®.

6 RealtyTrac, https://www.realtytrac.com/statsandtrends/foreclosuretrends/


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SHORT SALES & FORECLOSURE RESOURCE CERTIFICATION (SFR®)You can learn more about this aspect of the industry by exploring the SFR designation through the National Association of Realtors. It provides a framework for understanding how to qualify for short sales, negotiate with lenders, limit risk, and more. https://www.nar.realtor/education/designations-and-certifications/sfr.

VALUATION—HOW MUCH IS THIS PROPERTY WORTH?

Real estate professionals know that when a buyer—investor or home buyer—finds the right property, the first question is “How much is this property worth?” Accurate valuation is required to assess the risk of financing, as well as, the return to the investor. Valuation also helps to determine the benefits of renovations, the decision to sell a property, and local property taxes and insurance.

Real estate investments are valued in one of three ways:

f MARKET VALUE Market value is the price the property would command in the open, competitive market. It may be the estimate calculated by looking at sales of similar properties and presented in a comparative market analysis (CMA). Or it may be the outcome of an appraisal for a lender’s underwriting process. Trends discussed earlier impact market value as do larger forces such as interest rates. The value of a specific property can be influenced by renovations, upgrades, and good maintenance.

f INVESTMENT VALUE Investment value is more subjective than market value because it is a reflection of the investor’s specific requirements and is based on assumptions such as target cash flow or rate of return. Two of the most common ways to calculate this are net present value and discounted cash flow.

f REPLACEMENT VALUE Replacement value reflects the cost at current prices to replace or restore a property to its pre-existing condition and appearance. It is a common method of determining value for insurance coverage.

For purposes of this course, we will focus on determination of market value and investment value.


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MARKET VALUEComputation of market value is very familiar to residential practitioners because it’s the method used to price homes. The procedures and guidelines that apply to residential CMAs also apply to investment properties, as do many of the same challenges. The first step is to compare the listing price to comparable—physically, functionally, and geographically—properties in the area. However, the first step is also the first challenge. Comparable properties should include recently sold, as well as, currently on-the-market.

Comparables should be as geographically similar to the subject as possible. The size of the area may vary depending on the type of property and the population density in the area. A general rule of thumb might be a one-mile radius, but it might be larger in a sparsely populated area, and only a few blocks in a crowded urban environment.

You can learn more about pricing strategy by exploring the PSA certification course through the National Association of Realtors. It provides guidelines and strategies for determining property values by employing realtor knowledge and current technology. https://www.nar.realtor/education/designations-and-certifications/psa.

3 RULES-OF-THUMB FOR SELECTING COMPS

CITY

f within ½ mile radius f Condo—same complex or building

SUBURBAN

f Same subdivision or neighborhood f Same school district if schools are a force in your market f 1-mile radius if possible

RURAL

f 5-mile radius if possible f If not, stay within the area as buyers define it (e.g., a school district)

ADDITIONAL CONSIDERATIONS Include properties that have sold in the past three to six months that similarly align in terms of condition, age, and nearby features.


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HIGHEST AND BEST USEAnother factor in determining the market value of a property is analysis of its highest and best use. The concept of highest and best use is a principle used in appraisal of commercial and investment properties, particularly vacant land and properties in transitioning areas. In short, it is the reasonable and probable use of a property that will support the highest present value of the land. Highest and best use has four criteria. (Remember the criteria with the mnemonic: PLEM.)

f Physically possible

f Legally permissible

f Economically feasible

f Maximally productive

The highest and best use of the subject property might not be the current use. For example, consider a single-family residential property on a multiple-acre lot in an area of increasing population density. Zoning permitting, the highest and best use could be to remove the single-family home and develop a multi-family building on the land.

Up-to-date knowledge of zoning information for an investment property is critical in determining its highest and best use. Zoning ordinances can change, and what was once residential-only could be transitioning to commercial or mixed use. A real estate professional who does not have the correct zoning information could make a big mistake in estimating the market value of a property.

A determination and description of the highest and best use is included in the appraisal required by lenders. If the investment property is, for example, a single-family home on a standard-size lot in an area zoned exclusively for residential, the appraiser’s job in determining highest and best use is easy and usually accomplished with a simple check-off on the appraisal report. More complex properties such as land transitioning from agricultural use to development, or neighborhoods rezoned for mixed-use development, present greater challenges for the appraiser who must assign a value and provide a detailed rationale.


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AUTOMATED VALUATION MODELS

Automated valuation models (AVMs) are online databases that provide market value estimates by matching prices of recently sold similar properties. Although AVMs provide quick and convenient information, they may miss important value-influencing characteristics and have wide margins of error. Savvy agents should know what AVMs such as Zillow or Trulia have to say about a subject property. Clients check out these sites, so agents should be prepared to explain how AVMs work and the margin of error for their data and estimates.

You can also access the Realtors Property Resource (RPR), an exclusive website for realtors that was created by NAR to provide you with the data clients are asking for. RPR is discussed in greater detail later in this chapter. On this site, you will find the Realtor Valuation Model (RVM). This resource includes an RVM confidence score and multiple tools to define price and is an excellent starting point for pricing discussions.

INVESTMENT VALUEAs stated above, investment value is a subjective valuation of a property based on the investor’s criteria, such as rate of return, cash flow, or tax considerations. Investors usually use a combination of ratios along with comparisons to market data, to determine investment value. We’ll look at the most commonly used ratios and how they can be used to help investors evaluate and price properties.

GROSS RENT MULTIPLIER (GRM)The GRM is a quick method of determining value of an investment property compared to others in the same market.

Property Price (Market Value) = GRMAnnual Gross Income

(Gross Scheduled Income)

A higher GRM generally indicates a higher market value, a lower GRM, indicating a lower property value, may signal a bargain for the buyer. So even if a property looks like it has a higher gross income, it may not be a better value if the selling price is higher.


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EXAMPLE

PROPERTY A:$750,000 sales price = GRM 6.82$110,000 annual income

PROPERTY B:$800,000 sales price = GRM 6.61$121,000 annual income

Although GRM does not take into account operating expenses, in areas where operating costs tend to be uniform across properties, it may be especially useful for comparing investment properties for further analysis.

CASH ON CASH ($/$%)Cash on Cash ($/$%), also known as ConC, measures the investor’s desired rate of return on an initial investment. This ratio compares the equity invested in a property with the cash flow, before or after taxes, from one year. It is used most commonly to show year-to-year trends in performance.

Cash Flow = Cash on CashInitial Equity

Initial equity invested includes the down payment and all acquisition costs that are not financed. The cash-on-cash rate of return measures a one-year return on invested dollars.

EXAMPLE

A property is priced at $1,000,000. The investor will make a down payment of $200,000 and take a loan for $800,000. The annual before tax cash flow is $18,000 after loan payments. The ConC for this investor is 9.0%.

$18,000 = 9.0%$200,000 (down payment)


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RETURN ON INVESTMENT (ROI)ROI is a profitability measure that evaluates the performance of an investment. Although it can be calculated in various ways including before or after taxes, the basic calculation is the net gain (gain less expenses) divided by the cost of the investment. ROI measures how effectively capital is being used to generate profit; the higher the ROI, the better.

Net Gain (Gain Less Expenses)

= ROICost of Investment

CAP RATENet operating income divided by purchase price equals the cap rate. Cap rates are a quick determination of value, not necessarily a return on investment. A benchmark market cap rate is used to compare investment values.

Net Operating Income (NOI) = Cap RatePurchase Price

Below-market priced properties often come with greater risk, less desirable locations, or repair and maintenance issues. Attracting a buyer who will accept the risks requires a higher than market-standard cap rate. Conversely, risk-averse investors may accept a higher purchase price as a trade-off for better quality and stable cash flow.

Is a high or low cap rate better? The answer is yes to both. Property prices and cap rates move against east other. In other words, prices tend to decrease when cap rates go up and increase when cap rates go down. Investors generally want a high cap rate going in (buy low) and a low cap rate going out (sell high).

How can you find out about benchmark cap rates for your own or another market area? Major buyers of investment real estate, such as pension funds, real estate investment trusts (REITs), and life insurance companies publish information on cap rates. These companies are good sources for cap rates for large properties. Industry publications, other brokers, as well as, banks and other lenders are also good sources of cap rate information.


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CAP RATE INFORMATION SOURCES

f REALTYRATES.COM

[ National source for research data on markets

[ Provides a survey of current and historical average cap rates

f NATIONAL COUNCIL OF REAL ESTATE FIDUCIARIES

[ Offers Property Index report that shows capitalization rates computed from the NPI properties sold

[ Reports for major commercial property types and U.S. regions

f COSTAR GROUP

[ International commercial real estate and financial data firm

[ Frequently produces reports on market activity and cap rates

f COLLIERS INTERNATIONAL

[ Real estate data firm

[ Provides market-specific research on costs, sales prices, and cap rates for commercial real estate

f CBRE GROUP

[ International real estate firm

[ Provides data for markets throughout the world

f APPRAISAL INSTITUTE

[ Association of appraisers who calculate cap rates, adjust NOI, and estimate the market value of a property


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USING CAP RATE TO ESTIMATE MARKET VALUETo help investors determine which properties have the greatest potential to yield profits, a mathematical concept called income capitalization is used to calculate an investment value. The calculation consists of dividing the annual net operating income (NOI) by the capitalization rate, or cap rate, which is a real estate valuation measure used to compare different real estate investments.

A handy tool for estimated cap rate, income, and value is the IRV equation. The three components of the equation are: income, rate, and value. If you know any of the two components, you can calculate the remaining one. This formula is one of the central tools for understanding the relationship of income to the value of the asset.

Income (NOI) = Value (V)Rate (R)

Therefore,

Income (NOI) = Capitizalation Rate (R)Value (V)

and

Value (V) x Capitalization Rate (R) = Income (I)

It may help to think of the IRV formula in the form of a house, as shown below. Note that in the "house" image, the I is "over" R to derive V. In fact, any of the three elements of this equation can be flipped to derive each other.


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EXAMPLESCALCULATING CAP RATEConsider a property that was bought for $3.25 million with an NOI of $295,000.

$295,000 (NOI) = 9.08% (Rate)$3,250,000 (Value)

CALCULATING INCOMEConsider a property with a value of $200,000. The market cap rate for this property type is currently 7%.

7% Rate x $200,000 Value = $14,000 NOI

ONE MINOR DIFFERENCES IN THE CAP RATE CAN GREATLY IMPACT THE RESULTING VALUE

f A property with a net income of $100,000 and an 8 percent cap rate would indicate a value of $1,250,000.

f A cap rate of 8.5 percent would indicate a value of $1,176,470.

The difference in value is more than $70,000 due to the half a percent change in rate.

CALCULATING CHANGES IN VALUEConsider a property with an NOI of $200,000. The market cap rate is 7%.

Calculate the market value:

$200,000 (NOI) = $2,857,142.86 (V)7% (R)

The property manager of this building is evaluating spending $20,000 to insulate drafty corridors in the building, which will reduce energy costs and increase the income by $3,000.

Using the market cap rate of 7%, the IRV formula can be used to compare the cost of the investment to the return.

$3,000 (I) = $42,857.14 (V)7% (R)

The insulation costs less than the $42,857.14 increase in the value, which means spending the $20,000 is a good choice. The expected selling price would increase by $42,857.14.


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CASH FLOW AND NET OPERATING INCOME The ratios we’ve looked at so far are useful for comparing properties to each other as well as market benchmarks. Investors, however, need to carefully consider the actual bottom line numbers of a property. These calculations focus on cash flow and net operating income (NOI) and both are important indicators of the overall financial health of an investment property.

Cash flow is the amount of cash available after all expenses and debts have been paid. The first step in computing cash flow is determining the gross potential income. Gross potential income (GPI) is the maximum market rent that can be derived from 100 percent occupancy and collection of rents over the course of a financial period (normally, a year). Subtracting vacancies and credit losses yields effective gross income (EGI). Adding in miscellaneous income and expense reimbursements yield the gross operating income, the actual amount of income collected.

Operating expenses are all the costs of operating and maintaining a property. These expenses include real estate taxes, insurance premiums, utilities, salaries, payroll taxes, maintenance costs, repairs, refurbishing of units or other rental spaces, contracted services, professional services, and administrative expenses. Administrative expenses may include the management fee and office supplies. Gross operating income less operating expenses equals net operating income (NOI).

NOI is:

f The income from operations that goes to lenders (in the form of debt service) and to owners (in the form of return on investment)

f The basis for estimating the value of a property (an important consideration for both lenders and owners)

f A widely used measure of financial health in real estate, even though it is not the same as profit.

NOI shows how well a property meets its day-to-day operating expenses and how much cash is left over to pay on loans and the costs of major improvements. While NOI can change based on a property’s revenue and expenses, it is still considered a valuable way to determine if a property can earn enough to support payments on its debt.7

7 Adapted from Field Guide to Practical Apartment Management, Institute of Real Estate Management, 2015. www.irem.org. and the balance small business, June 2019, www.thebal-ancesmb.com/calculate-net-operating-income-2866795


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CASH FLOW ANALYSIS WORKSHEETProperty Name: Purchase Price:

Prepared For: Plus Acquisition Costs:

Prepared By: Plus Loan Fees/Costs:

Date Prepared: Less Mortgages:

Equals Initial Investment:

Mortgage Data Cost Recovery Data

1st Mortgage 2nd Mortgage Improvements Personal Property

Amount Value

Interest Rate C.R. Method

Amortization Period Useful Life

Loan Term In Service Date

Periodic Payment Future Sale Date

Annual Debt Service Recapture

Loan Fees/Costs Investment Tax Credit ($$ or %)

Taxable Income

End of Year 1 2 3 4 5

Potential Rental Income

– Vacancy & Credit Losses

= Effective Rental Income

+ Other Income (collectable)

= Gross Operating Income

– Operating Expenses

= Net Operating Income

– Interest: 1st Mortgage

– Interest: 2nd Mortgage

– Participation Payments

– Cost Recovery (Improvements)

– Cost Recovery (Personal Property)

– Amortization of Loan Fees/Costs

– Leasing Commissions

= Real Estate Taxable Income

Tax Liability (Savings) at 35%

Cash Flow

Net Operating Income

– Annual Debt Service

– Participation Payments

– Leasing Commissions

– Funded Reserves

= Cash Flow Before Taxes

– Tax Liability (Savings)

= Cash Flow After Taxes

Reprinted by permission of the CCIM Institute © CCIM Institute


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ANNUAL PROPERTY OPERATING DATAProperty Name: Purchase Price:

Location: Plus Acquisition Costs:

Type of Property: Plus Loan Fees/Costs:

Size of Property: Less Mortgages:

Purpose of Analysis: Equals Initial Investment:

Assessed/Appraised Values Balance Periodic Pmt. Pmts/Yr Interest Amort.

PeriodLoan Term

Land 15% 1st MortgageImprovements 85% 2nd Mortgage

Personal Property 0%Total 100%

Adjusted Basis as of

(ALL FIGURES ARE ANNUAL) $/SQ FT or Unit % of GOI Comments/FootnotesPotential Rental Income (PRI)

Less Vacancy & Cr. Losses (____ % of PRI)EFFECTIVE RENTAL INCOME

Plus: Other Income (collectable)GROSS OPERATING INCOME

OPERATING EXPENSES $/SQ FT or Unit % of GOIReal Estate Taxes:

Personal Property Taxes:Property Insurance:

Off-Site Management:Payroll:

Expenses/Benefits:Taxes/Worker’s Compensation:

Repairs and Maintenance:Utilities:

Accounting and Legal:License/Permits:

Advertising:Supplies:

Miscellaneous Contract Services:

(continued on next page)

(ALL FIGURES ARE ANNUAL) $/SQ FT or Unit % of GOI Comments/FootnotesTOTAL OPERATING EXPENSE

NET OPERATING INCOMELess: Annual Debt Service

Less: Participation PaymentsLess: Leasing Commissions

Less: Funded ReservesCASH FLOW BEFORE TAXES

Reprinted by permission of the CCIM Institute © CCIM Institute


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RPR® TOOLS FOR INVESTORS AND APPRAISERS REALTORS® can tap into a unique decision-making tool to help buyers make informed choices and narrow the property search. Realtors Property Resource® (RPR®) is a member benefit, which means it is already included in the dues you pay to the National Association of REALTORS®.

What can RPR® do for you? Consider this: you are driving around viewing properties when the buyer spots an interesting home and says “Can I see that one?” You respond by using your phone to search the home’s address which you use to download the RPR® Property Report, Mini Property Report, or Neighborhood Report. Each of these contains a wealth of public information such as sales and financing history, square footage, lot size, and more. In other words, you can present the buyer with facts about the property on-the-spot and if they’re interested, you can call the seller immediately to schedule a viewing. RPR® aggregates recent and current sales to calculate an estimated value for the property—this can indicate if it is over- or underpriced compared to similar properties.

The RPR® reports can be viewed online and can be downloaded. You can generate a full-color report that indicates your contact information and brand within minutes to present to your client. RPR® is an invaluable tool every Realtor should use.

THE REALTOR® CODE OF ETHICSThe REALTOR® Code of Ethics describes real estate practitioners’ roles and responsibilities. Article 11 specifically focuses on the real estate professional’s responsibilities when preparing an opinion of property value or price.


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ARTICLE 11

The services which REALTORS® provide to their clients and customers shall conform to the standards of practice and competence which are reasonably expected in the specific real estate disciplines in which they engage; specifically, residential real estate brokerage, real property management, commercial and industrial real estate brokerage, land brokerage, real estate appraisal, real estate counseling, real estate syndication, real estate auction, and international real estate.

REALTORS® shall not undertake to provide specialized professional services concerning a type of property or service that is outside their field of competence unless they engage the assistance of one who is competent on such types of property or service, or unless the facts are fully disclosed to the client. Any persons engaged to provide such assistance shall be so identified to the client and their contribution to the assignment should be set forth. (Amended 1/10)

STANDARD OF PRACTICE 11-1:

When REALTORS® prepare opinions of real property value or price they must:

1. be knowledgeable about the type of property being valued,

2. have access to the information and resources necessary to formulate an accurate opinion, and

3. be familiar with the area where the subject property is located unless lack of any of these is disclosed to the party requesting the opinion in advance.

SEC GUIDELINES ON INVESTMENT ADVICEInvestors often compare rates of return on real estate with potential returns on other types of investments such as stocks and bonds or Treasury Bills. The federal Securities and Exchange Commission (SEC) regulations state that it is unlawful to offer compensated investment advice about securities unless the practitioner is also qualified and registered as an investment adviser.

Therefore, real estate professionals should focus on providing the information about properties that helps buyers compare investment possibilities and make informed decisions about capital placement. But when working with clients who are weighing real estate as an investment and comparing its return with


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that of securities, practitioners should be careful to confine their advice to the merits of the property and avoid advising about comparative securities investments

MAKING AN OFFERWhen the investor has done all the homework and financial calculations and narrowed the choices, the next step is making the offer. Like residential transactions, the offer is conveyed by a purchase contract, which the seller may accept, reject, or counter. As noted earlier in the course, practitioners can expect to write many offers and counter-offers on investment properties to close a deal, with the exception of deals for foreclosures and REO properties.

NEGOTIATING A FORECLOSURE/REO TRANSACTIONMost REO transactions don’t involve a lot, or any, back-and-forth negotiation of price or contract details. Since many of these transactions result in multiple offers, a buyer’s best leverage lies in offering a cash deal and a quick close. Don’t expect hardball negotiations with listing agents to produce favorable results. They don’t have a lot of leeway to make concessions. The asset manager is in the driver’s seat and will reject or ignore an offer that threatens to take up too much time and effort. Anything the real estate agent does to make the transaction difficult for the listing agent or asset manager jeopardizes the deal for the buyer. The properties are typically listed “as is” with no room for negotiation. For asset managers, selling the property is a bottom-line financial transaction.

The workflow of REO transactions happens online, including submitting an offer. All offers may be rejected if submitted during an initial show-only period or reserve/first-look periods for first-time home buyers or nonprofit organizations. If the buyer falls into one of these categories, the reserve period presents an opportunity to make an offer on an REO property without competition from investors. Buyers must, of course, provide proof of their eligibility.

When the asset manager accepts an offer, the response will come in the form of a counter addendum. Read over this document carefully and compare it to the buyer’s offering terms. This is the time to sweat the details because asset managers may change or omit terms based on upper management approval or refusal. But don’t expect to write in changes on the counter addendum; markups invalidate it. Request changes and corrections on a separate form.8

8 Adapted from REO Properties: Responsibilities, Education, and Opportunities for Real Estate Professionals, Real Estate Buyer’s Agent Council (REBAC), http://rebac.net.


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CONTINGENCIESContingency clauses may be the best defense against making a bad deal. Exercising a contingency can prevent a buyer from purchasing a property with significant downsides that were not apparent during property showings. Contingencies don’t always have to be all or nothing. Buyers can use contingencies as tools to negotiate more favorable terms.

Because too many contingencies can make an offer less attractive, buyers should focus on those contingencies that are necessary to protect their interests. Buyers who routinely back out of contracts because of contingencies may get a bad reputation and find they receive fewer accepted offers. This can also impact the practitioner’s credibility and their other clients’ offers may be disregarded as frivolous in multiple offer scenarios.

COMMON CONTINGENCIES f INSPECTIONS

The inspection contingency should allow a reasonable amount of time for scheduling necessary inspections of the property by qualified property inspectors. With a multi-family building, the inspection contingency should give the buyer the right to inspect all of the units. This allows the buyer to negotiate with the seller to make necessary repairs, revise the purchase price, or terminate the agreement.

f APPRAISAL Appraisal of the property by a professional appraiser is an essential contingency and required as part of the financing package. The contingency can state that if the appraisal is not at least as high as the purchase price, then the contract is void. The alternatives are to ask the seller to reduce the price, back out of the deal, or bring more cash to the closing table. This is a valid strategy for when the appraisal will be low “as is” but the property will retail higher after renovation.

f FINANCING The financing contingency clause should specify terms, such as interest rate and the duration of the mortgage. If specified terms cannot be arranged, the buyer is not bound by the contract.

f TITLE AND SURVEY It may seem obvious from visual inspection of the property what the buyer is buying. What you see may not be what you get, particularly with undeveloped land. The survey should check for easements, covenants, conditions, restrictions, encumbrances, and liens, as well as current and future zoning and other land and property use matters.


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An owner’s title policy will, of course, protect the buyer in case of a title flaw, but a careful title and survey examination can help to prevent a costly and time-consuming error.

f FINANCIAL DATA A financial data contingency obligates the seller to produce current and historical data. The buyer should have the opportunity to review and verify that all expenses of operating the property have been reflected in the financial information provided by the seller. A review of several years of financial data, including tax statements, will likely reveal if the seller has recently enhanced the numbers to attract a buyer.

f REVIEW OF OPERATING DATA Review of operating data should include access to all property management files including utility bills. Important information includes maintenance schedules for equipment along with a list of warranties and expiration dates, and repairs and maintenance expenses. The review should verify that all service contracts can be terminated without penalty and that any licenses and permits are in the current owner’s name and whether transfer is required.

f REVIEW OF TENANT AGREEMENTS Pre-closing reviews should include an inspection of tenant leases along with a list of security deposits and tenant credit information and payment history.

f INSURANCE CLAIM HISTORY A C.L.U.E. report, which can be requested only by the owner, will show past insurance claims. Multiple claims can boost premium costs.


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Vicky Silvano, ABR® Century 21 SGR Chicago, Illinois [email protected]

The initial discussion I have with investor-clients varies, depending on whether they are new to the business or if they have some experience. It’s either exploratory or educational in nature. With new investors, I start out by determining how much they have to invest, whether they need financing, have they consulted an attorney. If they need names, I provide them. With experienced investors, we move right into a discussion of goals, what kind of return they want, what kind of properties they want, and what locations they’re considering.

GETTING STARTEDIn my experience, new investors really don’t know where to start. They may see one of my listings on an online site and come in to talk about it, but they haven’t really thought through all the aspects of what they’re taking on. I have to walk them through the costs involved, financing costs, and labor costs. I had one client who was a contractor and was planning to do the renovations himself. I had to remind him that his labor had a cost—his time had a value.

MANAGING EXPECTATIONSI think it’s important with investors to manage expectations. I like to give them a best-case scenario and a worst-case scenario, so they are prepared. They need to think about vacancy rates. With a single-family home, if the property is vacant, there is no income. I give them as much information and advice as possible. I tell them how much reserve they need to have for when there are vacancies, and for maintenance. I remind them that there will always be maintenance issues. Even with your home, there are maintenance issues.

ANALYZING PROPERTIESWhen it comes to analyzing properties, I use the MLS or maybe Costar to pull comps for a one-mile radius around the property for the past six months. Because of my experience, I know what the boundaries of a neighborhood are


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for a particular area. I look at more than sales figures and dates, I also look at the rents and absorption rates. I give that information to the client, so they know what the market has been for the past two-year period.

SHOWING PROPERTIESWhen it comes to showing properties, I like to drive around the neighborhood first, to give people a feel for the location to be sure it is right for them. On site, you get a feel for how intense the rehab will be, and I try to point out the structural items that are going to cost more to fix. Of course, I always tell them they should have an inspection by a licensed, professional inspector. Ideally, if someone is buying a two- or four-flat, I think they should look at all the units. With a larger building, that may not be necessary, but I think unless there is a current tenant who won’t allow access (and that might be an issue in itself), a prospective investor (and an inspector) should take a look at every unit.


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EXERCISE: NEIGHBORHOOD ANALYSISReview the details of the following neighborhood and respond to the questions that follow:

NEIGHBORHOOD f Close to a major interstate and state highway

f Estimated population last year: 34,065 (an 11.4% increase during the past 8 years)

f Largest segment of population consists of young and middle-aged professional and business people

f 86% are in family households, 14% are in nonfamily households

f Two-block downtown redevelopment recently approved will include 1,181,000 square feet of retail and high-rise office space, including major retail shops, restaurants, and 230 additional parking space

f Public golf course, public tennis center, fitness clubs, two city parks

f Median annual household income of $51,000

f Major employers include Fortune 500 corporations

f New construction of apartments was down 19% in the region last year.

f Single-family homes in immediate vicinity of subject property range in value from $125,000 to $250,000

f Older and more modest homes located near the state highway, upper-end homes on hillside to the west

f Some premium riverfront homes on large lots


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1. What neighborhood characteristics should an investor consider about a property located in this neighborhood? Which are positive? Which are negative?

2. What types of renters might be attracted to a property in this neighborhood?

3. Would this neighborhood be more conducive to vacation investment properties or rental investment properties?

4. What other information might an investor want to know about this neighborhood?


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module

3Working with Investor Clients

AFTER YOU COMPLETE THIS MODULE, YOU WILL BE ABLE TO:

f Use statistical data on investor profiles and preferences to plan business strategy.

f Identify and make contacts with clients and customers who need investment real estate services and help them refine their investment goals.

f Identify other professionals who can provide ancillary services for purchasing, managing, and maintaining real estate investment properties.

CHARACTERISTICS OF INVESTORSWhile there is no “one-size-fits-all” definition, successful real estate investors, and real estate professional who work with them, tend to share some or all of the following characteristics:

f SELF-CONFIDENT: Investors who believe they can succeed are more likely to be successful than those who are doubtful.

f KNOWLEDGEABLE: Investors do their homework and recognize what drives the market, when the market cycles, and other clues that indicate when a property is worthy of investing.


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f DECISIVE: Investors who know what they are looking for act decisively on investment opportunities. Indecisive investors may look for scapegoats, including the real estate professional, for their indecision and lost opportunities.

f PATIENT: Success in real estate investing takes time. Finding the right property, rehabbing and reselling, or waiting until the value appreciates are not quick or simple processes. Impatience leads to bad decisions and money-losing deals.

f RISK TOLERANT: Real estate is subject to cyclical ups and downs. Experienced investors accept the cyclical ups and downs of real estate. They take the time to do up-front analysis, minimize risk as much as possible, and accept the remaining risks.

f TEACHABLE: The best investors know that they don’t know it all. They are willing to learn more to make better deals or to better manage their properties.

f REALISTIC: Novices may view real estate investing as a surefire get-rich-quick tactic. Successful investors understand that bargains are rare and that building wealth requires time and attention.

f COMMITTED: Analyzing, purchasing, and managing residential property requires a significant time commitment particularly if an investor plans to self-manage the property.

f COMFORTABLE WITH UNCERTAINTY: Just as every investment involves a measure of risk, most also involve some degree of uncertainty. A prospective investor who is uncomfortable with too many unknowns may lack the temperament for investing. Education and experience help to lessen discomfort with uncertainty.

f PEOPLE PERSON: One of the challenges of managing rental properties is managing relationships with tenants. Investors who are not comfortable dealing with people may need to hire a property manager.

f LOYAL: A loyal investor is one who understands that good relationships with others, including real estate professionals, are a significant part of their success.

Module 3: Working with Investor Clients

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f PRUDENT: The best investors are careful with their money. They understand the need to maintain properties adequately, but don’t overspend or incur too much debt. They protect themselves and their properties with sufficient cash reserves and insurance.

f GOAL-ORIENTED: Successful investors have a clear vision of what they want to accomplish in the future. They may have specific goals, often with written plans, which they revisit and update annually.

Fast Facts About the Typical Real Estate Investor9

f $82,000: Median household income level of investors

f $155,000: Median price of single-family home (an increase of $11,000 from prior year)

f 1,500: Average square footage of single-family homes purchased for investment

f 20 MILES: Median distance to the investor’s primary residence

f 35%: Percentage of investors who did not use a mortgage

f 37%: Percentage who purchased the property to rent to others, 15% because it was a good deal, 16% for price appreciation potential

f 9 YEARS: Median length of time investors plan to hold the property



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PROSPECTING FOR INVESTOR-CLIENTSBecause the market is smaller and more specialized, prospecting for investor-clients may take more time and effort than prospecting for home buyers and sellers. It takes more effort than just “hanging out a(virtual) shingle” and hoping that clients find you. You need to budget time and resources as well as plan a strategy with a timeline, objectives, tactics, and measurable goals.

START HERE... INVESTMENT CLUBS AND GROUPSA good place to start is a local real estate investing club that meets to discuss market trends and investment strategies, share best practices, and network. The National Real Estate Investors Association (http://nationalreia.org) offers a list of all member organizations by state, as well as information on how to start your own group.

MOST LEADS COME FROM... REFERRALS Most agents get the majority of their leads from referrals—their spheres of influence and past clients. Other agents, in your own firm or those who don’t have the expertise or desire to work with investors, are also a good source of referrals. Be sure these groups know that you are actively seeking investor-clients. Another way to make new contacts is by attending state, regional, and national conferences and expos and getting involved in investment-related REALTOR® association activities. The more people you know from other regions, the more likely you are to receive referrals.

CONSIDER... FINANCIAL PLANNERS AND ESTATE ATTORNEYS Financial planners, particularly those who specialize in retirement planning, may be looking for low-volatility, income-producing investments for their clients. Get to know the leading financial planners and wealth managers in your area and inform them of the services you can offer to help investors diversify and reach their financial goals. Self-directed IRA providers may host get-togethers to provide information, share ideas, and network with potential investors interested in using IRA funds for real estate purchases. Attorneys who specialize in estate planning can be a business connection for both clients and properties.

PLAN... REAL ESTATE INVESTMENT SEMINARSAn effective way to meet and introduce yourself to clients is offering information seminars for real estate investors. A real estate investment seminar can break the ice between you and prospective clients because attendees have an opportunity to get acquainted with you before meeting one-on-one or signing


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a representation agreement. Co-presenters, such as accountants, tax advisors, or lenders, enrich the program content and enhance your credibility as a real estate investment professional. Program topics should focus on information of concern to investors—local market overview, financing for investment properties, year-end tax planning—but not sales, and the event should be held in a non-sales environment, not your real estate office.

Fast Facts About International Real Estate Investors10

f $121 BILLION: The total of residential property purchased by foreign buyers from April 2017-March 2018

f 39%: Percentage sales of residential real estate non-resident foreign buyers

f $292,400: Median price of properties purchased by non-resident foreign buyers, average price is $454,400

f 72%: Percentage of all-cash purchases made by non-resident foreign buyers

f 16%: Percentage of non-resident foreign buyers who purchased the property as a vacation and/or residential rental property for investment.

f 5: Number of countries that account for the majority of purchases by foreign buyers: Canada, China, Mexico, India, and the United Kingdom

f 5: Number of states that account for 53% of international sales: Florida, California, Texas, New York, and Arizona



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INTERNATIONAL INVESTORSThe global economy is awash with capital, particularly from Asian markets such as Hong Kong and Singapore, seeking investment opportunities. Brazil has also come into the spotlight of investment activity. There is a noticeable shift in both the Europe and U.S. market by some investors to second-tier cities that distance themselves from the higher-priced major markets. Political pressures cause some investors to look for “safer” markets. U.S. real estate is sometimes seen as a safe, inflation-proof place to park cash assets away from the attention of tax authorities, governments, and public awareness in buyers’ home countries.

Perhaps you have clients interested in conducting real estate business outside of the United States. Keep in mind that real estate practices vary in every country and you need to have knowledge of these nuances to prepare your clients for the process. Many countries have strict laws in this area and it’s imperative for you to know them. For details on real estate activities in a host of countries go to www.nar.realtor/global/real-estate-practices-around-the-world.

Some suggestions for finding international investors include:

f START CLOSE TO HOME Start by researching the extent of international business in your market area and the level of interest of international buyers. Two data-rich tools are available for delving into the international presence in your area.

[ NAR.realtor offers comprehensive reporting on the market interest of global buyers searching in the United States. These reports are updated monthly and can be accessed on www.nar.realtor/foreign-investors.

[ NAR State-by-State International Business Reports provide the international profile of your market and where buyers are coming from. Go to www.realtor.org/reports/state-by-state-international-business-reports.

f NARROW YOUR FOCUS Pick one or two countries that make sense for your market and learn all you can about them.

f REACH THE RIGHT PEOPLE Find out where your target audience can be found online and advertise there. For example, if you are trying to reach the Chinese market, it may make sense to advertise on a popular search engine like Baidu, or a social networking/microblogging site.


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f DEMONSTRATE YOUR EXPERTISE NAR’s Certified International Property Specialist is well known and respected among real estate professionals worldwide. For information on earning the designation, as well as, other international real estate education opportunities, go to www.nar.realtor/global.

f MAKE YOUR WEBSITE INTERNATIONAL-FRIENDLY Make your website user-friendly for international clients by adding tools such as Google Translator, a currency converter, and your Skype contact information. For even more impact, include client testimonials in foreign languages.

FIRST MEETINGS WITH CLIENTSAs with home buyers and sellers, your first meeting with a prospective investor-client is an opportunity to get acquainted and decide if you want to work together. Take time to learn about the investor’s goals and expectations, knowledge, background, and real estate and investment experience.

LEARNING ABOUT THE CLIENTAs with all clients, you need to be prepared to answer their questions. While some may be the questions all buyers have (“Is this a good time to buy?”), others will ask questions to test your understanding of the investment process and your knowledge of your market. You can use the A-I-R (ask, inform, respond) question model discussed at the end of this section as a job aid for preparing and conducting meetings with prospective clients.

SHAPING EXPECTATIONSEven more than home buyers, real estate investors need to have a clear road map of the process for purchasing, managing, and eventually exiting an income-generating property. You should be prepared to spend some time educating prospective clients about what to expect, and more importantly, what not to. Clients may have misconceptions about investing, particularly about potential rates of return. They may think that “fixing and flipping” is a surefire ticket to wealth with a guaranteed return on investment. Many agents find that first-time investors have misconceptions about the process and often aren’t sure of their goals beyond “wanting to make money.” Although enthusiastic about investing, they may not have considered the requirements of different property types or the impact of market conditions. Discussion of local market conditions helps to create realistic expectations.


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FINANCIAL PREPARATIONYou don’t want to work with a client who is not financially able to work with you. Many investors have been seduced by no-money-down promotions and don’t understand the fees and costs that might be involved, even in an investment that doesn’t involve a down payment.

You need to have a clear and complete picture of an investor’s finances and make sure it’s a match with investment goals. For example, an investor who plans to purchase a distressed property, (which 35 percent of investors do)11 needs sufficient cash on hand for repairs and upkeep. Even an immaculate property requires sufficient reserves to cover loan payments when vacancies reduce cash flow. For cash investors, you should request a proof-of funds document from the client’s bank, to confirm the amount of cash on hand and the availability and source of the funds for a real estate transaction. At minimum, you want clients who plan to leverage the property to obtain a pre-approval for a property investment loan.

You want to work with clients who are solvent and credit-worthy. Red flags include low FICO scores, low ratios on portfolio loans, and a low equity position.12 Another warning signal is an open line of credit on a personal residence to fund investment property. This may be a viable option for some, but it could indicate that the investor isn’t really solvent enough to invest.

If a client is not making a cash purchase or financing, but is participating in a partnership or using a private loan, their financial viability may be less important than the deal itself. Many investors start out working with people they know as their first partner (family member, friend), or use a windfall inheritance or bonus to finance their first deal or down payment. Most private lenders and partners are more concerned with the deal potential, and how their funds will be secured, than the investor’s financial status. They may ask for credit information or references, but what they expect is security and equity potential. They will secure the property with a first trust deed, so they can foreclose on an investor in case of failure to perform. These types of deals are always negotiable, and less experienced investors can expect a lower percentage.

11 NAR Investment and Vacation Home Buyer’s Survey 2017, National Association of REAL-TORS®, Research, www.realtor.org/research-and-statistics/research-reports.

12 Lenders will look at ratios on full portfolio (all properties owned) and require a mini-mum ratio of 1.25% of PITI. Example: If PITI = $1000, minimum gross rents should be $1250. More conservative lenders and investors will prefer 1.40% or more.


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GETTING TO KNOW THE INVESTMENT CLIENT: THE A-I-R MODELUse this three-step process when working with the investment client: ask, inform, and respond.

ASK

LEARN AS MUCH AS YOU CAN ABOUT THE CLIENT SO YOU CAN TARGET THEIR INTERESTS.

f What type of property are you interested in? What area are you interested in?

f Is there a particular type of tenant or renter you want to attract?

f Is this your first real estate purchase? What prompted you to invest now?

f Will there be others involved in the investment?

f Are you looking for a profit in the future or additional income in the present?

f What is the source of your current income? What assets do you have?

f How do you plan to fund the investment? Do you have a business or financial plan?

f What is your current tax liability?

f Will you self-manage the property or hire a management company?

INFORM

PROVIDE THE CLIENT WITH YOUR KNOWLEDGE AND THE RESOURCES THEY CAN USE DURING THE PROCESS.

f Local market overview

f Availability of financing and local lending sources

f Cap rate trends

f Types of properties and price ranges

f How you work with investor-clients


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f Your own experience with investment real estate

f Lenders who specialize in financing investment purchases

f Availability of properties and their pros and cons

f Tax and ownership form considerations

RESPOND

THE INVESTMENT CLIENT WILL HAVE QUESTIONS ABOUT THE PROCESS. THIS IS YOUR OPPORTUNITY TO SELL THE SERVICES YOU PROVIDE.

PROCESS AND RELATIONSHIP

f Why do I need an agent?

f What's the process? Why is it so complex?

f What if you have two clients competing for the same property?

MARKET CONDITIONS

f Is it a good time to buy? Is it a buyer's or seller's market?

f Do you have any properties for sale or pocket listings?

f What's a good area?

MONEY AND FINANCING

f Who will give me a loan? How much down payment do I need?

f How do I find financial partners? Will you partner with me?

f Will you discount your commission?

SPECIFIC PROPERTIES

f What is needed, in relation to rents and improvement?

f How do you know it's a great deal?

f Can you provide an analysis spreadsheet?


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Investment GamesOne tactic brokers may use with first-time investors is to ask them to read books like Creating Wealth by Robert Allen, and Robert Kiyosaki’s Rich Dad, Poor Dad and Cashflow Quadrant to ensure that they are prepared and have sufficient commitment to follow-through. If the client is unwilling to take the time to do their homework, it may indicate that they lack the necessary traits to be a successful investor. Another tactic is to use games that illustrate the investment process. The CASHFLOW® game from the Rich Dad franchise is a way for prospects to practice different investing scenarios. In the game, players start in a typical 9–5 job and attempt to build wealth by acquiring assets. Players compete against each other as well as the housing market, stock market, and even Mother Nature. Monopoly is another game that teaches players about the importance of location in real estate investing, and the benefits of passive income.

GOAL SETTING FOR REAL ESTATE INVESTORSInvestment goals vary depending on the investor’s current economic situation and their long-term plans. Some want to flip a property for a quick profit, but most intend to buy and hold for a longer period. Investors have one of the following goals as their top priority.

f SAFETY (CAPITAL PRESERVATION)

[ GOAL: Protect the principal investment by acquiring and maintaining quality properties that hold value over time. The property may not provide a strong return, but it should retain its initial value and may appreciate due to market trends or neighborhood improvements.

f PERIODIC INCOME (CASH FLOW)

[ GOAL: Obtain a recurring source of income over time. The cash flow provides a rate of return that can be compared to other investments. The number of rental units, vacancies, and market conditions impact the amount of cash flow.


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f LEVERAGE (USING BORROWED FUNDS)

[ GOAL: Return on the acquisition that exceeds the cost of the borrowed funds. Leverage lets the investor control an asset and increase its value with minimal outlay of personal capital.

f CAPITAL APPRECIATION (HEDGE AGAINST INFLATION)

[ GOAL: Income from rents stays ahead of inflation and asset value increases over time.

f TAX ADVANTAGE (INCOME TAX SHELTER)

[ GOAL: Recover the cost of income-producing property through tax deductions for operations and depreciation.

CLARIFYING GOALSIf a prospective investor cannot state investment goals clearly, it may mean that the goals are not completely thought out. You can help investment buyers clarify their goals so that they can act decisively when evaluating properties. The tried-and-true communication methods of careful listening and paraphrasing can help prospective investors narrow in on their goals. If a first attempt at articulating investment goals seems vague, do not be discouraged. Try describing goals others have achieved through purchasing property.

How do you know if a goal is clearly stated? One way is to use the SMART goal system. It can be used to test if a goal is specific, includes measurable numbers, has a timeframe for accomplishment, and is relevant to the property and the investor’s lifestyle.

Source: [email protected]


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SPECIFIC

Help the investor articulate exactly what they want from the investment. “More money” is not enough. Use the A-I-R model questions discussed earlier to help them understand investment possibilities.

MEASURABLE

It is important to get beyond vague statements like “additional cash flow” or “comfortable retirement income.” How much extra cash flow per month or income in retirement is necessary?

ATTAINABLE

A get-rich-quick goal is neither realistic nor attainable. Help prospective investors form realistic expectations for each investment.

RELEVANT

An investor may be interested in a specific type of property, tenant, or location, which may not be a good match for financial goals. Explain to the client that meeting their goals may require some trade-offs in the choice of investment properties.

TIME-BASED

How long does the investor intend to hold the property? How often do they expect to receive income?

UNDERSTANDING AND MANAGING RISK Although less volatile than other types of investments, real estate is still subject to risks. When it comes to balancing risk and return, real estate professionals should help investor-clients assess their risk tolerance and form realistic expectations about the “what ifs” of ownership. The good news is that there are defensive actions to manage risks and keep them under control.

f BUSINESS RISK The real estate market is unpredictable. Plan for changes in economic conditions by maintaining several resources for refinancing and a healthy equity position on each property. The investor will be better prepared to sell quickly if increases in vacancies, renewable loan interest rates, property taxes, insurance, or operating expenses make ownership economically unsupportable.


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f FINANCIAL RISK Plan for financial risk by including financial partners and dedicating rents to pay down debts and build equity. Avoid over-leveraging. Avoid negative cash flow by calculating income and expense before buying a property.

f LIABILITY RISK Plan for liability risk with adequate hazard insurance including an umbrella policy to protect other assets. Require tenants to carry renter’s insurance and list the landlord as an additional insured.

f INFLATION RISK Plan for inflation risk by keeping properties well maintained so that annual rent increases are justifiable. Set fair market rents for new tenants.

f INTEREST RATE RISK Plan for interest rate risk by maintaining good credit and avoiding highly leveraged properties, which incur higher interest charges. Poor credit, resorting to high-risk lenders, or using hard money can impact risk significantly. Maintaining good credit, nurturing relationships with alternative lenders and cash partners, and building equity are valuable tools for managing interest rate risk.

f PROPERTY DAMAGE RISK Plan for property damage risk by maintaining a property that attracts multiple applicants and screening tenants. Use material—floor and wall coverings—that handle frequent wear and tear. Schedule regular inspections and charge immediately for repairs; don’t wait for walk- throughs when tenants move out. Make sure insurance coverage is adequate for replacement and covers all weather perils.


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EXERCISE: DETERMINING INVESTOR GOALS AND TOLERANCE FOR RISKThe best way to understand an investor’s goals is to ask the right questions. Use this exercise to outline some questions you would ask to help your client clarify their goals and risks. Topic references are listed to guide you.

SAFETY (CAPITAL PRESERVATION)

Q1: __________________________________________________________

Q2: __________________________________________________________

PERIODIC RETURN (CASH FLOW)

Q1: __________________________________________________________

Q2: __________________________________________________________

LEVERAGE (USING BORROWED FUNDS)

Q1: __________________________________________________________

Q2: __________________________________________________________

CAPITAL APPRECIATION (HEDGE AGAINST INFLATION)

Q1: __________________________________________________________

Q2: __________________________________________________________

TAX SHELTER (INCOME TAX ADVANTAGE)

Q1: __________________________________________________________

Q2: __________________________________________________________

RISK TOLERANCE

Q1: __________________________________________________________

Q2: __________________________________________________________


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BUILDING A TEAMReal estate investing is more complicated than home ownership and both investors—and the real estate professionals who work with them—need a support team of knowledgeable professionals. A support team helps investors manage and maintain their property, as well as, move quickly when a deal comes along. Following is a list of professionals and service providers you should have on your team to help you and your investor-clients throughout the investment process.

f TAX ADVISOR A tax advisor is an important part of any team for an investor. Every investment has different tax considerations, and a knowledgeable tax advisor with property investment experience can recommend appropriate ownership models, identify deductions, and avoid pitfalls. Tax management and bookkeeping becomes increasingly difficult as portfolios grow; it’s a good idea to hire an accountant, preferably a CPA, early in the process.

f FINANCIAL PLANNER It’s important to find a financial planner who can help an investor plan a comprehensive financial strategy, including how real estate fits into the overall plan. A financial planner who charges a flat fee for services may be more objective than one who is compensated by fees or commissions for sale of investment products.

f LENDER/MORTGAGE BROKER Most real estate professionals already have contacts for lenders and mortgage brokers, but you want to be sure that the people to whom you refer investors have expertise with income-generating properties. A knowledgeable lender can help an investor determine the best type of financing for the situation and help investors with the complexities of loan documents. Furthermore, loan officers and mortgage brokers may be a source for mutual referrals.

f REAL ESTATE ATTORNEY Before progressing too far in the purchase process, investors should consult with an attorney on forming the appropriate type of business entity—LLC, partnership, corporation—and separating properties when working with different partners. It’s also a good idea to engage an attorney to review tenant contracts.

f HOME WARRANTY COMPANY A home warranty company can provide your investor-clients with peace of mind, so they don’t have to worry about appliances and systems failing after the purchase.


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f INSURANCE AGENT An insurance professional can provide information on recommended coverages and premium costs. Insurance is a very competitive business so shopping around and comparing premium prices can help control insurance costs.

f APPRAISER An appraiser is an essential member of an investor’s team. Appraisers not only help establish the maximum price an investor should pay for a property but also identify ways to repair and upgrade a property to maximize value.

f WHOLESALER A wholesaler may be the solution for an investor looking for a quick transaction. Wholesalers look to flip a property but, unlike a fix-and-flip investor, don’t make any repairs or renovations. Wholesalers make money by signing a contract with a seller and then making a quick assignment of the contract to another seller—for a higher price—before the due date. Developing a relationship with a wholesaler will give you and your clients access to potential deals.

f INSPECTOR A real estate investor wants to know what they are buying, even with as-is sales. A professional home inspector tests the working systems of a property, conducts a visual inspection of the elements, and prepares a room-by-room report on the property.

f PROPERTY MANAGER Many investors start by self-managing their properties, but if that is not in the investor’s plan, a good property manager is a necessity. The Institute of Real Estate Management (IREM.org) is one source for finding professional property managers to handle the day-to-day management tasks and work with the investor to maximize the investment property.

f CONTRACTOR AND HANDYPERSON Finding a reliable, licensed, bonded, and insured contractor who gets things done on time and under budget may be crucial for an investor’s profit margin. An all-purpose handyperson is essential for the small problems that come up on a daily basis.


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Sher Powers, CRS Urbane Residential Specialists Nashville, Tennessee [email protected]

If real estate professionals are going to make a commitment to work with investor-clients, they need to have a passion for educating their clients. First-time investors need a lot of time and help determining their investing niche, plus assistance with planning and creating a list of resources and team members. It’s an honor to work with investors from the beginning, helping them set goals, accomplish milestones and grow their dreams. Having participated in over 400 renovations for resale and rental, it’s exciting to see my clients succeed and to be a significant part of it.

Investors are different from other kinds of buyers. They don’t have the emotional attachment to properties that home buyers do. They are trying to build wealth or passive income, so our job is to build a relationship with them and make sure that we understand their goals and how we can help them accomplish those goals. I do think a thicker skin is needed to work with investors. For example, since they’re budget minded, we can expect them to ask us to lower our commission. We need to not take that personally and to have a ready answer for why we won’t do it.

It’s important to set boundaries you’re comfortable with. My business model is to work with select investors who do more deals, who renovate the majority of their properties for resale and list with me, regardless of their source for finding the original deal—wholesalers, fellow investors, homeowners, or investing clubs. Loyalty and long-term, repeat business are the priority for me. I have learned to be willing to let people go who want to work with several agents, in order to use my resources to assist the clients who are loyal and value my expertise.

Establishing a strong reputation with is key. When I first started out, I worked with some clients who didn’t want to make needed repairs when they were discovered during inspection. I couldn’t afford to risk my reputation, or the reputation of my other clients, by being associated with them. Firing clients is


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hard to do, especially during lean times but I had to do it. I don’t regret it, and my reputation for having desirable renovations has grown exponentially, but I can’t say it was always easy to let go of listings or clients!

On the other hand, I’ve worked with investors who were just starting out. One client had a dead-end job that he hated, two toddlers, and wanted to get into the business of renovating and selling homes. He did it part-time for three years while he kept his day job, and has now been renovating full-time for four years, with his wife acting as bookkeeper (she has now left her job, too!) We’re currently working with them on twelve projects. We have quarterly reviews to make sure he’s on target to meet his goals, and we tour each project frequently. He’s happily building long-term wealth and providing for his family.


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EXERCISE: ROLE PLAYING PROSPECTIVE INVESTORSWork in teams to role play the following scenarios. If you are the agent working with these prospective investors, what will you ask them? How will you respond to their questions? If you are the investor, what do you want to know? How can you ensure that the agent understands your needs?

STAN NEWMAN Single man in his early 30s wants to make “a quick buck” by fixing

and flipping houses. He lost his job a year ago and is planning to “get

his buddies” to help.

ANGELA BERNAL Single woman, aged 40, wants

a rental property for retirement income. She is caring for an aging parent, but she is also concerned

about her own retirement.

DINO SCALA AND PORTIA DAVIS

Married couple with two young children, interested in renovating and flipping properties. They both have full-time jobs but plan to do the renovation work themselves.

FILIPE AND DEMETRA DELEON

Married couple, 40s, who live in Canada, are looking to invest in

vacation homes for rent to upscale clients. They make occasional visits and may want a property they can

use for vacations.

PAM, PAUL, AND PETER WILSON

Siblings who have inherited a condo from their mother, which is currently occupied by a rental

tenant. They cannot agree whether to keep it or sell it.

MAYA ARON AND CAROLE SYMONS

Professional couple, looking for a 4-flat, to live in one unit and rent

the others.

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module

4Financing Options and Tax Issues


f Identify types of ownership and help clients and customers find sources for financing and choose appropriate financing for achieving investment goals.

f Describe the measurement and impact of positive and negative leverage on real estate investment.

f Alert investors to tax considerations for various investment strategies and transactions, and recommend that they seek advice from tax experts.

Early in the process, before even looking at properties, investors should consider the deal factors that will shape how they own, pay for, and manage taxes for their properties. There is a range of options and each has different considerations for liability, amount at risk, and tax treatment. Because ownership structure, financing, and tax treatment are so closely linked, we will look at these aspects together. Let’s start where investors usually begin—ways to own a property.

FORMS OF OWNERSHIPWhen considering a real estate investment, investors need to consider the forms of ownership. Each has different implications for asset protection, transfer of ownership, taxation, and how the property is financed, improved or used as collateral. Choices depend on the investor's personal situation, financial capabilities, and goals.


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SOLE PROPRIETORSHIPA sole proprietorship is a business owned and run by an individual or spouses. The owners receive the net income as ordinary income, which is taxed at the owner’s personal rate. Simplicity is its main advantage as organizing as a sole proprietorship requires no legal setup, no extra tax reporting, and no additional partners. Its main disadvantage is unlimited liability. Sole proprietorships do not provide any asset protection. In the case of a lawsuit, all of the owner’s personal assets are all at risk.

GENERAL PARTNERSHIPA general partnership is similar to a sole proprietorship in that each of the individual owners is liable for income taxes on his or her share of the business income. Partners are also personally liable for the actions and debts of the partnership. The partnership terminates upon the death, disability, or withdrawal of any one partner. However, most partnership agreements anticipate these types of events; by prior agreement, the remaining partners purchase the departing partner’s share.

LIMITED PARTNERSHIP A limited partnership is structured around a general partner and limited partners, who invest in the enterprise. The general partner has management control and is responsible for all business actions and debts. The limited partners, who contribute capital and have little involvement in day-to-day operations, are not liable for any debts. The advantage for the general partner is access to a pool of capital. The limited partners receive a stream of profits and losses without any of the work of property management.

Until the Tax Reform Act of 1986, syndication of real estate limited partnerships flourished as tax shelters for high-income taxpayers. Before institution of the legislation, limited partners benefited from unlimited pass through of losses, which could offset other ordinary income. TRA ’86 ended this benefit by limiting losses to the amount of investment (the amount at risk) and generally disallowing offset of these losses against ordinary income.

Although its use—or misuse—as a tax shelter has lost its luster, the limited partnership is still a valid ownership option. Today, limited partnership investments are promoted to investors for the income potential.

Module 4: Financing Options and Tax Issues

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LIMITED LIABILITY COMPANY (LLC)Limited liability companies have the advantage of providing asset protection but at the same time avoiding the double taxation that comes with a C corporation. LLCs also limit the owner’s liability to the extent of their investments. They are also easier to set up than corporations, and do not require shareholders or annual meetings. LLCs can have multiple owners (called members), and the members can be individuals or partnerships, trusts, foreign investors, or corporations, each owning different percentages. Most states permit single-member LLCs (although there may be tax consequences for these), but spouses are considered two members when forming an LLC.

The LLC is a pass-through entity that helps the owners avoid paying both corporate and personal taxes. The owner of a one-member LLC does not need to file a separate tax return for the business entity. All of the income and expenses, which are deductible, are reported on the LLC operator’s tax return. On the downside, the single-owner is required to pay self-employment tax on income generated. The challenge for single- owner LLCs is to keep a strict separation between the business entity and the owner’s personal and other business affairs.

S CORPORATIONThe S corporation is a pass-through entity that offers the benefit of limiting the liability of the owners. Owners pay personal income tax on corporate profits, while the corporation reports those taxes under its own corporate tax returns. Owners pay taxes on their salaries, bonuses, and dividends as well as retained earnings. As a separate structure, S corporations require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers, and records maintenance.

S corporation owners are compensated by paying themselves a salary. Excess profits can be distributed as dividends. The S corporation, however, has limited utility as an ownership entity for investment real estate because no more than 25 percent of gross receipts can come from passive activity.

C CORPORATIONThe C Corporation is an independent legal entity owned by the shareholders and is treated as a separate entity for tax purposes. It is separate from those who own, control, and manage it, therefore the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.


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The C Corporation pays corporate tax, and the owners pay personal income tax only on their salaries, bonuses, and dividends. The C Corporation not only has the disadvantage of double taxation, it is also more costly and time-consuming to set-up and operate, and requires additional recordkeeping.

REAL ESTATE INVESTMENT TRUSTS (REITS)REITs are corporations that own and, in many cases, operate income-producing real estate. They operate like mutual funds and their shares are sold on the major exchanges. A mortgage REIT makes or owns loans and other obligations that are secured by real estate collateral. An equity REIT owns an interest in investment real estate. A hybrid REIT combines the investment strategies of the two.

REITs sell publicly traded shares, similar to the stock market, and distribute at least 90 percent of taxable income to shareholders in the form of dividends. REITs do not pay taxes at an entity level, but like limited partnerships and limited liability companies (LLCs), they pass returns through to the investor to be taxed at the individual’s tax rate. The funds provide a way to invest in real estate with relatively small amounts of cash and without the cost or responsibility of direct ownership. REITs, however, offer less control than owning a property because investors own equity in a company, not tangible real estate, which diminishes inflation protection. Because public REITs are traded on equity markets, they are sensitive to market swings.


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Fast Facts About Investment Financing and Rentals13,14

f 64%: Percentage of investors who used a mortgage, 35% did not use a mortgage

f 53%: Percentage of investors who found the difficulty of the mortgage application and approval process not difficult and about as expected

f .05-1.0%: The additional percentage rate compared to a residential mortgage that investors can expect to pay

f 5.6: Average cap rate for apartments in 2018 nationwide

f 74%: Percentage of rental apartments owned by individual investors

f 77%: Percentage of 2-4 Unit rental property owned by individual investors

f 34%: Percentage of U.S. households that rent

f 43%: Percentage of renters who live in single-family homes, 17% of renters live in 2-4 unit rental properties

FINANCING AN INVESTMENT PROPERTYNote: the following discussion of financing options focuses on options for rental properties of less than 5 units. Properties of five units and larger are considered commercial properties and must meet commercial loan underwriting criteria.

LOCAL BANKSThe neighborhood bank probably comes to mind first when investors think about where to turn for financing. Banks provide long-term mortgage financing for acquisitions, as well as, short-term financing for development and construction, and loans for capital improvements, equipment replacement, and lines of credit.


14 Quick Facts and Figures, National Multifamily Housing Council, www.nmhc.org/re-search-insight/quick-facts-figures


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Banks are the source for both FHA and VA mortgage loans. Both types of federally insured loans allow financing of multi-family properties of up to four units if the owner occupies one of the units. Compared to other types of mortgage loans, VA and FHA financing have more liberal allowances for loan-to-value and debt-to-income, require a lower down payment, and will consider rents when approving the loan.

SELLER FINANCINGIf a buyer cannot meet down payment requirements, but can afford payments, seller financing may offer a solution. A strategy to consider is a combination of a 75 percent first mortgage, a 10 percent down payment, and seller carry-back financing of 15 percent. This strategy is allowed by the secondary mortgage market, which purchases second-home loans, and may enable a buyer to avoid private mortgage insurance (PMI) because the first mortgage is less than 80 percent.

PRIVATE MORTGAGESA private mortgage made by a relative, friend, or a third party and secured by the property is another possible strategy. A properly formalized mortgage, serviced by a professional, accords the lender the same rights of foreclosure as a lending institution in the case of default. For the borrower, the loan’s interest is tax deductible. To the private mortgage holder, this interest is income.

Private third-party loans, sometimes called hard money, are often arranged through mortgage brokers. In return for accepting the risk, the lender gains a return in the form of interest payments that exceeds the return from other financial investments. Hard money loans are usually short term and carry a higher interest rate than banks, but the approval process is shorter. The lender tends to focus more on the quality of the property than the borrower does.

A relative or friend making a private loan can set a higher or lower rate than a bank. The private mortgage between family members keeps the money within the family and offers flexibility; payment amounts and due dates can be adjusted or forgiven as the lender sees fit. A handshake or verbal agreement are not enough even between close friends or family members. An attorney or accountant should handle formalization of the agreement. Involving a neutral third party may safeguard personal relationships. On the downside, the personal relationship can suffer if the borrower is erratic in making payments.


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SECOND MORTGAGE AND HOME EQUITY LOANSA home equity loan on a primary residence to finance some or all of an investment purchase is another option. However, as home equity loans tend to be a point or two higher in interest rates, the investors could end up paying more than if they had obtained a mortgage for the entire amount. For high-income or high-net-worth buyers, a home equity line of credit (HELOC) may be the easiest and quickest type of financing to obtain. A line of credit usually has a lower interest rate than a second mortgage and a quicker approval process. Collateral that cannot be disposed of during the life of the loan is a customary requirement for securing the line of credit.

Real estate professionals who work with investors cite the use of home equity financing as a red flag indicating a lack of adequate financial resources. If the investment property fails, the lender could call the loan and the investor’s primary home could be at risk. A HELOC may make sense, however, to pay for short-term renovations before reselling, with the line of credit being paid off and any profits used for the next project. The interest on a HELOC loan is no longer tax deductible.

MORTGAGE BROKERSA mortgage broker is a go-between for the borrower and sources of funds. They are often the conduit between mortgage-backed securities, cash-rich pension funds and life insurance companies, REITS, and private lenders. Investors should look for a mortgage broker who understands investment properties and creative financing, not just primary residences, and can structure a deal accordingly. While mortgage brokers may be able to find better deals than investors can on their own, they also may steer buyers towards lenders who give them the best commissions.

First-time investors may find it easier to work with a mortgage broker who can help them sort through possible options, particularly if the investor has a less than stellar credit rating or can only make a small down payment.

CASH DEALS—PERSONAL SAVINGS AND INHERITANCESAs noted earlier, about 35 percent of investors do not use a mortgage and thus have no need to involve a lender. Owning a property free and clear from the outset will certainly increase the cash flow because there is no annual debt service to eat into bottom-line profits. Depending on the cost of borrowed funds and the potential return on alternative cash investments, borrowed funds—leverage—may actually increase the rate of return on the property.


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Individual investors, acting alone or in limited partnerships, may pay for a real estate purchase with personal savings or with inherited funds. Clients who have recently inherited a property may look to real estate professionals for help in selling the inherited property—particularly one far away from home—and finding another investment property.

CROWDFUNDING: WHAT INVESTORS SHOULD KNOW When the Jumpstart Our Business Startups (JOBS) Act went into effect it opened the door for crowdfunding by allowing “non-accredited” investors to back private companies. Prior to this, an investor had to be accredited which basically meant they had substantial net worth. The JOBS Act gave individual investors the opportunity to add real estate to their portfolio. However, you should caution your clients that while real estate can provide big rewards, it also comes with big risks. Real estate has historically been a stable investment but like all investments is cyclical.

f OPERATES ONLY ONLINE Crowdfunding portals, or platforms, operate solely online. Companies seeking funding may not approach investors directly. The crowdfunding online platform must complete a rigorous SEC registration process.

f THE SEC SETS ANNUAL LIMITS ON BOTH THE AMOUNT AN INDIVIDUAL CAN INVEST AND THE AMOUNT THAT CAN BE COLLECTED FOR A PARTICULAR INVESTMENT. New crowdfunding regulations abolished the general solicitation ban that formerly limited the pool of potential participants to accredited investors only. But the SEC set limits for individual investors based on annual income and net worth not including the value of the investor’s home.

[ If the investor’s annual income or net worth is less than $107,000, the maximum that can be invested within a 12-month period is the greater of either $2,200, or the lesser of 5 percent of annual income or net worth.

[ If the investor’s annual income or net worth is more than $107,000, the maximum that can be invested within a 12-month period is the lesser of 10 percent of annual income or net worth, not to exceed $107,000.

The amount a project sponsor can raise through crowdfunding cannot exceed $1.07 million within a 12-month period.


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f WHAT ARE INVESTORS ACTUALLY INVESTING IN? Crowdfunding of real estate investments can involve actual equity in a property or a debt obligation known as project payment dependent notes, or borrower payment dependent notes.

[ An equity investment gives the investor an ownership stake in the property. Investors receive a share of the rental income, which is usually paid on a quarterly basis.

[ Instead of equity in the property, project payment dependent notes pay the investor a stated interest rate for a specific term depending on the payment of the underlying loan agreement between the funding platform and the project sponsor. As loans are repaid, the investor receives a percentage of the interest, which may be paid monthly or quarterly.

f CROWDFUNDING INVESTMENTS CANNOT BE FREELY SOLD OR TRADED TO ANOTHER INVESTOR. Unlike shares of a publicly traded company or an exchange-listed REIT, shares in a crowdfunded investment cannot be sold whenever the investor wishes. In fact, once an investment is made, the investor has a limited time frame —up to 48 hours prior to the end of the offer period—to back out. Resale or transfer of shares is usually restricted for the first year unless the shares are transferred under specific circumstances, such as death or divorce, or to specified parties, such as the issuing company or a family member.

f WITH FUNDING PLATFORMS SPRINGING UP, HOW CAN AN INVESTOR KNOW WHICH ARE LEGITIMATE? Funding portals—called intermediaries—must register with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA). In addition to FINRA registration, funding portals must make financial disclosures, including financial statements and tax returns. The level of reporting depends on the amount of money to be raised, or the amount the portal has raised in the preceding 12-month period. An intermediary can be checked out by going to FINRA’s BrokerCheck website at http://brokercheck.finra.org, or calling the BrokerCheck hotline at (800) 289-9999. The SEC maintains information about brokers at www.sec.gov.


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f SOME OF THE TOP REAL ESTATE CROWDFUNDING PLATFORMS INCLUDE:15

[ ArborCrowd: First crowdfunding platform launched by a real estate institution

[ RealCrowd: Investors need a minimum of $25,000; investor goes through deal’s sponsor

[ Groundfloor: Investors provide short-term, high-yield loans, secured by real estate

[ CrowdStreet: Minimum investment $25,000, highly selective, growing rapidly

[ PeerStreet: Requires only $1,000 to invest, stable, consistent returns

[ Small Change: For the socially conscious small investor

[ RealtyMogul: Caters to accredited and non-accredited investors

[ Fundrise: No accreditation required, a $500 account minimum

[ Patch of Land: Peer to real estate lending marketplace

[ Realtyshares: Real estate investing platform that gives investors direct access to quality investing opportunities and real estate operators the ability to raise capital

[ FundThatFlip: Works in real estate debt investments (fix and flip loans) as well as multifamily and business loans, lowest LTV of any platform

15 U.S. News, March 27, 2019, 7 Top Real Estate Crowdfunding Platforms, https://money.us-news.com/investing/real-estate-investments/slideshows/best-real-estate-crowdfunding-plat-forms


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CAN AN IRA OWN REAL ESTATE?A traditional IRA, Roth IRA, or SEP can own real estate in a self-directed account. The investor, however, must comply with a set of very specific rules.

f The IRA must have a qualified trustee or custodian to provide administrative services and the title to all IRA assets is vested in the name of the custodian for the benefit of the IRA.

f The IRA cannot purchase property owned by the investor or a disqualified person.16

f Neither the investor nor disqualified persons can receive any personal or indirect benefit from property owned by the IRA; for example, occasional use of a vacation home, or of an office in an owned property.

f The property must be titled in the name of the IRA, not the investor. Property title should be titled, “[Name of the holding institution] Custodian for the benefit of (FBO) of [investor name] IRA.”

f The IRA can purchase property using financing, if the transaction is structured properly, and the loan is non-recourse. The property is subject to unrelated business income tax (UBIT).

f All expenses for the property must be paid from the IRA.

f All income produced must return to and remain in the IRA.

Real estate may be withdrawn from an IRA for use as a residence or vacation home when the owner reaches age 59½; the IRA can sell the property or transfer the title to the owner. Income tax will be due on the current value of the property if it has been held in a traditional IRA; if the property was held in a Roth IRA, there is no tax on the distribution.

16 Disqualified persons include spouse, family members, and certain fiduciaries such as CPAs and financial planners.


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QUALIFYING FOR A LOANThe type and source of financing an investor plans to use should be identified early in the process. How the investor will pay for the property impacts almost every decision point and is crucial to calculating bottom-line income and return on investment.

LENDER PERCEPTIONSHow a lender views a loan applicant can be summarized with the following five “Cs” of credit:

f CHARACTER

[ What is the character of the borrowing individual or firm?

[ Has the borrower ever defaulted on a loan payment?

[ Does he or she have an unblemished borrowing history?

f CAPACITY

[ Does the property have the capacity to produce an income stream?

[ What does the cash flow sheet look like?

[ What is the ability to pay expenses and capital improvements?

[ Has the borrower hired a Certified Property Manager® (CPM®) or an Accredited Management Organization® (AMO®) to manage the property?

f CONDITIONS

[ What are the loan terms?

f COLLATERAL

[ How will the loan be supported?

[ What is the value of the property?

f CAPITAL

[ How much does the borrower have at risk?

[ How much additional capital does the borrower have available to fund unexpected shortfalls or meet other capital needs?


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DEBT-TO-INCOME RATIOS—FRONT AND BACKLenders qualify buyers by determining their debt-to-income (DTI). There are two numbers lenders use: front-end ratio and back-end ratio. What a borrower pays towards a mortgage payment is the front-end ratio, which is determined dividing PITI (principal, interest, taxes, and insurance) by monthly gross income. Lenders generally look for a front-end ratio of 36% or less.

PITI (principal, interest, taxes, insurance) = Front-end ratioGross monthly income

Back-end ratio is the total monthly debt commitments, and is defined as all debt commitments divided by gross income. Total monthly debt commitments include the front-end ratio plus other recurring debt payments such as car, credit card, student loan, alimony/child support and other debt payments.

PITI + debt payments = Back-end ratioGross monthly income

LOAN-TO-VALUE RATIO (LTV)In addition to DTI ratios, lenders use a loan-to-value ratio to assess the safety of loans. The LTV is the ratio that expresses the relationship between the loan and appraised value. It is calculated by dividing the loan amount by the property value and expressed as a percentage. The lower the LTV, the lower the risk to the lender.

Loan amount = Loan to value ratioProperty value

In figuring the LTV, the value may be simply the sales price but appraised value—higher or lower—may be used.

Loans for investment properties typically required lower LTV percentages than residential mortgage loans. Typical investment loan LTVs range from 60 to 75 percent. Some states set maximum LTV limits.


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For example, consider a building that has been appraised at $980,000. Lender A requires an LTV ratio of 75 percent but Lender B will go as high as an LTV ratio of 80 percent.

LOAN A: $980,000 x 75% = $735,000

LOAN B: $980,000 x 80% = $784,000

Which loan has more risk? Loan B would usually be seen as riskier due to the higher loan amount on the same value of property. A higher risk may also call for higher interest rates.

EFFECTIVE INTEREST RATESBecause the interest rate is the major determinant of the investor’s return, an effective interest rate must be calculated to see a complete picture of the cost of borrowing. Effective interest rates for loans are calculated by adding prepaid interest and or penalties to the total interest.

A loan’s effective interest rate will vary from the stated interest rate in the following circumstances:

f Lender points and fees paid at the time of loan origination

f Prepayment penalties for repaying a loan before the loan maturity date

f Lender participation in the property’s income or equity

A shortened term is another common reason for a higher effective interest rate. This isn’t considered additional interest, but is the amortization of up-front additional interest costs over a shorter period of time.

Note that effective interest rates for loans are calculated differently than effective interest rates for savings, which are calculated by compounding the interest.


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LEVERAGEA characteristic that makes real estate notably different from other kinds of investments is its use of leverage—the use of borrowed funds to increase purchasing power. Leverage affects the decision-making process by changing the rate of return an investor earns on equity. It describes how effectively an investor uses debt.

f POSITIVE LEVERAGE When the cost of debt on a property is lower than the rate of return the property can produce free and clear of debt. As a result of borrowing this “relatively cheap” money, the investor increases the actual rate of return on the property.

f NEGATIVE LEVERAGE When the cost of debt on a property is higher than the rate of return the property can produce free and clear of debt. As a result of borrowing this “relatively expensive” money, the investor decreases the actual rate of return on the property. Just because financing a property puts it in a negative leverage position does not mean that an investor should not borrow. Borrowing may be the only way to acquire the investment if there is not enough cash to purchase the property outright. Negative leverage simply tells an investor to be on the lookout for more favorable financing as soon as it may be available.

f NEUTRAL LEVERAGE When the free-and-clear rate of return equals the loan constant, the leverage position is neutral.

DETERMINING LEVERAGEThe leverage position is determined by comparing three critical measures:

f Loan constant (k%)

f Free-and-clear rate of return

f Cash-on-cash rate of return ($/$%)

LOAN CONSTANTThe loan constant (k%) is the percentage of the loan amount that is required annually to make the annual principal and interest payments on the loan. It represents the amount paid for each dollar borrowed. The term “constant” refers to a constant method of calculation, not a constant value. Because


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the loan constant includes both principal and interest payments, it is always higher than the loan’s interest rate, except on interest-only loans, where the loan constant equals the interest rate.

Short-term debt has a higher constant because a larger portion of principal is being paid with each payment. Long-term debt has a lower constant—one closer to the interest rate—because each payment includes a lesser amount of principal.

Loan constants are used to assess the cost of borrowed funds. When shopping for a loan, the investor usually looks for the loan with the lowest constant because it will produce the lowest annual debt service and, consequently, the highest cash flow. The size of debt service has an important effect on cash flow.

FREE-AND-CLEAR OR LEVERAGE?Comparing the free-and-clear rate of return with the loan constant (k%) indicates whether the leverage position is positive, negative, or neutral.

EXAMPLE

Free-and-Clear 30-year, 9.25% loanCost of Property $750,000 $750,000

– Loan – 0 − $600,000= Equity = $750,000 = $150,000

Net Operating Income (NOI) $83,000 $83,000– Annual Debt Service (ADS) – 0 − $59,233

=Before Tax Cash Flow (BTCF) = $83,000 = $23,767

The result of this positive or negative leverage position is reflected in the cash-on-cash rate of return ($/$%).

To determine whether the leverage is positive or negative, calculate the free-and-clear rate of return, the loan constant, and cash-on-cash rate of return:

1. Free-and-Clear Rate of Return = NOI ÷ Value $83,000 ÷ $750,000 = 11.07%

2. Loan Constant (k%) = ADS ÷ Loan Amount $59,233 ÷ $600,000 = 9.87%


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3. Cash-on-Cash Rate of Return ($/$%) = BTCF ÷ Initial Equity $23,767 ÷ $150,000 = 15.84%

4. Free-and-Clear Rate of Return (11.07%) > k% (9.87%) Positive Leverage Thus, $/$% (15.84%) > Free-and-Clear Rate of Return (11.07%)

EQUATIONS

LOAN CONSTANTk% = ADS ÷ Original Loan Amount

EXAMPLE 1:

Consider a property with a loan amount of $150,000 and an ADS of $15,055. The loan constant is 10.04%.

k% = 15,055 ÷ 150,000 = 10.04%

EXAMPLE 2

An investor takes out a 30-year loan of $125,000 for a property at an interest rate of 8.5%. The ADS is $11,533.70. The loan constant is 9.23%.

k% = 11,533.70 ÷ 125,000 = 9.23%

EXAMPLE: COMPARING K %

Property 1: k% = 14% Property 2: k% = 15%NOI: $160,000 NOI: $160,000ADS: 140,000 ADS: 150,000

BTCF: $20,000 BTCF: $10,000

BTCF decreased by half because of the 1% rise in the loan constant.


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FREE-AND-CLEAR RATE OF RETURNFree-and-Clear ROR = NOI ÷ Property Value

EXAMPLE

Consider a property with an NOI of $235,000 and a total property value of $2,300,000. The free-and-clear rate of return for the investor is 10.22%.

235,000 ÷ 2,300,000 = 10.22%

BEFORE TAX CASH FLOWBefore-Tax Cash Flow (BTCF) = NOI − ADS

CASH-ON-CASH RATE OF RETURN ($/$%)$/$% = BTCF ÷ Initial Equity

EXAMPLE

Suppose an investor has invested $990,000 into a property. This year’s NOI was $105,000 and ADS was $42,200. The $/$% is 6.34%

BTCF = 105,000 – 42,200 = $62,800 $/$% = 62,800 ÷ 990,000 = 6.34%

LEVERAGE

POSITIVE LEVERAGE

f If: Free-and-Clear ROR > k%

f Then: $/$% > Free-and-Clear ROR

NEGATIVE LEVERAGE

f If: Free-and-Clear ROR < k%

f Then: $/$% < Free-and-Clear ROR

NEUTRAL LEVERAGE

f If: Free-and-Clear ROR = k%


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Prepayment Penalties on Commercial LoansUnlike residential mortgage loans, investment loans may contain penalties for paying off the loan before its maturity date. Although, many commercial lenders allow loans to be paid off early without penalty under certain circumstances. There are several types of prepayment penalties when dealing with commercial mortgage lenders: yield maintenance, declining, lockout, and defeasance. The prepayment penalty on commercial loans is usually negotiated at the start when the lender prepares a Term Sheet. Make sure your client understands the terms of their loan.

TAX CONSIDERATIONS FOR REAL ESTATE INVESTORSAs noted in chapter one, the basic financial reasons for owning investment real estate are rental income and value appreciation. In addition to these dollar-and-cents reasons, investment real estate benefits from deductions for expenses, cost recovery, and mortgage interest, exemptions for depreciation, and lower capital gains taxes.

The following discussion presents the basic tax benefits and concerns a real estate professional should know about. It is not intended to make the practitioner an expert on investment tax matters. Real estate professionals should alert their clients to tax issues and encourage them to contact tax professionals for expert guidance.

INCOME CLASSIFICATIONIRS regulations classify income as follows:

f ACTIVE Income and losses from salaries, wages, tips, commissions, and other trade or business activities in which a taxpayer materially participates

f PORTFOLIO Income and losses from interest, dividends, capital gains, and royalties

f PASSIVE There are three subcategories of passive income:

[ Investments in which the taxpayer does not materially participate. Material participation means involvement in the operations of an activity throughout the year on a regular, continuous, and substantial basis.


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[ Limited business interest includes interest in investments in which the taxpayer’s liability is limited, for example, a limited partnership. Partners receive a K-1, which reports their portion of the property’s income and cost recovery.

[ Most rental activity is specifically included in the passive income category, whether the taxpayer materially participates or not. Rental activity produces income that consists of payments for the use of tangible property not the performance of services.

PASSIVE INCOMEThese distinctions are important for real estate investors because income from real estate, such as rents, is considered passive income unless the owner meets very specific criteria for active or material participation. Furthermore, losses from passive activities can only offset income from other passive activities.

Any resulting net passive income is fully taxable in the year generated. The passive income is added to the taxable income from other income categories. Any resulting net passive loss is generally suspended until it can be used to offset net passive income generated in a future tax year or until the owner disposes of the property. Net losses from passive activities are allocated each year to those passive activities experiencing losses. Suspended passive losses may be carried forward indefinitely.

The suspended losses attributed to a property that have not been used against other income in previous years can be used to reduce taxable gains when the entire interest is sold to an unrelated third party in a taxable transaction. Offsetting ordinary income with the losses is better than using them to reduce capital gains on the property’s sale because ordinary income is taxed at a higher rate than capital gains.

Because income and losses from all passive activities are aggregated, the tax code provides a method for allocating excess losses to a particular property. Generally, the portion of the suspended loss attributable to a specific property depends on the ratio of the loss from the property to the total loss from all passive activities. Suspended losses are deductible against income at the time of sale in a specific order—first, any gain recognized on the transaction; second, net income or gain for the tax year from all passive activities; third, active or portfolio income when interest in the activity is sold. If the losses attributable to a property have already been used to offset income from other passive activities, the taxpayer cannot use them again at disposition.


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EXEMPTIONS AND EXCEPTIONSA limited exemption to the passive loss rules is available for taxpayers who invest in rental real estate. If three conditions are met, the taxpayer may offset up to $25,000 in losses from real estate activities against non-passive income:

f ADJUSTED GROSS INCOME LIMIT The taxpayer must have an adjusted gross income (AGI) of less than $150,000. For every AGI dollar over $100,000, the $25,000 allowance is reduced by 50 percent. Therefore, the $25,000 exception is totally eliminated when AGI reaches $150,000.

f ACTIVE PARTICIPATION The taxpayer must actively participate in the investment. Active participation is not the same as material participation—a distinction that applies only to this limited exception. A taxpayer who actively participates makes management decisions or arranges to have others provide services (such as repairs) in a significant sense. Relevant management decisions include approving new tenants, rental terms, capital and repair expenditures, and other similar decisions.

f 10 PERCENT INTEREST The taxpayer must own at least a 10 percent interest in the investment—but not as a limited partner.

The taxpayer can offset active income under this exception only if net passive losses exist. Passive losses in excess of the $25,000 exception are suspended and carried forward subject to the same restrictions as other passive losses. If, due to insufficient active income, a taxpayer cannot use any of the passive losses under this exception, the unused loss becomes an active loss that can be carried back or forward.

To learn more, go to: https://www.irs.gov/pub/irs-pdf/p925.pdf.

INCOME TAX DEDUCTIONS The tax code specifies allowable deductions from income to determine taxable income. These deductions include the following:

f OPERATING EXPENSES Tax laws provide for deductions for all expenses related to the production of income. These deductions include operating expenses.

f MORTGAGE INTEREST Only the interest portion of the annual debt service may be deducted to calculate taxable income.


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f COST RECOVERY The tax code allows an annual deduction for the diminishing economic life of the building, fixtures, furnishings, landscaping, yard improvements, and mechanical systems.

COST RECOVERY (DEPRECIATION) Deductions for cost recovery, also referred to as depreciation, provide another tax benefit of investment real estate. The deduction for cost recovery relies on the premise that real estate is a wasting asset. That means the asset loses value with age and use. Therefore, under federal tax law, the owner may take a deduction from taxable income for the tangible property used up (through exhaustion, wear and tear, and normal obsolescence) in a trade or business or for the production of income.

Cost recovery reduces the net taxable income of the property. However, the deductions do not represent cash payments and therefore have no impact on cash flow. They are a “paper” expense only that is recognized on the taxpayer’s income tax form.

Cost recovery deductions are most often calculated using percentage tables provided in IRS Publication 946, How to Depreciate Property.

To learn more, go to: https://www.irs.gov/pub/irs-pdf/p946.pdf.

CATEGORIZE PROPERTY COMPONENTSFor depreciation purposes, the components of a real property—building, appliances, furnishings, mechanical systems, landscaping—are categorized, or bifurcated. Each of the components is depreciated on a separate schedule based on its economic life. For example, appliances and furnishings are depreciated over a span of 5 years and landscaping over 15 years. In the straight-line method, you deduct the same amount of depreciation each year over the useful life of the property. Rental real estate placed in use after 1986 must use the straight-line method. Straight-line cost recovery may also be elected for other types of property.

Land is never depreciated. Therefore, the value of the land, as if vacant and unimproved, must be subtracted from the total value of the property. In some resort markets, the land value is quite high which substantially lowers the amount available for depreciation.


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DEPRECIATION RECAPTUREWhen a depreciated property is sold, the amount of tax benefit that has accumulated over the years of ownership is calculated—recaptured—and taxed at a rate of 25 percent. This is in addition to capital gains tax.

CONSULT A TAX PROFESSIONALPractitioners should encourage clients to consult with a tax professional on these matters. Categorizing property components, setting up a depreciation schedule, calculating yearly cost recovery deductions, and determining depreciation recapture and capital gain on a future sale are all rather complex processes with numerous exceptions and nuances in the tax code.

CAPITAL GAINSWhen you invest in the real estate market, the home or property you invest in is a capital asset. When you sell this asset, the difference between the adjusted basis in the asset and the amount you realized from the sale is known as a capital gain when you sell the asset for more than your adjusted basis, or a capital loss if you sell the asset for less. Losses are not tax deductible.

SHORT-TERM OR LONG-TERMCapital gains and losses are classified as long-term or short-term. For the most part, if you hold the asset for more than one year before selling it, your capital gain or loss is considered long-term. There are exceptions to this rule. Review IRS Publication 544 and Publication 550 for the most current information on Sales and Disposition of Assets and Investment Income and Expenses.

CAPITAL GAIN TAX RATESIf you have a net capital gain, a lower tax rate may apply to the gain than the tax rate that applies to your ordinary income. The term "net capital gain" means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss for the year. The term "net long-term capital gain" means long-term capital gains reduced by long-term capital losses including any unused long-term capital loss carried over from previous years. The tax rate on most net capital gain is no higher than 15% for most taxpayers. Some or all net capital gain may be taxed at 0% if you're in the 10% or 12% ordinary income tax brackets. However, a 20% tax rate on net capital gain applies to the extent that a taxpayer's taxable income exceeds the thresholds set for the 37% ordinary tax rate ($425,800 for single; $479,000 for married filing jointly or qualifying widow(er); $452,400 for head of household, and $239,500 for married filing separately).


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NET INVESTMENT INCOME TAXThose taxpayers who realize significant investment income may be subject to the Net Investment Income Tax (NIIT). You can learn more about this in IRS Topic #559.

To learn more go to www.irs.gov/taxtopics/tc409.

TAX-DEFERRED 1031 EXCHANGESUnderstanding the rules for tax-deferred 1031 exchanges is important, as rental and investment properties may be acquired or disposed of using this tax-deferral method. A real estate professional should be able to recognize situations in which a 1031 exchange would be permissible and advantageous to a client and assist clients in finding the needed experts to carry out the exchange.

Few exchanges involve a simple trade of titles and keys for two equally valued properties. Tax-deferred 1031 exchanges are very complex transactions with specific requirements and restrictions on possession and disposition of property and monies. Although not required by law, the involvement of a qualified intermediary is essential for successful completion of the transaction.

A 1031 exchange postpones but does not eliminate taxes, although with the basis step-up that occurs when a property is transferred to an heir, capital gains taxes are in essence forgiven at that time.

Recent changes by the government in the form of the Tax Cut and Jobs Act that went into effect on January 1, 2018, affected 1031 exchanges and included the complete repeal of personal property exchanges. Personal property that is not held for rental, investment, or use in a trade or business is not considered to be qualified use personal property and will not qualify for 1031 Exchange treatment. This law-limited exchange to only real estate.

That being said, personal property must be of like-kind or like-class to qualify for tax-deferred exchange treatment. Like-kind property reflects the same nature, character, or class. Most real estate will be like-kind transactions; however, U.S. real estate property may not be like-kind to property located outside of the U.S.

A 1031 exchange involves an exchange of like-kind real estate. It is treated under the tax code as a continuation of the ownership of the property instead of a taxable sale. The tax-deferred exchange of assets is neither a tax loophole nor a privilege available only to wealthy investors. It is a method of equity


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preservation available to all owners of investment and trade or business property. The benefits extend beyond conserving capital assets. Tax-deferred exchanges can be used to:

f Increase equity by deferring capital gains tax.

f Acquire property with more appreciation potential.

f Consolidate assets by combining several properties into one larger asset or diversify holdings by exchanging one large asset for several smaller ones.

f Acquire a future retirement residence. (Special rules apply.)

f Divide real estate holdings prior to distribution to heirs.

f Relocate or increase investment holdings in another location.

f Obtain space for business expansion.

f Dispose of underperforming property.

f Increase net cash flows by acquiring a property with better financing.

f Obtain non-taxable cash by acquiring property that can be mortgaged. (Special rules apply.)

f Increase depreciable property basis by acquiring higher-value property or exchanging bare land for improved property.

f Increase estate value by acquiring properties that are more valuable.


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BASIC RULES FOR TAX-DEFERRED 1031 EXCHANGES

f The properties, both old and new, must be used in trade or business or held for investment. Property that is held for resale is considered dealer property and is not eligible for a 1031 exchange. A personal residence is not eligible for exchange.

f Property must be exchanged for like-kind property. Investors sometimes erroneously think they must acquire a replacement property exactly like the relinquished property. Like-kind does not refer to the type of property; instead, it addresses the use of the property. A property used in trade or business or held for investment must be exchanged for property to be used in trade or business or held for investment. Some examples of like-kind are a rental house for a multiunit rental, bare land for an apartment building, ranch land for an office building, or several rental houses for an office building.

[ Both the purchase price and the new loan amount has to be the same or higher on the replacement property.

f The names of titleholders on the replacement property must match those on the title of the relinquished property.

f Replacement property must be identified within 45 days of transferring the relinquished property.

f The replacement property must be acquired (closed) within 180 days of transferring the exchange property or the tax filing deadline, whichever comes first. The tax filing deadline can be extended to preserve the 180-day replacement method.

f There is no limit on the number of properties that may be relinquished.

[ Types of real property that qualify for a 1031 Exchange:

[ Unimproved property for improved property

[ Fee for a leasehold with 30 or more years

[ Vacant land for a commercial building

[ Duplex for a retail property

[ Single-family rental for a multi-family apartment

[ Industrial property for rental vacation property in a resort area


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f A personal residence is not eligible for 1031 exchange

f Cash or non-like-kind property, known as boot, received in an exchange is taxable. For example, if an exchanger acquires a replacement property of lesser value than the relinquished property, the resulting cash out would be taxable. Mortgage relief is also considered taxable boot. The tax will be less than the amount of capital gains tax owed and can never exceed what would be owed on a sale.

DOCUMENTING THE INTENT TO EXCHANGEWhen the intent is to transfer and acquire property through a tax-deferred 1031 exchange, the purchase and sale agreement (or an addendum) should contain language reflecting the exchanger’s intent and requesting the other party’s cooperation. If the exchanger decides prior to closing not to proceed with the exchange, the transaction is simply closed as a taxable transaction. The wording could be as follows: “It is the intent of the seller to perform a Section 1031 exchange, and the buyer is asked to cooperate by signing an Assignment Agreement at no cost or liability to the buyer.”

To learn more about current guidelines regarding 1031 exchanges review this website: www.ipx1031.com/1031-tax-reform-updates/.

FOREIGN INVESTORSForeign buyers and sellers want to know how U.S. tax law applies to them. Although real estate professionals should not give advice on tax matters, they should have general knowledge of how real estate transactions involving foreign ownership are taxed. When real estate professionals know about tax regulations and processes, they can alert their clients to tax considerations and guide them to seek expert advice.

As a basic principle, all transactions by foreign buyers and sellers of U.S. real estate are U.S.-sourced and therefore subject to U.S. taxes on income and sales. Foreign individuals who meet certain criteria are also subject to U.S. income tax. Failure to comply in a timely manner with U.S. tax regulations can trigger serious consequences for a buyer, seller, or real estate professional.


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DEFINITION OF RESIDENT STATUS FOR U.S. TAX PURPOSES The primary consideration in determining how federal tax laws apply to foreign investors is residency.

f U.S. CITIZEN Taxed on worldwide income; credits are allowed for foreign taxes paid

f RESIDENT ALIEN Taxed on worldwide income; credits are allowed for foreign taxes paid

Caution: Do not confuse these tax-resident definitions with immigration and visa classifications.

TAX TREATIESThe United States maintains tax treaties with a number of countries. These agreements do not necessarily limit or reduce the amount of taxes due in relation to the U.S. real property interest, but they do prevent double-taxation. Tax treaties change frequently. For up-to-date information on U.S. tax treaties go to www.irs.gov and type “treaties” in the search bar.

FATCAThe Foreign Account Tax Compliance Act (FATCA), effective in 2014, targets tax non-compliance by U.S. taxpayers with foreign accounts, but has broader implications for transactions with foreign investors. FATCA requires foreign financial institutions (FFIs) and U.S. withholding agents to implement procedures for tax information reporting and withholding, account identification, and documentation. It also requires certain FFIs to enter into an agreement with the United States (an FFI Agreement). As an alternative, certain countries have entered into intergovernmental agreements (IGAs) with the U.S. to overcome legal impediments that prevented FFIs from entering into FFI Agreements.

Real estate professionals should recommend that clients who may be subject to FATCA reporting consult a tax professional for guidance on complying with regulations.


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FOREIGN INVESTMENT IN REAL PROPERTY TAX ACT (FIRPTA)A foreign owner’s first contact with the U.S. income tax system may occur at the time of sale, when money is withheld to comply with the Foreign Investment in Real Property Tax Act (FIRPTA).

The basic requirement of FIRPTA is this: when a U.S. real property is purchased from a foreign seller, the buyer, or withholding agent, must withhold a specified percent of the sale price—currently 15%—and forward the amount to the IRS within 20 days after the transaction closing. The actual amount of tax is calculated and paid when the seller files an income tax return. Any tax paid in excess of the required withholding is returned to the seller.

Basic guidelines are as follows:

f If the sales price (the amount realized) is $300,000 or less and the buyer will use the property as a residence, no reporting or withholding is required.

f If the amount realized is more than $300,000 but less than $1 million and the buyer will use the property as a residence, then the withholding rate is 10 percent on the full amount realized (not the net sale proceeds).

f In order to be classified as residential property, the buyer must have definite plans to reside at the property for at least 50 percent of the time the property is in use during the first two years after the date of the transaction.

f If the amount realized is $1 million or more, the withholding rate is 15 percent on the entire amount, regardless of use by the buyer.

In addition to the under $300,000 threshold for residences noted above, transactions might be exempt from FIRPTA withholding if:

f The IRS provides a statement to the buyer that the seller is exempt from withholding or has made satisfactory arrangements.

f The seller furnishes an affidavit certifying that the seller is not a foreign person.

Real estate professionals for the buyer or seller can be held liable for up to the amount of their commissions if they fail to disclose to the buyer their knowledge of the sellers’ false certifications or false claims of exemption from withholding.


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WITHHOLDING AGENTSThe process of FIRPTA withholding and reporting may be handled as part of the transaction closing. The withholding agent may be an attorney, a CPA, or the real estate broker. A withholding agent who fails to properly withhold and report may be liable for the tax. This can have very serious consequences, particularly if there are large sums of money involved, as is often the case in real estate transactions.

A real estate professional who serves as a withholding agent, may be personally liable for the full amount of FIRPTA withholding tax required plus interest and penalties. A withholding agent is generally any person who pays an amount to the foreign person that is subject to withholding.17

FIRPTA does not require disclosure of a foreign person’s identity during the ownership phase of a U.S. real property investment, but it does necessitate disclosure of identity on various documents at the time of sale.

FIRPTA AND COMMERCIAL REAL ESTATESale of a commercial property is subject to 15 percent withholding. This regulation is particularly costly to a foreign seller if the sale will be at a loss or if the foreign seller's tax liability will be less than the 15 percent withholding. The foreign seller can apply to the IRS for a reduction of the withholding; however, the IRS review can take up to 90 days. During this time, the seller does not have access to the funds that exceed the amount he or she will ultimately owe in taxes.

In addition to withholding funds at the time of sale, FIRPTA requires a foreign investor who holds U.S. real estate as a passive investment (i.e., with any type of net lease) to withhold 35 percent of the gross rental income.

To learn more about current guidelines regarding FIRPTA review this website: www.irs.gov/individuals/international-taxpayers/firpta-withholding.

17 The IRS defines a withholding agent as any person having the control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding.


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2018 TAX CUTS AND JOBS ACT (TCJA)The 2018 Tax Cuts and Jobs Act applies to tax years after 2017 and before 2026 and contains substantial benefits for real estate investors. In general, be aware of:

f SECTION 199A – PASS THROUGH DEDUCTIONS

[ The 199A provision provides a new 20% deduction on pass through income for sole proprietors, LLCs and S-corporations that allow the corporations not to pay income taxes. Instead, those taxes are “passed through” to the owner.

[ Taxable income must be lower than $157,500 if filing as an individual or $315,000 when filing married/jointly.

f 100% BONUS DEPRECIATION (SECTION 168K)

[ Temporary rule and the 100% rate will reduce to 80% in 2023 and lower in the following years.

[ Something that depreciates in 20 years or less can be fully written off the first year. Machinery, equipment, computers, appliances, and furniture generally qualify.

f Interest on home equity lines of credit is no longer deductible.

f HIGHER SECTION 179 DEDUCTION

[ The section 179 deduction is an immediate deduction for the full cost of qualified tangible personal property used in a trade or business, instead of depreciating it over a number of years.

[ Included items such as refrigerator, water heater, stove, HVAC unit.

[ There is a 1 million limit each year.

[ Expanded types of property that can qualify and now includes roofs, HVAC and fire alarms for only NON-RESIDENTIAL buildings.

f LIKE KIND EXCHANGES (SECTION 1031)

[ Eliminates tax deferred like kind exchanges treatment for exchanges of personal property. From now on these exchanges will be limited to real property.


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f REAL ESTATE INVESTMENT TRUST (REITS) RECEIVE A VERY FAVORABLE TREATMENT.

[ For the very first time, REITS can claim a 20% deduction on qualified business income.

[ New pass through rules drop the top marginal tax rate from 39.6% to 29.6%.

f The “Real Estate Professional” classification is no longer recognized in the IRS tax code.


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EXERCISE: PUTTING IT ALL TOGETHERUse the description of the rental property and answer the questions that follow:

A 4-unit rental property has the following income and expense figures:

f Initial investment = $181,500

f Gross potential income = $143,600

f Effective gross income = $129,200

f Operating expenses = $33,200

f Net operating income = $96,000

f Annual debt service = $45,000

f Loan amount = $478,500

f Property value = $660,000

1. WHAT IS THE LTV? (see page 83)

______________________________________________________________

______________________________________________________________

______________________________________________________________

2. HOW RISKY WOULD YOU CONSIDER THIS LOAN? (see page 83)

______________________________________________________________

______________________________________________________________

______________________________________________________________

3. IF ALLOWABLE LTV IS 85, HOW MUCH CAN BE BORROWED?

______________________________________________________________

______________________________________________________________

______________________________________________________________

4. WHAT IS THE FREE-AND-CLEAR RATE OF RETURN? (see page 88)

______________________________________________________________

______________________________________________________________

______________________________________________________________


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5. WHAT IS THE LOAN CONSTANT FOR THE LOAN ON THIS PROPERTY? (see page 87)

______________________________________________________________

______________________________________________________________

______________________________________________________________

6. WHAT IS THE CASH-ON-CASH RATE OF RETURN? (see page 88)

______________________________________________________________

______________________________________________________________

______________________________________________________________

7. IS THIS PROPERTY IN A POSITIVE OR NEGATIVE LEVERAGE POSITION? (see page 88)

______________________________________________________________

______________________________________________________________

______________________________________________________________

8. UNDER WHAT CIRCUMSTANCES MIGHT THE INVESTOR USE NEGATIVE LEVERAGE? (see page 88)

______________________________________________________________

______________________________________________________________

______________________________________________________________

9. WHAT IS THE MINIMUM BREAK-EVEN POINT FOR THIS PROPERTY? Hint: (operating expenses + annual debt service) ÷ gross potential income = break-even point

______________________________________________________________

______________________________________________________________

______________________________________________________________


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Jay Rinehart, GRI, CRS Rinehart Realty Rock Hill, South Carolina [email protected] www.rinehartrealty.com

When it comes to choosing an ownership entity, there are many things to consider. Of course, there are the tax consequences, and risk considerations. But there are also privacy considerations. An individual who doesn’t want their name associated with an investment, for personal or professional reasons, may choose to invest as LLC.

It’s also important for the investor to consider overall investment goals. For someone just starting out with one or two properties, it probably makes sense to begin as an individual investor. But over time, if they acquire more properties, they are going to want to start looking to investing as an entity, since an individual owner can’t have more than five secondary market loans at one time (including his home).

Entities are not eligible for secondary market loans, so the kind of financing you have is going to be a large part of the decisions you make. Not just what entity you choose, but also the kinds of property you buy and the margins you can expect. If you’re planning to purchase any kind of commercial property (and multifamily units over four units count as commercial), then you will have to invest as an entity and find shorter term loans outside of the secondary markets.

The biggest mistake most investors make is not considering the impact the interest rate their loan has on their margins. If an investor has a 5-year loan, they need to consider what the interest rate will be in year six, and what impact that will have on their margin. I recommend people look at historic norms.

Anyone considering investing should always have a good tax advisor. The best advice I can offer is to find someone who has experience advising people who have invested in rental properties. Then they will have the expertise to advise you about the best way to structure your investments, and they will know how to file your entity returns. Of course, you can always get referrals from people


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you know, but I wouldn’t rely on that. Take the time to interview them. Pay for their time, if you need to. It will be worth it to find the right person, who can make a commitment to you for the long haul, who can give you good advice, and who isn’t just telling you what you want to hear.

If someone asks me if a real estate professional should invest in real estate, I say “Why not? If you sell the product, why wouldn’t you want to invest in it?” Of course, I grew up in this business. My parents bought their first rental property before they bought our first family home, so I may be biased.

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module

5Owning the Property

AFTER YOU COMPLETE THIS MODULE, YOU WILL BE ABLE TO:

f Help investors consider pros and cons of managing their own investment properties versus hiring a property manager.

f Describe techniques for developing and managing tenant relationships, including tenant and manager rights.

f Suggest exit strategies for owners who want to divest of investment properties.

Whether a rental property is self-managed or managed by a professional property manager, the management tasks are the same. The frequency and complexity may vary depending on the size of the property, but the tasks themselves are consistent and fall into five general areas:

f Renting the property

f Managing tenants

f Maintenance

f Insurance and risk management

f Fiscal management

In this chapter, we will look at aspects of all of these tasks. As information is presented, real estate professionals who want to invest in property, or offer property management services, should consider how these principles and situations apply to them.


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PROPERTY MANAGEMENT: SELF-MANAGERSRental property owners must decide whether to manage their properties themselves or hire professional property managers. The primary reason most investors choose to self-manage is cost. Self-management helps save the expense of property management fees. However, this fails to put a value on the time of the investor. According to some estimates, landlords can expect to spend about four hours a week managing a rental.18 Emergencies seldom happen when it is convenient, so self-managers have to be prepared to handle problems whenever they arise. Managing a rental property, even one with long-term, stable tenants, and minimal maintenance still requires considerable time and attention. Self-management may also be impractical for investors who don’t live in close proximity to the property. Moreover, single-family houses require more time, resources, and logistical considerations when it comes to operation and maintenance, because they are in multiple locations.

Investors should consider not just whether they have sufficient time, but also whether they have the necessary temperament and skills for the job.

f PROBLEM SOLVING Managers need problem solving skills to assess situations and make decisions involving tenants, maintenance issues, financial calculations, and legal situations.

f COMMUNICATION Managing properties is not just about managing assets, it is about working with people. Properties need to be advertised, tenants interviewed, contractors hired, and conflicts resolved. Investors with poor communication skills or those uncomfortable working with people should reconsider self-management.

f ATTENTION TO DETAIL Property managers are operating a business, and as such must deal with financial data, monetary transactions, and legal documents. They should be comfortable with detail and organized with paperwork.

f PATIENCE Property managers require patience and need to remain impassive in challenging situations to be successful. Tenants who are having personal problems, for example, may ask for special treatment. It is important for the property manager to be fair, firm, and friendly to

18 Brenton Hayden, “Top 10 Reasons You Need a Property Manager,” REALTOR® Magazine. September 2015.

Module 5: Owning the Property

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all prospects and tenants, and to treat them impartially. To enforce policies and rent collection rules, the manager must remain positive, unemotional, and non-confrontational.

In addition to personal qualities, a property manager needs a comprehensive knowledge base in many different areas, including rental laws and regulations, maintenance and repairs, financial and accounting practices, advertising strategies, and leasing tactics.

PROPERTY MANAGEMENT: PROPERTY MANAGERHiring a professional property manager is desirable when an owner lacks the time, temperament, inclination, or proximity to manage the property.

It’s important to choose a management company that is professional, reputable, and experienced. An effective property manager can also ensure that an investor gets maximum value from the investment. So, it is worth the time to do the research to find the best manager for the property. Ask for recommendations from friends, colleagues, and local professional associations, and don’t forget to ask for the names of companies to avoid, as well those to hire. Find out if their rates are competitive. Search online databases for real estate management associations such as the Institute of Real Estate Management (IREM) at www.irem.org and the National Association of Residential Property Managers (NARPM) at www.narpm.org. Check references from the management company, and contact clients with similar properties who have a long track record with the company. Check online review sites, as well as, the Better Business Bureau to read opinions from others who have used a particular company or manager.

INTERVIEWING A MANAGEMENT COMPANY It’s a good idea to visit the management company’s office and interview the prospective property manager. Questions to ask include:

f How many years of experience do you have?

f What management services do you provide? Can I have that in writing?

f How do you structure your fees? Are there fees when the property is vacant?

f How do you screen tenants?

f What kind of insurance coverage do you have? Are employees bonded?


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f How are funds for different properties handled? Is there a single account for all properties or an individual account for each?

f How do you stay current on local, state, and federal laws?

f How often do you communicate with clients and how do you present reports?

f How quickly do you get properties on the market?

f What are your average vacancy rates?

MANAGEMENT COMPANY BEST PRACTICESHere are a few best practices that all professional property management companies should adhere to:

f OWNER’S OBJECTIVES The management company should confirm the owner’s objectives for the property in writing. The owner’s goals may require different management strategies and determine the primary direction for the management of the property. These objectives should be reflected in the management agreement.

f MANAGEMENT AGREEMENT A written management agreement establishes the business relationship between the management company and the client. The management agreement defines the manager’s authority and compensation for services provided, outlines procedures, specifies limits of the manager’s authority and actions, states financial and other responsibilities of the property owner, and provides for termination of the agreement at a certain time or under specific conditions. The management company should not act beyond what is specified in the management agreement without documented client approval.

f OPERATING REPORTS The management company should provide financial and operating reports to the client on a regular, timely basis in accordance with the client’s instructions with respect to content, format, and frequency. Reports to the client represent the primary communications link between the management company and the client, and form the basis for determining the performance of the property, as well as, the client’s assessment of the performance of the management company.

f MAINTENANCE PLAN The management company should have a pre-determined plan in place that ensures that most maintenance requests can be addressed in an agreed-upon timeframe (such as within 48 hours).


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f PROPERTY AUDIT The management company should recommend that the client perform an annual review or financial audit of property operations and cooperate in the conduct of a financial audit.

f PROPERTY INSURANCE The management company should help clients identify insurance needs and acquire and maintain appropriate policies.

f PROPERTY TAXES The management company should assist and support the client in complying with all property tax obligations and appealing tax levels and assessments when requested by the client.

PROPERTY MANAGEMENT FOR OTHERSWhen considering expanding a skill set to include real estate investments, real estate professionals might also consider adding property management. Managing properties can be a way to ease into investing and can provide a reliable income stream. Property managers may be paid by a percentage of rental payments, flat service fees, or a menu of services for fees. Real estate professionals who manage properties are the agents of the owner. Although not as lucrative as sales, it can provide a steady base income to see the practitioner through periods of lean sales. Plus, managing properties puts you in touch with owners who may become sellers and renters who may become buyers.

Managing property, however, entails a different set of liabilities than sales and requires different E & O insurance coverage. States vary on the licensing requirements for property managers; some require a real estate license, others a separate license or permit for property management, and some do not regulate it at all.

A practitioner who wants to start a property management business can adapt core prospecting skills to find properties and renters. You could start by looking around your area for unsold properties, rental signs, and builder inventory. In a down market, when properties are not selling, owners may be willing to rent their properties. Also, go back to the basics—your spheres of influence within the real estate market. In addition, don’t count out word-of-mouth referrals.

Before you decide to launch a property management business, talk to other practitioners in the field and complete some training in the basics, such as through the Institute for Real Estate Management. Go to www.IREM.org.19

19 Adapted from Home Sweet (Second) Home: Vacation, Investment, Luxury Properties. Real Estate Buyer’s Agent Council, www.rebac.net.


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QUALITIES EVERY PROPERTY MANAGER SHOULD HAVEWhether you’re a real estate agent looking to add to your income stream by becoming a property manager or you’re an agent assisting someone who is looking to hire a property manager, there are several important qualities this person should exhibit. Over-arching all of these qualities is a candidate’s commitment to ongoing education about the industry. Find out what they read and how they learn about changes in the industry.20

EXPERIENCE

Make sure to ask the right questions during the interview to understand how many properties they have managed, whether or not they understand local regulations and real estate laws, and basic operating procedures associated with property management.

INVESTOR MINDSET

This assures you that the property manager understands the “big picture” and uses this as the basis for making important business decisions such as what to spend money on.

PATIENCE

Property managers deal with a variety of people, from contractors who fall behind schedule or don’t do the work as requested to demanding tenants. During the interview, look for someone who is willing to listen and reflects good customer service skills.

AGGRESSIVENESS

In balance with being patient, a property manager also needs to know when more aggressive action is necessary. For instance, tracking down late rental payments or making sure a contractor completes a job on time.

PROFESSIONALISM

Property managers must get along with residents, contractors, and others in a professional manner—respectful, but firm.

20 Adapted from 10 Qualities to look for when hiring your next property manager, Amanda Maher, Buildum, www.buildium.com/blog/10-qualities-of-a-good-property-manager/


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STRONG COMMUNICATOR

This job requires exceptional written and oral communication skills. Clear, precise communication can minimize disputes and provide the property owner with peace of mind.

ORGANIZATION

Property managers typically manage multiple properties and within each individual property there can be a multitude of activity so organization skills are key. Ask candidates to give you an example of how they stayed organized on one of their busiest days.

TECH-SAVVY

Just like every other industry, the property management industry is constantly being introduced to new technologies. Understand if the candidate is comfortable with current technology and ask how they keep up with this aspect of the industry.

FLEXIBILITY

Inevitably, something will go wrong. During the interview, ask what they would do if a tenant stops paying rent or the lawn maintenance people stopped showing up.

INGENUITY

Some candidates might reveal their ability to think outside the box. This refreshing quality can be a benefit down the road.

PROPERTY MAINTENANCERegular and timely maintenance reduces operating expenses due to more efficient use of time and labor. Deferring maintenance on issues may result in more complex and expensive repairs later on. Planned, scheduled, proactive maintenance helps extend the useful life of a building. While emergencies will happen despite the best planning, keeping the property in optimal condition helps limit the occurrence of expensive and disruptive reactive maintenance.

Maintaining the property will not only increase tenant satisfaction and foster a satisfactory relationship, it is more likely to result in lease renewals and higher rents. Tenants should be encouraged to report problems as soon as they are discovered, so they can be addressed as soon as possible. Respond quickly


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to tenants’ complaints and take care to document responses. Self-managers should consider developing a property manual with information on contacts and how tenants should handle maintenance issues and emergencies during the day, after hours, and on weekends and holidays.

PROPERTY INSPECTIONSThrough regular inspections, owners and managers can anticipate problems, address them promptly, and thus reduce the extent of maintenance work and related expenditures. Furthermore, inspections are the best way to identify risks. An owner or manager should visit the property at least monthly to view the premises and inspect for any maintenance issues. Using a property inspection app or worksheet ensures that all physical components, as well as, building systems are inspected and any problems are noted. A sample Property Inspection Worksheet can be found in the Resource Section at the end of this course manual.

The property should be inspected regularly as part of the maintenance program, and paperwork should be retained to demonstrate how problems were addressed, in case of future litigation.

WORKING WITH CONTRACTORSOne of the largest expenses for a rental property is maintenance and an investor should ensure that they have sufficient cash flow and reserves to handle regular upkeep and possible emergencies. Property managers should maintain a list of reliable service providers for property repairs and maintenance. The list might include a contact for:

f Carpenter

f Electrician

f Plumber

f Heating and air conditioning

f Lawn care and landscaping

f Internet and cable

Those who manage the property should maintain a list of preferred firms who they’ve worked with in the past and have good track records.

Non-technical maintenance, such as custodial service, snow removal, or parking lot sweeping, can be negotiated on a standard maintenance contract. It is a good idea to have an attorney review all contract forms before use.


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Technical maintenance, such as elevator or HVAC, requires a maintenance agreement designed specifically for that service. Ensure that the contractor is bonded as a guarantee of performance and provides a certificate of insurance.

For larger projects, it is a good idea to solicit bids, ask for references, and have a written contract specifying work to be performed. The contract may include penalties for missed deadlines. When contractors are working on site the manager or owner should meet them at the property on the first day and visit regularly to ensure the work is being performed as expected. Tenants should be informed in advance of any work to be done at the property, and contractors should be instructed not to communicate with tenants directly.

Payment should not be made for contract projects until the work has been inspected and completed to the satisfaction of the owner or manager.

RISK MANAGEMENTInvestors who own rental properties face a variety of risks and liabilities. They need to protect their investments, as well as, the health and safety of tenants and visitors to the property. The first step toward managing risk is identifying the possible risks, evaluating the likelihood of their occurrence, and assessing the potential losses. After identifying and evaluating the risks, consider how they can be managed or mitigated. Some risks may be easier to eliminate than mitigate, like swimming pools or playground structures.

INSURANCEThe smart way for real estate investors to protect themselves and their investments is sufficient insurance coverage. Proper insurance coverage helps protect assets from devastating lawsuits.

Types of insurance to consider include:

f LIABILITY INSURANCE COVERAGE: Protects against claims that a property owner's negligence or inappropriate action resulted in bodily injury or property damage.

f CASUALTY INSURANCE: Covers claims against the property owner for accidental injuries or damages.

f PROPERTY (HAZARD) INSURANCE: Includes coverage for direct physical loss to the property from any event that is not specifically excluded or limited.


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f UMBRELLA INSURANCE: Overarching liability coverage that protects the investor’s other assets. Policies are sold in increments of one million dollars. The term “umbrella” is used because it covers liability claims from all policies underneath it.

RENTERS INSURANCESuggest tenants obtain renters’ insurance to cover damages or losses to their personal property. Landlords can help tenants by providing brochures, websites, or contact information for local insurance agents. Some landlords help tenants purchase insurance by signing a lease addendum and adding the premium cost to the rent.

SETTING RENTSDetermining an appropriate rent is a crucial part of owning investment property. If rents are too high, units will remain vacant; if rents are too low, there may not be sufficient cash flow to cover expenses. Part of the analysis that an investor does prior to purchasing a property should be to determine whether the rents would cover expenses including annual debt service and meet income and ROI targets.

The two most common methods for determining rental rates are market analysis and return on investment.

MARKET ANALYSISKnowing the rental rates of comparable properties in the area is important even when considering the ROI method. Renters will likely avoid properties with significantly higher rents than similar properties in the area. Vacancy rates impact rental too—higher vacancy rates usually mean lower rents.

It pays to spend some time finding out what amenities competing properties offer, and investing in some improvements. Upgrades and desirable amenities can justify higher rents. Replacing appliances with new, high-end, energy efficient models, providing in-unit laundry facilities, or adding wood flooring can all make the space more appealing and add to the investors’ ROI.

ROI TARGETDetermining rent based on the return on investment starts with adding up the costs for mortgage, property taxes, insurance, maintenance, leasing, and management, plus the rate of return.


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For example, if the monthly mortgage, taxes, and operating expenses for a single-family property came to $1000, and the owner expects a 10 percent return on a $24,000 investment ($200/month), the monthly rent should be set at $1,200.

This might be problematic if comparable properties in the area rent for less. It may be necessary to lower expectations for ROI. Alternatively, the owner can look for ways to reduce operating costs or make the property more attractive to tenants. If debt service remains constant and over time rental rates can increase faster than expenses, the ROI may improve.

SCREENING AND SELECTING TENANTSThe owner should establish a minimum set of standards to evaluate each prospective tenant for the property. Selection criteria should be in writing and must be applied consistently and fairly to all applicants. Discrimination in sale, lease, or rental of housing because of race, color, religion, sex, handicap, familial status, or national origin is illegal. Criteria you can consider includes:

f YEARLY INCOME: Minimum rent-to-household income ratio, such as 3–4 times the amount of the annual rent.

f CREDIT CHECK: Satisfactory references regarding credit. A prospect must show the ability to pay rent and demonstrate acceptable prior performance as a renter. Make sure that the application indicates that signing gives permission to run a credit report on the prospect.

f REASONABLE PERIOD OF EMPLOYMENT: Employed by the same employer for at least 12 months during the preceding two years. For applicants with less than six months with a current employer, look at least a year back for a prior employer. Exceptions, for example, may be seasonal workers or recent college graduates who are new to the workforce.

f RENTAL HISTORY: Verified references from two previous landlords that show on-time payments and responsible behavior. These are indications of the stability of the renter.

f IDENTITY VERIFICATION: It is important to document both the lessees’ names as well as any other occupants’ names on the lease.


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f OCCUPANCY LIMITS BASED ON THE NUMBER OF BEDROOMS: There are less likely to be challenges of discrimination if the number is not more restrictive than two persons per bedroom are. Check with local jurisdictions before establishing specific limits since there may be maximum occupancy levels in place.

f AGE LIMITATIONS: Regulations vary from state to state. Residents must be old enough to sign a lease.

f CRIMINAL BACKGROUND CHECK: If allowed by state law, criminal background checks may be performed for both the lessees (18 and over) and the occupants of an apartment. Arbitrary or blanket criminal history-based policies could violate the Fair Housing Act. Criminal history-based policies are not prohibited; however, housing providers should create thoughtful policies that are tailored to serve a substantial, legitimate, and nondiscriminatory interest of the housing provider, such as resident safety or the protection of property. Policies should be applied consistently. Also, some states may bar criminal checks, so landlords should check the laws of their state.21

Professional screening services can be an objective, cost-effective way for self-managers to handle screening prospective tenants. These services have the staff and resources to check databases and make phone calls to check references.

GUIDANCE ON CRIMINAL BACKGROUND CHECKSThe Department of Housing and Urban Development published Fair Housing Act guidance on the use of criminal background checks in 2016. In 2018, HUD warned that denying housing applications based on a criminal record may be discriminatory. The housing provider should follow these guidelines.22

f A tenant should not be rejected because of an arrest, for any crime, where the tenant was not ultimately convicted.

21 For more information, go to www.nar.realtor/fair-housing.

22 “Criminal Background Checks: HUD Issues Warning that Denying Housing Applications Based on Criminal Record May Be Discriminatory,” AriasBosinger, February 2018, ablawfl.com/criminal-background-checks-hud-issues-warning-that-denying-housing-applica-tions-based-on-criminal-record-may-be-discriminatory/


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f A housing provider must be able to show that the denial “accurately distinguishes between criminal conduct that indicates a demonstrable risk to resident safety and/or property and criminal conduct that does not.”

f Federal law allows rejection of applicants with drug distribution and drug manufacture convictions. This exception does not include drug possession convictions.

f Treatment of criminal issues on applications must be uniform.

f Selective use of criminal history as a pretext for unequal treatment of individuals based on race, national origin, or other protected characteristics is discriminatory.

SCREENING CHECKLIST: FINDING THE RIGHT TENANTTake these steps when screening potential tenants to find the ones most suitable for the property. Keep in mind that discrimination, in any form, is not acceptable.

f Create a list of screening criteria for the rental

f Advertise the rental by listing with an online service

f Pre-screen applicants over the phone before showing the property

f Invite the applicant to view the property and screen in-person

f Accept the rental application

f Run appropriate background checks

f Verify all application responses against background checks

f Select your tenant

f Use legal processes to deny any other applicants


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TENANT’S RIGHTS AND RESPONSIBILITIES Landlord-tenant law provides the tenant the following rights:

f QUIET ENJOYMENT This includes the right to privacy, peace and quiet, and lawful use of the apartment, common areas, and facilities. Tenants are expected to respect each other’s rights to privacy and peaceful enjoyment. Quiet enjoyment also means that the tenant can occupy the premises free from interference by the landlord, except for the landlord’s right of entry to make repairs and show the property.

f WARRANTY OF HABITABILITY If the landlord does not maintain the leased premises in habitable condition or provide essential services, the tenant may have the right to withhold rent, vacate the apartment without penalty, make repairs and deduct their cost from the rent, and collect damages in court based on the landlord’s breach of contract. In general, tenants are required to provide the landlord with formal notice of the breach (usually in writing) and give the landlord the opportunity to make corrections before exercising any of these remedies. However, the tenants’ specific rights and responsibilities under the warranty of habitability are subject to the applicable landlord-tenant law.

f CONSTRUCTIVE EVICTION If a tenant can document that a landlord was aware of a problem and failed to correct it, that may constitute violation of the implied warranty of habitability. In that case, the tenant may be able to vacate the premises on the basis of constructive eviction. That type of eviction may also apply if the tenant’s right to quiet enjoyment is disturbed by some action of the landlord that renders the leased premises uninhabitable or deprives the tenant of enjoyment of the premises.

f ANTI-DISCRIMINATION LAWS Under the federal Fair Housing Act, a landlord may not discriminate against current or prospective tenants on the basis of race, gender, familial status, religion, ethnicity, national origin, or disability.

TENANTS’ RESPONSIBILITIESTenants also have specific responsibilities under landlord-tenant law, including the following:

f Comply with the terms of the lease.

f Maintain the dwelling unit in a clean, safe condition and use the fixtures and appliances appropriately.


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f Respect the privacy and right to quiet enjoyment of other tenants.

f Abide by the rules and regulations of the premises, provided the purpose is to promote the welfare of all the tenants and preserve the property from abuse. Rules must be reasonable and apply uniformly to all tenants. They are typically an addendum to the lease.

f Grant the landlord reasonable access to the dwelling unit to make repairs or show the unit to prospective renters, purchasers, or lenders.

f Use the dwelling unit only as a residence, unless otherwise agreed.

f Give proper notice before vacating the premises.

LANDLORD’S RESPONSIBILITIES AND RIGHTSLandlord‐tenant law spells out the respective rights and responsibilities of landlords and tenants. Local ordinances may also address the handling of security deposits and identify specific tenants’ rights in regard to the relationship with the landlord. The landlord’s responsibilities include the following:

f Deliver the premises at the beginning of the lease term. If a landlord is unable to deliver possession to an incoming tenant, the landlord may be obligated to abate the rent until the tenant can move in.

f Maintain the premises in a habitable condition.

f Provide for the tenant’s quiet enjoyment of the premises.

f Supply essential services, including heat and hot water (the landlord does not have to pay, just make available).

f Give proper notice of changes to rules and regulations or a change of ownership.

f Notify the tenant of any changes to the terms of the lease including rent increases.

f Notify the tenant before lease expiration.

f Return the security deposit within the prescribed period.


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LANDLORD’S RIGHTSIn exchange for fulfilling responsibilities, the landlord is to receive timely payment in the form of rent. The lease should clearly state the amount of rent, when it is due, how often it is to be paid, and where payment is to be made. It should also specify any fees or other charges, such as the late payment of rent; local regulations may cap late fees. If the rent is not paid or if the tenant is otherwise in violation of the lease, the landlord has the right to terminate the lease agreement and evict the tenant.

The landlord has the right to set reasonable policies and rules for the property. Such rules generally concern promotion of the convenience and welfare of all the tenants, preservation of the landlord’s (owner’s) property, and allocation of services and facilities.

Landlord-tenant law provides the landlord the right to enter a unit to make repairs and improvements and provide agreed services. Usually, specific notice is required—except in an emergency. The landlord is also allowed to show the apartment to prospective tenants, contractors, purchasers, and lenders.

RECORD KEEPING

Landlords who are careful in choosing tenants, and who keep careful payment records, respect tenants’ privacy, and perform maintenance promptly are less likely to experience lease violations or adverse actions by tenants.

COLLECTIONSAn occupied apartment for which no rent is collected is more costly than a vacant one; a vacant apartment is not subject to damage, and its utility costs are negligible. The lease should indicate the date rent is due, the grace period, and penalties for late payments. If tenants fail to pay rent, the collection process should begin.

The first day the rent is delinquent the landlord should send a firm but friendly reminder notice to the tenant and follow up with a visit or phone call. If there is no response, a second notice should be sent. Prior to beginning eviction proceedings, a notice to pay or quit should be sent.

PAY OR QUIT NOTICESState and local laws prescribe the period of time allowed and the form and content of the notice to pay or quit, as well as, how it is to be served and witnessed. The notice should also state any late or legal fees, if they are permitted. Generally, the landlord may not be able to accept partial payment


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without jeopardizing the effectiveness of the notice or the right to bring suit. However, local requirements differ so widely that an attorney should be consulted to determine what applies in each jurisdiction.

EVICTIONSometimes legal action may be necessary to remove a tenant from the leased premises. Grounds for eviction for cause are:

f Nonpayment of rent

f Violation of the lease terms, including nonpayment of monies other than rent (i.e., utilities, deposits, fees)

f Misuse or destruction of property

f Failure to maintain the premises

f Creating a nuisance—unlawful activities, persistent noisy behavior

f Expiration of lease

Even in the best of circumstances, completion of the eviction process may take several months, although, some states allow eviction within as few as 10 days. The best way to minimize the need for evictions is to be diligent in screening prospective tenants. This can be done by checking credit references and verifying information provided on the lease application.

FAIR HOUSING The Fair Housing Handbook from NAR is your go-to source for fair housing guidelines. It includes suggestions for fair housing office procedures, background on fair housing regulations, samples of the HUD Equal Housing Opportunity poster and logo, equal service report forms, and details on the NAR/HUD partnership. There is also a self-assessment questionnaire so you can review your own standards and see if they meet fair housing requirements.

Discrimination on the basis of race, religion, color, sexual orientation, physical ability, familial status, or national origin is forbidden by law and leasing practices must reflect this.

State and local laws may cover other protected classes with regards to fair housing, such as military discharge status or ancestral background. All statutes should always be adhered to.


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Fair housing laws impact almost every aspect of the leasing process. It is wise to seek advice of legal counsel regarding specifics to ensure compliance. Policies and procedures should be followed to the letter for every ad, phone call, and prospect. Consistency is the key to avoiding fair housing violations. Examples of discriminatory activities include:

f Refusal to show, rent, or negotiate units

f False representation of non-availability

f Imposition of different rental charges or security deposits

f Steering

f Requesting discriminatory information on the application

f Differing provisions in rental agreements

f Eviction on the basis of protected class

Two other less blatant forms of discrimination include:

f DISPARATE TREATMENT This refers to intentional discrimination such as refusing to rent to someone based on their gender or sexual orientation.

f DISPARATE IMPACT This occurs when policies, practices, rules, or other systems that appear to be neutral result in a disproportionate impact on a protected group.

Familial status remains one of the most confusing areas of fair housing. Although it is a protected class, occupancy guidelines—how many persons may occupy a given size of apartment—are lacking. For example, occupancy guidelines cannot be created that limit the number of children in a unit. Under a recommended occupancy guideline, four people in a two‐ bedroom unit could mean two adults and two children or one adult and three children. It is important to be careful not to impose occupancy guidelines based on the number of children who will occupy the unit. “People” means people, regardless of age.

MRS. MURPHY’S EXEMPTIONThe “Mrs. Murphy’s” exemption provides that if a dwelling has four or fewer rental units and the owner lives in one of the units, that home is exempt from the FHA. The exemption does not apply to rental advertising. Which means that a landlord cannot run a discriminatory advertisement indicating that


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certain religious groups are not welcome to rent an apartment. Also, this exemption does not apply when a real estate agent is representing the property owner.

AMERICANS WITH DISABILITIES ACT (ADA)The Americans with Disabilities Act (ADA) mandates equal access for persons with disabilities to employment, public services, public accommodations —including residential and commercial properties—telecommunications, and other provisions.

Title III of the ADA addresses accessibility of areas of accommodations that are open to the public for people with disabilities and therefore it requires that all buildings open to public commerce, including the rental office of small properties, must be made accessible. This means that architectural and communication barriers are to be removed in existing facilities where this is readily achievable and can be carried out without much difficulty or expense. This can range from widening the doorways to making sure a website is accessible.

Although small rental properties without a leasing office wouldn’t be subject to the ADA, if there were an office located in the manager’s apartment, the ADA requirements apply to that apartment.

Under the language of the ADA, commercial facilities are required, among other things, to make public restrooms, drinking fountains, and public telephones accessible to people with disabilities, including those in wheelchairs. Examples include handicapped parking, curb cuts, ramps to the entrance, easy-to-open doors, or elevators. It does not apply to any areas of the property used by residents and their guests such as the apartments and common areas.

The “mixed use” property is a significant challenge. This property type combines the FHA protections for residents with disabilities and the ADA protections for public access. Under the ADA, businesses that operate on the property are fully subject to ADA compliance.


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EXIT STRATEGYAs investors are determining their goals, they should take time to think about the “if, when, and how” of an exit strategy. If the goal is cash flow and the property continues to produce the expected yield, then there may be no need to consider selling. But if the investors’ goal is appreciation, a time may come when it makes sense to divest the property. Knowing when to move on is an important part of the investment process, and the key to building wealth over time.

SALES OPTIONS f SELLER FINANCING

Seller financing may be the right choice when mortgage loans are hard to get or too expensive. The seller can also step in when there is a gap between the buyer’s down payment and the LTV. Sometimes, the seller and buyer prefer a private arrangement, although the financing agreement should always be formalized by a written agreement. As an exit strategy, seller financing for part or all or the sale provides a continuous cash flow, without the burden of maintenance, tenants, or rentals; all of the work becomes the responsibility of the buyer. Seller financing also reduces capital gains taxes, as the gain is apportioned among payments. Seller financing is only possible for properties that are owned free and clear. If the buyer defaults on payments, the seller may foreclose and retake possession of the property, which can be costly and time consuming. Sellers can protect themselves by carefully screening buyers and requiring a large, non-refundable down payment.

f LEASE OPTION A lease option exit strategy provides the property tenant the option to purchase at a pre-determined price in a pre-determined period of time. During that period, it is illegal for the landlord to sell the property. The tenant typically pays an upfront non-refundable option fee that will be applied later toward the purchase, or pays a higher rent with the excess amount put towards the purchase price. A lease option provides positive cash flow for the investor and the opportunity to lock-in a possible buyer. Lease option tenants tend to take better care of the property than a typical renter does. Furthermore, minor repairs can be the responsibility of the tenant in preparation for assuming ownership. A lease option may be considered a sale and have legal ramifications, such as liability for failure to comply with seller disclosure laws


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including reassessment of property taxes and loss of tax benefits for deductible expenses and depreciation. In some cases, the owner may be unable to evict the tenant because they arguably have equity in the home, based on the supplemental rent.

f INSTALLMENT SALE/LAND CONTRACT Installment sales are similar to seller financing, in that the buyer pays the seller on the balance of the loan in incremental amounts. It allows taxpayers to report their earnings from a sale over time instead of in a lump sum in the year of sale; each payment includes a pro-rated portion of gain, principal and interest, each of which is treated differently for tax purposes. This type of transaction is effective for sellers who may be in a lower tax bracket in future years.

f 1031-EXCHANGES When the time comes to reconfigure a real estate investment portfolio, the tax-deferred 1031 exchange enables postponement of capital gains tax.


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EXERCISE: TENANT SELECTIONBased on the property information provided, help your investor develop specific tenant selection criteria.

Property Information: A three-floor, 3-unit building. Each of the apartments has 2 bedrooms and 2 baths. Each apartment rents for $1,500 per month. One apartment will be available the first of next month. Refer to the criteria for tenant selection discussed earlier in this chapter.

1. Determine the tenant selection criteria for:

f Number of occupants: ______________________________________

f Income minimum: ________________________________________

f Employment record: _______________________________________

f Credit standards: __________________________________________

f References from previous landlord: ___________________________

2. The purchase price for the 3-apartment building was $524,000. The investor has $100,000 of equity in the property. The monthly mortgage payment is $3,100 PITI and the monthly expenses are $700. The investor wants an 8% annual return on the equity. Does the rent of $1,500 per unit cover the mortgage payment and expenses and achieve the investor’s ROI goal?

______________________________________________________________

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______________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________

______________________________________________________________

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Reveille Schaeffer, GRI, CRS Arizona Focus Realty Gilbert, Arizona [email protected] www.arizonafocusrealty.com

A lot of owners think they want to manage properties themselves because they want to save on management fees. What many fail to realize, however, is just how stressful managing tenants can be. Finding tenants, screening tenants, and then dealing with individual problems can be more time consuming and emotionally draining than many people expect. I’m not saying that no one should self-manage, it is a great option for those who go in with their eyes open, but it’s not for everyone.

If you are going to hire a management company, you need figure out what feels right to you. Different companies charge different fees for different levels of service. It may be worth it to an owner to pay more because the management company will be more hands-on and involved with the property. It is really important to ask questions and find out as much about the company and their management style as you can. Ask to look at the lease agreements they use, and make sure that those agreements have been looked over by a lawyer. Ask about their tenant screening procedures. You don’t want to find yourself with a fair housing violation because of the tactics of your management company. Of course, you also want to get references from other owners who have used the company.

If you’re going to manage the property yourself, there are a lot of considerations. It’s a good idea to visit the property regularly, maybe have a quarterly maintenance visit just to get into the unit and have a look. Of course, you want to have a list of preferred vendors for whenever you have a problem. Make sure the contractors you use have liability insurance and that you have insurance certificates for anyone who does work on the property.

Another really important factor for self-management is tenant selection. Think carefully about where you advertise your vacancies. We use the MLS mostly. Craigslist has not been good for us, although we have gotten good word-of-mouth from social media sites like Facebook. Of course, you should do credit and income verification and criminal background checks. I think the


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most important thing you can do is contact, not the most recent landlord, but the one prior to that. You want to be sure that they are financially stable. You need to be careful about fair housing and publish your qualifying criteria. But in the end, it is about using your judgement. You can get a feel for the people – How are they dressed? Do they look you in the eye? Are they respectful?

My advice for owner-managers is to be emotionally detached. Don’t let your emotions sway your decisions. If someone is rushing you, or asking for special treatment, or they just make you feel uncomfortable, they’re not someone you want to do business with.

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module

6Investing as a Real Estate Profession


f Apply investment techniques presented in the course to build your own portfolio of real estate investments.

f Take advantage of favorable tax treatment for real estate professionals who invest in real estate properties.

f Avoid conflicts of interest between your own real estate investment activities and those of your clients and customers.

As property investors, real estate professionals, like their clients, need to address some basic questions: why invest in real estate, what are the right investments, and how to go about it. Additional questions for practitioners involve how to avoid conflicts of interest with clients’ investment activities, as well as, balance the demands of a real estate career with building and managing an investment portfolio. The good news for real estate professionals is this: the benefit of market knowledge and information along with tax advantages puts them in a unique position for success as real estate investors. Furthermore, owning investment property creates and reinforces credibility with investor-clients and helps build a secure financial future.

INVEST IN THE PRODUCT YOU BELIEVE INDo you believe in the value of investment power of real estate and property ownership? Almost any career practitioner would respond with a resounding “Yes.” Real estate provides your livelihood, it’s your profession, and you’ve


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made a career commitment to it. Investing for your own portfolio affirms your belief in the product you sell. In short, if you want your clients to be persuaded that real estate investing is safe and profitable, you should set the example.

If you think leading by example doesn’t lend credibility with prospective investors, picture this scenario. You are standing at the top of a mountain, looking down a steep ski run. The ski instructor is giving you instructions on the best way to ski the course safely, hazards to avoid, and the easiest path down the mountainside. You turn to the instructor and ask, “How difficult is this ski run?” and the instructor answers, “Wouldn’t know. I’ve never tried it myself.” How confident would you feel about pushing off? You could apply the plot of this scenario to any number of situations, but the bottom line is this: there’s no substitute for first-hand experience.

BUILD YOUR FUTURE FINANCIAL SECURITYBecause most real estate professionals are independent contractors, they often lack access to retirement savings benefits like pension plans, 401(k) plans, and profit sharing that corporate salaried employees usually enjoy. When it comes to securing retirement savings and future income sources, real estate professionals are usually on their own. Purchasing an investment property augments the investor’s current income and secures a future income stream for retirement. In addition to an income source, investment in real estate provides a stream of tax benefits and an inflation-proof asset that appreciates in value.

INFLATION—PRESERVE VALUERegardless of whether the rate is high or low, inflation is a risk factor that is beyond the control of investors. Even a modest increase in the inflation rate can quickly erode returns on financial assets and eat into fixed retirement incomes. Real estate, however, is a durable defense against value erosion as both rents and values tend to rise along with the rate of inflation. For example, for investors who were in the market prior to the 2008 crisis, the financial rewards from real estate far exceeded those of any other type of investment.

PLAY TO YOUR STRENGTHSWho knows more about buying and selling real estate than the career practitioner? With knowledge and experience, as well as, access to property information, real estate professionals are uniquely positioned to invest in real estate for their own portfolios. You have access to listings every day on the MLS, understand the market, and have the knowledge and expertise to evaluate the potential of a property. Because you can act as your own agent, you can move quickly and negotiate for yourself.

Module 6: Investing as a Real Estate Profession

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You are already an expert on your market area and the properties in it and there is no learning curve on how to purchase a property.

HANG OUT WITH THOSE WHO SHARE YOUR GOALS

A surefire way to expand your knowledge and network is to hang out—in person and online—with real estate investors. If your REALTOR® association has a commercial division, a specialized membership section, or association special interest groups or committees, find out how to get involved. Look for social media groups sharing real estate investment information. And, if you haven’t already attended one, look for local investment clubs. The National Real Estate Investors Association provides information on investment clubs around the country. Visit the REIA Website at http://nationalreia.org.

WORK YOUR NETWORKSIn addition to your market knowledge, you already have a network of connections to professionals in finance, construction, property maintenance, remodeling, and others who can help you find, maintain, and operate investment properties. If not already in your network, get to know local contacts for foreclosures at credit unions and banks. Contact larger lending institutions for their foreclosed properties list. Connect with the probate attorneys in town and let them know you are willing to work with an estate to facilitate the disposal of the assets. Other real estate professionals experienced with working with investors can be an invaluable source of guidance and knowledge. All of your connections are stakeholders in your success too. Technology can help you spread the word through social media connections.

CONSIDER YOUR GOALSLike counseling investors, the first step in property investing is determining what you want to accomplish. Your goal is a “what” statement, not a “how” statement. That means that you don’t have to have every detail of your strategy mapped out to begin. But it will help you formulate your investment goals if you have a general idea of what is most important. For example, your top priority could be:

f Safety (capital preservation)

f Periodic income (cash flow)

f Capital appreciation (value increase and inflation protection)

f Tax advantage (income tax shelter)

f Short-term profit (fix and flip)


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Start by writing down some goal statements. The beginning process can be as simple as filling in the blanks of the following statement.

f My goal is to _______________________________________(priority)

f by investing in a _____________________________(type of property)

f that will yield _______________________________________(% or $).

Your goals will evolve and gain in detail as you educate yourself on aspects of achieving them. Keep learning, stating, and restating your goals, and testing your assumptions.

The more your talk about your goals, the clearer the picture will become of the perfect property, the right investment, the great deal. Finding a “great deal” starts with knowing what one looks like. If you can visualize and describe it, you’ll recognize a great deal when you see it.

STRATEGY: SHORT-TERM OR LONG-TERM?If you have identified your top priorities and formulated goals, you will know what type of strategy to develop.

SHORT-TERM: FIX AND FLIP?A short-term strategy focuses on moving quickly to take advantage of opportunities that arise. If your strategy is “fix and flip,” you will need to do the homework on property fix-ups and assemble a reliable renovation team. Essential knowledge is a very informed estimate of the cost and potential added value of renovations as well as a realistic future list price. A mistake in the purchase of a fix-and-flip property can be a drag on an investment portfolio for years. The ultimate question is, “Will this investment really return a sufficient profit to justify my investment?”

LONG-TERM: PORTFOLIO BUILDING A long-term strategy focuses on building a portfolio through planned investments. The goal is total return comprised of two pieces: operating positive cash flow and long-term appreciation. The starting point is a long-term goal and net cash flow target at a certain date in the future. Portfolio building allows the investor to spend time investigating the market to see which type of investment is the best choice—residential, multi-family, apartments, or commercial—before beginning a property search. A long-term strategy involves balancing the elements of price, value, cash flow,


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and appreciation and allows for tradeoffs. For example, a property with below-target net cash flow may be an acceptable investment if it has good appreciation potential.

USE THE TOOLS YOU ALREADY HAVEFinding the right investment property involves staying vigilant and on top of your market knowledge, so you can spot the opportunities when they come along. You must use all the information sources you already have access to:

f MLS

f Commercial Information Exchanges

f Networks and spheres

f Websites and social media

f Auction sites

f FSBOs

f Foreclosures and short sales

CLUES—KNOW WHAT TO LOOK FORSometimes just by driving around your market area, you will spot potential investment properties. Some of the clues experienced real estate professional investors look for include:

f Properties needing cosmetic fixups (may indicate an owner who has lost interest in or lacks resources for upkeep and may be interested in selling).

f Under-rented or under-developed properties.

f Small multi-family properties with below-market rents.

ANALYSIS TOOLS f FORMS

You should learn how to collect operating cost data needed to calculate net operating income (NOI) before and after taxes, as well as, analyze cash flow. The standard tool for figuring NOI is an Annual Property Operating Data (APOD) form. You can find sample forms for calculating NOI and cash flow at http://chapters.ccim.com/attachments/documents/public/08895018117.pdf.


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f RPR® VALUATE INVESTMENT ANALYSIS TOOLS The Realtors Property Resource® provides the Valuate suite of investment analysis tools. Valuate’s interactive interface allows users to respond on the spot to client inquiries and needs. Agents can work alongside clients as they input assumptions, run scenarios, and quickly retrieve and share versions of listed properties they find most appealing. This collaborative environment weeds out unattractive deals, prevents mistakes and omissions, and keeps all parties up to speed on the latest developments. You can take Valuate for a test drive at http://blog.narrpr.com/ commercial/investment-analysis-valuate. RPR® is a member resource available to all REALTORS®. Register for RPR® at https://www.narrpr.com.

MANAGING YOUR PROPERTIESA fundamental question any investor needs to answer is, “Should I try to manage my investment properties, or turn the responsibility over to a property management company?” The primary reason most investors choose to self-manage is cost savings. They want to maximize the return on their investment by avoiding property management fees. However, this fails to put a value on the time of the investor. As a real estate professional, if you plan to self-manage, you should ask yourself how much time you can take away from prospecting, listing, and selling.

Managing a rental property, even one with long-term, stable tenants, and minimal maintenance still requires considerable time and attention. Whether a rental property is managed by the owner or a professional property manager, the management tasks are the same. The frequency and complexity may vary depending on the size of the property, but the tasks themselves are consistent,

Of course, if you are already managing properties for other investor-clients, adding the management of your own properties will be easier. If not, you will need to learn a new set of skills, as well as, get up to speed on state and local regulations of rental property. Check your state’s real estate licensing regulations; some states require a specialized license for property managers. Not sure whether to self-manage or outsource? Take a look back at the essential qualities for a property manager presented earlier. Ask yourself, “Does this description sound like me?”


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REAL ESTATE PROFESSIONALS—MATERIAL PARTICIPANTSFor active real estate professionals, the IRS allows two income tax advantages that are generally not available to other investors.

f Presumption of material participation

f Exemption from net investment income tax

MATERIAL PARTICIPATIONThe IRS views the both the participation of most real estate investors and rental real estate activities as passive. Passive participations mean that tax deductions and losses are limited and cannot offset income from other sources. The IRS, however, views real estate professionals who meet baseline qualification criteria as material participants.

Why is material participation an advantage? Material participants are allowed to offset deductions and losses from rental property activities against other earnings including ordinary income. In order to qualify as a material participant, the real estate professional must meet two criteria:

f Work more than 750 hours in all real estate businesses during the year.

f Devote more than 50 percent of all work time to real estate businesses.

f A spouse’s participation may also count toward determination of material participation.

NET INVESTMENT INCOME (NII) TAXThe NII tax, enacted in 2013, assesses a separate flat 3.8 percent tax on unearned income, including rental income and gains from selling rental property. Individuals, estates, and trusts owe the tax if they have net investment income and modified adjusted gross income over the following thresholds:

f SINGLE: $200,000

f MARRIED FILING JOINTLY: $250,000

f MARRIED FILING SEPARATELY: $125,000


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The IRS says that if a real estate professional participates in rental real estate activities for more than 500 hours per year (or for more than 500 hours per year in five of the last 10 taxable years), the rental income associated with that activity will be viewed as derived in the ordinary course of a trade or business. Meeting this qualification test exempts the real estate professionals from NII tax.

GET TAX HELPAs with all tax related issues, rules may change. Every tax strategy should be verified yearly for updates or changes in laws and regulations. And don’t forget to take the tax regulations of your state, and the states where properties are located, into consideration. Seek out the expert advice of a tax professional.

PROPERTY FLIPPERS BEWARE

The IRS views property flippers, who actively purchase and remodel real estate for profit on a continuing basis, as dealers instead of investors. The properties they own are considered inventory instead of investments that qualify for capital gains tax treatment upon sale. Profits on the sale of flipped properties are treated as ordinary income and the individual may be subject to the self-employment tax. Furthermore, fix-and-flip properties are usually viewed as dealer property that disqualifies them for tax-deferred 1031 exchanges. There are no hard and fast criteria for distinguishing a fix-and-flip property from an investment one. Instead, the IRS looks at the set of facts, circumstances, and—very important—the taxpayer’s intentions.

COMPLYING WITH THE REALTOR® CODE OF ETHICSThe NAR Code of Ethics is quite specific about the ethical duties of REALTORS® when working with investor-clients and investing for their own portfolios.

f ARTICLE 1—PUT CLIENTS’ INTERESTS FIRST Article 1 states that “REALTORS® pledge themselves to protect and promote the interests of their client” and treat all parties to the transaction honestly. Practitioners who represent investors must always be mindful of their fiduciary responsibilities to their clients. That means putting clients’ interests first and never trying to outbid them for a property.

[ Standard of Practice 1-9—Protect confidential information REALTORS® must preserve clients’ confidential information. This obligation continues after the agency relationship ends.


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REALTORS® can’t use or reveal confidential information learned in the course of an agency relationship to the disadvantage of clients or to further their own interests.

[ Standard of Practice 1-11—Manage property prudently Protecting and promoting the client’s interests include prudent management of properties. “REALTORS® who are employed to maintain or manage a client’s property shall exercise due diligence and make reasonable efforts to protect it against reasonably foreseeable contingencies and losses.”

f ARTICLE 3—COOPERATE WITH OTHER BROKERS REALTORS® shall cooperate with other brokers except when cooperation is not in the client’s best interest.

[ Standard of Practice 3-7—Disclose your REALTOR® status When seeking information from another REALTOR® concerning property under a management or listing agreement, REALTORS® should disclose their REALTOR® status and whether their interest is personal or on behalf of a client and, if on behalf of a client, their relationship with the client.

f ARTICLE 4—DISCLOSE OWNERSHIP INTERESTS Article 4 requires REALTORS® to inform prospective buyers in writing of any ownership interest in properties they are selling. The obligation to disclose ownership interests includes family members too.

f ARTICLE 5—DISCLOSE ANY INTERESTS BEFORE OFFERING AN OPINION Article 5 requires REALTORS® to disclose any interest in any properties for which they are asked to provide services or valuation. For example, a REALTOR® must disclose management responsibility for property if a potential purchaser asks for an assessment of it.

f ARTICLE 11—REFER CLIENT TO APPROPRIATE EXPERTS Article 11 states “REALTORS® shall not undertake to provide specialized professional services concerning a type of property or service that is outside their field of competence unless they engage the assistance of one who is competent on such types of property or service, or unless the facts are fully disclosed to the client.” As noted throughout the course, clients should be referred to experts for legal and tax advice.

f ARTICLE 12—STATE YOUR STATUS AS A REAL ESTATE PROFESSION Article 12 requires REALTORS® to be up front in their real estate communications about their status as real estate professionals.


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AVOIDING BAD DEALS AND CONFLICTS OF INTEREST When it comes to selecting investment properties for your own portfolio, the advice you would give a client should be advice you take yourself.

BAD DEALS IN DISGUISE?You need to do a thorough analysis of any potential investment property and crunch the numbers to be sure they will achieve the expected return. Don’t make a deal that isn’t going to work for you in the long run or allow pride of ownership to overcome good analysis. Sometimes what looks like a bargain is a bad deal in disguise. For example, a property that has great cash flow but is deteriorating or sitting in the path of blight is seldom worth the trouble involved in managing it. Great cash flow will not overcome loss of appreciation as a hedge for your financial future.

CONFLICTS OF INTERESTVeteran real estate professional investors would urge you, as a new investor, to think twice before purchasing your own listings. Purchasing a property from a listing client has inherent conflicts. Of course, the seller wants the highest price possible for the property and the buyer is looking for the lowest price. If the buyer is the listing agent, clients may question whose interests took precedence—their own or the real estate professional.

If there is any possibility of a conflict of interest or Code of Ethics violation, the prudent course of action is to refer the listing to another broker for a referral fee. Furthermore, you should always disclose that you’re a licensed real estate professional whenever you’re buying a property, even if you have no agency role in the transaction.

CHECK YOUR E&O COVERAGEE&O insurance covers your activities as a licensee when selling the property of others, but it may not cover your own activities as a seller or buyer. These exclusions can apply to your own home as well as investment property. Before purchasing your own listing, check with your insurer to confirm coverage. If the transaction triggers a lawsuit, you may not have insurance protection.


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A FINAL THOUGHT—GUARD YOUR REPUTATIONThe real estate professional’s reputation in the marketplace, particularly among investors, is invaluable and once harmed, is very difficult to repair. Practitioners who buy and sell for their own portfolios need to make sure that their actions don’t compromise their reputations. Veteran real estate professionals assert that a reputation for selling only the properties you don’t want to buy will hurt your standing in the marketplace. As noted, the clients’ interests always rank first. If, for example, you show an investor a property and then choose to purchase it for yourself, without giving the client the opportunity to make an offer, you will likely damage your relationship with that client, as well as, any prospective client they speak to. No individual deal is worth the damage to your good name.


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OMAR CAPELLAN, ABR, GRI, SRS, RENE Semper Realty & Property Management Cape Canaveral, Florida [email protected]

I began as an incidental investor in 2001 and have been for the past 19 years but really conscientious since 2009. I didn’t think I would begin with my own property after receiving an offer for a job in a different city. I had purchased the property 5 months prior, it didn’t make sense to sell it, so I rented it. From there, I began to buy houses and renting them as a side “gig.” Eventually in 2008, arguably at the bottom of the real estate market, I began transitioning into commercial investing particularly in the multi-family arena. I currently own 96 doors in three different multi-family projects. The latest project is the biggest acquisition I have ever attempted, at 60 doors.

Becoming an investor is a conscious decision and a commitment you should not take lightly. You need to see this as a business, because it is a business. Hence you begin by assembling your team; which at the minimum is composed of a real estate attorney and an accountant. You will also need an inspector, a property manager, an appraiser, a title company, a mortgage broker and an insurance broker amongst others. Most of the team can be assembled as you go along, but the attorney and the accountant are not negotiable and should be lined up before your first deal.

Next, decide what specific asset-class you want to invest in. Once you identify your niche, for example condos, you can learn all about condo law, what it takes, its advantages and disadvantages. Then you can concentrate on what areas and price point you want to invest in. You have to learn how to analyze a property financially and “stress it.” You can “stress” a property financially by lowering the rent and/or by showing the property being empty for several months, to find out if you can still afford that property under those conditions.

I encourage you to become a real estate investor. Why? The main reason is because if we are in the business of real estate, why not invest in it. It makes sense to invest in the product we sell. In addition, we should know our


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marketplace. Finally, as you become a seasoned professional, you can leverage your sales efforts against the income being produced by your investments and in retirement, you get to enjoy the fruits of your investments.

There are plenty of things to keep in mind as an investor but if I can single one out, it would have to be, make sure you have reserves: capital available to you in a moment’s notice. This is where most investors loose it. Investors mistakenly purchase a property in hopes that everything will remain status quo and nothing will break down. Items will wear out and mechanical equipment will break down. These are pricey repairs and if you don’t have the reserves available to you, how are you going to maintain the property? Don’t hesitate to contact one of us to help you if you feel lost in this business. Go forth and conquer!


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Resources

NAR CODE OF ETHICS, ARTICLE 11

EFFECTIVE JANUARY 1, 2014

ARTICLE 11 The services which REALTORS® provide to their clients and customers shall conform to the standards of practice and competence which are reasonably expected in the specific real estate disciplines in which they engage; specifically, residential real estate brokerage, real property management, commercial and industrial real estate brokerage, land brokerage, real estate appraisal, real estate counseling, real estate syndication, real estate auction, and international real estate

REALTORS® shall not undertake to provide specialized professional services concerning a type of property or service that is outside their field of competence unless they engage the assistance of one who is competent on such types of property or service, or unless the facts are fully disclosed to the client. Any persons engaged to provide such assistance shall be so identified to the client and their contribution to the assignment should be set forth. (Amended 1/10)


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STANDARD OF PRACTICE 11-1When REALTORS® prepare opinions of real property value or price they must:

1. be knowledgeable about the type of property being valued,

2. have access to the information and resources necessary to formulate an accurate opinion, and

3. be familiar with the area where the subject property is located.

Unless lack of any of these is disclosed to the party requesting the opinion in advance.

When an opinion of value or price is prepared other than in pursuit of a listing or to assist a potential purchaser in formulating a purchase offer, the opinion shall include the following unless the party requesting the opinion requires a specific type of report or different data set:

1. identification of the subject property

2. date prepared

3. defined value or price

4. limiting conditions, including statements of purpose(s) and intended user(s)

5. any present or contemplated interest, including the possibility of representing the seller/landlord or buyers/tenants

6. basis for the opinion, including applicable market data

7. if the opinion is not an appraisal, a statement to that effect

8. disclosure of whether and when a physical inspection of the property’s exterior was conducted

9. disclosure of whether and when a physical inspection of the property’s interior was conducted

10. disclosure of whether the REALTOR® has any conflicts of interest

(Amended 1/14).

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STANDARD OF PRACTICE 11-2The obligations of the Code of Ethics in respect of real estate disciplines other than appraisal shall be interpreted and applied in accordance with the standards of competence and practice which clients and the public reasonably require to protect their rights and interests considering the complexity of the transaction, the availability of expert assistance, and, where the REALTOR® is an agent or subagent, the obligations of a fiduciary. (Adopted 1/95)

STANDARD OF PRACTICE 11-3 When REALTORS® provide consultive services to clients which involve advice or counsel for a fee (not a commission), such advice shall be rendered in an objective manner and the fee shall not be contingent on the substance of the advice or counsel given. If brokerage or transaction services are to be provided in addition to consultive services, a separate compensation may be paid with prior agreement between the client and REALTOR®. (Adopted 1/96)

STANDARD OF PRACTICE 11-4The competency required by Article 11 relates to services contracted for between REALTORS® and their clients or customers; the duties expressly imposed by the Code of Ethics; and the duties imposed by law or regulation. (Adopted 1/02)


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Resources

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SAMPLE RENTAL AGREEMENT WITH PROVISIONS AND ATTACHMENTS

RENTAL AGREEMENTThis agreement is made and entered into _____________________________ on between ________________________________ hereinafter “Landlord” and ____________________________ hereinafter “Resident”. Subject to the terms and conditions below, Landlord rents to Resident and Resident rents from Landlord, for residential purposes only, the premises located at ________________________________________. The lease term shall be for _______ months. The tenancy term shall commence on _______________ with a completion date of ____________________. The rent for the above premises shall be $_______________ per month. Security deposit shall be $_________, Other deposits $___________ for _________________________________________________________________________________________________.

1. Month-to-Month Tenancy after Fixed Term. This is a tenancy for a fixed term, but after the expiration of the Minimum Lease Term this will be a month-to-month tenancy. A “month” for purposes of this Agreement means a calendar month, The Resident’s obligation to pay rent will continue until terminated in the manner set forth in this Agreement.

2. Notice of Non-Renewal or Termination. If Resident intends to vacate at the end of the fixed term, Resident must provide written notice of the non-renewal of this lease at least 30 days prior to the end of the term. Thereafter, either party may terminate this lease upon 30 days written notice to the other.

3. Rental payment. Rent is due on the FIRST day of each month. If the rent has not been received by the end of the 3rd day of each month, the Resident agrees to pay a Late Payment Fee in the amount of $25.00 and $5.00 a day thereafter for each day any amount of rent remains unpaid until the end of the month. Returned check fees (NSF) will be $25.00. Resident will be responsible for rent payment for 30 days from the date that the Landlord receives a written 30-day notice to vacate or until Resident returns the keys to the premises, whichever is longer. Resident shall be responsible for rent for the entire term of this Agreement even if the Resident vacates the premises prior to the termination of this Agreement. If a rent discount, move-in special or concession is provided with this Agreement, and if the Resident does not fulfill the terms and conditions of this Agreement, the discount, move-in special or concession must be repaid in full along with all other provisions of the Agreement.


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4. Deposits. Any deposits received from the Resident will be applied as provided in the PROVISIONS AND ATTACHMENTS. For health and safety purposes, all carpets will be professionally cleaned after each vacating resident and the cost deducted from the deposit unless the resident makes other arrangements with the Landlord in writing. Any remaining balance will be returned to the Resident within thirty (30) days after the Premises have been vacated as evidenced by the return of the keys to the Landlord,

5. Utilities Provided by Landlord: __________________________________.

6. Resident Agrees to Obey Rules, Resident agrees to abide by such reasonable rules and regulations as Landlord may from time to time establish for all Residents of the same multiple dwelling unit. A copy of the current Community Rules and Regulations is attached hereto. Resident acknowledges that these Rules and Regulations are a legally binding part of the Rental Agreement.

7. Attorney Fees. The prevailing party to a suit or other proceeding to enforce the terms of this Rental Agreement will be entitled to all court costs and attorney’s fees from the non-prevailing party.

8. Agreement Binding on Each Party. It is expressly understood that this rental Agreement is between the Landlord and each Resident jointly and severally, and that in the event of default in payment of rent, or any other provision of this Agreement, each and every Resident can be held individually responsible for complete payment of rent or any other costs,

9. Forbearance not a Waiver, Any forbearance by Landlord to strictly enforce all of the terms and conditions of this Agreement will not be construed as a waiver of Landlord’s right to strictly enforce all of such terms and conditions in the event of any further, continued, or additional default by Resident.

10. Other Terms, Conditions or Regulations, if any: (Initials of both parties are required for any changes or additions.)

11. This instrument, any attachments, and the Rules and Regulations constitute the entire agreement between Landlord and Resident and there are no other promises or agreements whatsoever. It supersedes all prior or existing written or oral agreements and may be modified only by a written instrument, signed by all parties, expressly modifying the terms of this Agreement.

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12. NOTICE: BY EXECUTING THIS AGREEMENT, YOU ACKNOWLEDGE THAT YOU HAVE RECEIVED A COPY OF THIS AGREEMENT, ANY ADDENDUMS OR ATTACHMENTS, INCLUDING ANY CURRENT RULES AND REGULATIONS AND THAT YOU HAVE READ THEM AND UNDERSTAND THEM TO THE BEST OF YOUR ABILITY AND ARE WILLING TO ABIDE BY THE AGREEMENT. YOU AGREE AND UNDERSTAND THAT THIS IS A BINDING LEGAL CONTRACT DESCRIBING YOUR AND YOUR LANDLORD’S RIGHTS AND OBLIGATIONS. In Witness Whereof, Landlord and Resident have executed this Agreement as of the day and year first above written.

BY:

_________________________________________Landlord or Agent

_________________________________________Resident

_________________________________________Resident

SAMPLE PROVISIONS AND ATTACHMENTS 1. RENT Resident agrees to pay Landlord the amount of Rent agreed to in the

Rental Agreement each month in the exact amount due. Any amount tendered that exceeds the amount due will be applied to the following month’s rent. All payments tendered will first be applied to any outstanding debts in the order they were incurred, if any, then to the current month’s late charges, if any, and only then to the current rent owed. Rent for the first and last month will be prorated on a daily basis if the lease commences or terminates on a day other than the last day of the month.

2. PLACE OF PAYMENT Rent will be paid at the Landlord’s Rental Office or at such other address as Landlord may from time to time designate in writing as the place for payment of rent. Mailed envelopes containing rent must be postmarked on or before the due date. Landlord will not be responsible for cash delivered through the mail/mail drop.

3. DEPOSITS The deposit will be used as a security/rent deposit. It will first be applied to damages and cleaning, then to unpaid late charges and administrative fees, and then only to unpaid rent. Any remaining balance will be returned to the Resident within thirty (30) days after the Premises have been vacated. However, if the Resident terminates the tenancy prior to the end of the Minimum Lease Term, the Resident will forfeit all deposits at Landlord’s option. Resident cannot apply the Deposit for payment of the last month’s rent.


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4. RETURNED CHECKS All checks returned for insufficient funds must be redeemed by money order. An administrative fee will be added to the rent due for any such returned check. Late charges and other fees will continue to accrue until the check is redeemed. If the Resident has more than two (2) checks returned for insufficient funds within twelve (12) months of each other, the Resident must pay all rent thereafter by money order. FOR SAFETY REASONS LANDLORD DOES NOT ACCEPT CASH. DO NOT ATTEMPT TO PAY YOUR RENT IN CASH.

5. RESIDENT’S RESPONSIBILITY FOR UTILITIES The Resident will pay in full all utilities not provided by Landlord as they become due. The Resident agrees to place utilities in Resident’s name upon occupancy of the Premises and not to remove Resident’s name until the termination date. The Resident further agrees to notify the Landlord of any interruptions of utility services to the Premises prior to such interruption. Any damages or loss incurred by the Resident’s failure to pay utilities, or to inform the Landlord of any shut off, will be the responsibility of the Resident. The Resident will hold the Landlord harmless for utility charges incurred by the Resident.

6. MAXIMUM OCCUPANCY The Premises will be occupied as living quarters by no more than 2 persons per bedroom, not including children under the age of 2 years. Only those persons who have signed the Rental Agreement and their minor children (including foster and step children) may reside there.

7. TERMINATION UPON THREE (3) DAY NOTICE If the Resident fails to pay the rent when due or any of the other terms and conditions of these Rules or the Rental Agreement are breached, the Landlord may terminate this tenancy and Agreement upon three (3) days written notice. The Resident will have until the end of the third day following delivery of the notice to correct the matter in default or deliver possession to Landlord. During this time, Resident’s rights are only forfeited, not terminated and Resident remains liable for rent for the balance of the lease.

8. LEGAL ACTION BY LANDLORD Should the Landlord institute an unlawful detainer or any other legal action to recover possession because of non-payment of rent, and should Resident tender payment after commencement of such action, the Landlord will not be required to accept such payment unless the Resident pays all actual administrative, attorney’s and service fees, court costs and moving and storage costs incurred by Landlord and also the entire rent in default. Acceptance by the Landlord of any or all amount will be at Landlord’s option and will-not operate to stay said legal proceedings or act as a waiver of Landlord’s right to possession of the Premises, unless specifically waived in writing by the Landlord. The Landlord is not required to dismiss an unlawful detainer action, even if the full sum is paid.

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9. VACATING PREMISES Resident will leave Premises in the same or better condition (normal wear and tear excepted) than when first occupied. Upon returning keys to Landlord, Resident represents and affirms to Landlord that the Premises are thoroughly cleaned and in good repair. If further cleaning and/or repairs are required, Landlord will not be Obligated to notify Resident other than noting deficiencies along with other charges, if any, on the security/rent deposit refund request form, which will be mailed to Resident’s forwarding address, provided one is given by Resident, within thirty (30) days from receiving keys in Landlord’s office. If Landlord is required to change locks or do further cleaning and/or repairs after Resident has vacated the Premises Resident agrees to pay for Landlord’s loss of rental income during any period which is reasonably required to perform such lock changes, cleaning and/or repairs.


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CHECKLIST FOR MAKING AN INSURANCE CLAIMProper handling of incidents will make filing a claim with the insurance company easier and more successful. Before disaster strikes, read your insurance policy and know your rights. You should also document all your belongings using a still or video camera. The following checklist covers steps to follow in the event of injury or property damage.

f Ensure immediate aid is given to any injured person.

f Call emergency personnel for assistance.

f Report a crime to the police and provide necessary information for the police report.

f Obtain the names and addresses of people involved and any witnesses. Write down the name of everyone you see at the site of the loss in case you need to contact them later.

f Take pictures or videos of all damaged property.

f Make any temporary repairs to protect the property from further damage and people from additional injuries. Keep handy the number of a restoration company that can handle any form of safeguards 24/7/365.

f Designate an authorized person to call the insurance company. Check policy for requirements about reporting a loss. Some policies have time limits to file claims.

f Arrange for a claims adjuster to inspect the property.

f Prepare a list of lost or damaged articles. Include diagrams and/or photographs if possible.

f File a signed and sworn Proof of Loss form.

f Do not discuss the incident with anyone other than your insurance representative or attorney.


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SAMPLE APARTMENT INTERIOR INSPECTION REPORTProperty: ______________________ Address: ________________________Apt. No._______________________ No. of Rooms: ____________________Report Submitted By: ______________________ Date:_________________

Item Character and Condition Needs

Estimated Expense Involved

Vestibule1. Door2. Hinges3. Lock4. Safety Chain5. Doorplates6. Transom7. Floor (Carpeting)8. Walls9. Ceiling10. Light Fixtures & Switches11. Draperies/BlindsCoat Closet12. Door13. Floor14. Interior Walls15. Ceiling16. Shelves, Rods, HooksLiving Room17. Floor (Carpeting)18. Baseboards19. Walls20. Ceiling21. Windows22. Doors23. Light Fixtures & Switches24. Electric Outlets25. Draperies/Blinds


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Dining Room26. Floor (Carpeting)27. Baseboards28. Walls29. Ceiling30. Windows31. Doors32. Light Fixtures & Switches33. Electric Outlets34. Draperies/Blinds35. Buffets36. Wainscot or Chair RailKitchen37. Doors38. Transoms39. Locks40. Floor41. Baseboards42. Walls43. Ceiling44. Light Fixtures & Switches45. Electric Outlets46. Dishwasher47. Range48. Sink49. Cabinets50. Refrigerator51. Pantry52. Doorbell53. Ventilating Hood54. DisposalFirst Bedroom55. Floor (Carpeting)56. Baseboards57. Walls58. Ceiling

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59. Windows60. Doors61. Light Fixtures & Switches62. Electric Outlets63. Draperies/Blinds64. ClosetsSecond Bedroom65. Floor (Carpeting)66. Baseboards67. Walls68. Ceiling69. Windows70. Doors71. Light Fixtures & Switches72. Electric Outlets73. Draperies/Blinds74. ClosetsThird Bedroom75. Floor (Carpeting)76. Baseboards77. Walls78. Ceiling79. Windows80. Doors81. Light Fixtures & Switches82. Electric Outlets83. Draperies/Blinds84. ClosetsHousekeeping Room85. Floor (Carpeting)86. Baseboards87. Walls88. Ceiling89. Windows90. Doors91. Light Fixtures & Switches


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92. Electric Outlets93. Draperies/Blinds94. ClosetsFirst Bathroom95. Doors96. Floor97. Walls98. Ceiling99. Window100. Tub (Glass Door)101. Shower102. Shower Curtain or Door103. Lavatory104. Toilet Bowl105. Flush Tank106. Faucets107. Light Fixtures & Switches108. Electric Outlets109. Exhaust Fan110. Towel Racks, etc.111. CabinetsSecond Bathroom112. Doors113. Floor114. Walls115. Ceiling116. Window117. Tub (Glass Door)118. Shower119. Shower Curtain or Door120. Lavatory121. Toilet Bowl122. Flush Tank123. Faucets124. Light Fixtures & Switches125. Electric Outlets

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126. Exhaust Fan127. Towel Racks, etc.128. CabinetsWindows & Shades129. Frames130. Sashes131. Sills132. Stops133. Weights134. Locks135. Glass136. Weather Stripping137. Shades138. Blinds139. Drapery FixturesLinen Closet140. Door141. Floor142. Ceiling143. Walls144. Shelves145. Drawers146. Electrical LightsEnvironmental Controls147. Heating Equipment148. Air Conditioning Unit(s)

ADDITIONAL NOTES:


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WEBSITES f NATIONAL ASSOCIATION OF REALTORS®

www.NAR.realtor

f NATIONAL ASSOCIATION OF REALTORS RESEARCH www.Realtor.org/research-and-statistics

f REALTORS PROPERTY RESOURCE® www.narrpr.com

f RSPS CERTIFICATION https://www.nar.realtor/education/designations-and-certifications/rsps-certification

f SFR DESIGNATION https://www.nar.realtor/education/designations-and-certifications/sfr

f PSA CERTIFICATION https://www.nar.realtor/education/designations-and-certifications/psa

f INSTITUTE OF REAL ESTATE MANAGEMENT (IREM) www.irem.org

f FEDERAL EMERGENCY MANAGEMENT ADMINISTRATION (FEMA) www.fema.org

f FINRA’S BROKERCHECK http://brokercheck.finra.org

f FLOOD INSURANCE PROGRAM www.fema.gov/national-flood-insurance-program

f FLOOD INSURANCE REFORM ACT 2012

[ www.fema.gov/national-flood-insurance-program/flood-insurance-reform-act-2012Flood Maps

[ www.fema.gov/floodplain-management/flood-insurance-rate-map-firm

f FLOOD SMART www.floodsmart.gov

f NATIONAL ASSOCIATION OF RESIDENTIAL PROPERTY MANAGERS (NARPM) www.narpm.org.

f NATIONAL MULTIFAMILY HOUSING COUNCIL www.nmhc.org.


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GOVERNMENT SITES f https://www.irs.gov/pub/irs-pdf/p925.pdf

f https://www.irs.gov/pub/irs-pdf/p946.pdf

f www.ipx1031.com/1031-tax-reform-updates/

f www.irs.gov/taxtopics/tc409

f www.irs.gov/individuals/international-taxpayers/firpta-withholding

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GLOSSARYABSORPTION RATE: the amount of space or units leased within a market or submarket over a given period, usually one year.

ADA: the Americans with Disabilities Act mandates equal access for persons with disabilities to employment, public services, public accommodations, telecommunications and other provisions.

AIR QUESTION MODEL: a job aid for preparing and conducting meetings with prospective clients. A=Ask, I=Inform, R=Respond

AUTOMATED VALUATION MODELS: online databases that provide market value estimates by matching prices or recently sold similar properties.

CAP RATE: net operating income divided by purchase price equals the cap rate. Provide a quick determination of value.

CAPITAL GAINS: the difference between the adjusted basis of an asset and the amount the seller realized from the sale.

CASH ON CASH: measures the investor’s desired rate of return on an initial investment. Compares the equity invested in a property with the cash flow, before or after taxes, from one year. Also known as ConC.

CASH FLOW: the amount of cash available after all expenses and debts have been paid.

CASUALTY INSURANCE: covers claims against the property owner for accidental injuries or damages.

C CORPORATION: an independent legal entity owned by the shareholders and treated as a separate entity for tax purposes. The corporation, not the individual shareholders that own it, is held legally liable for actions and debts incurred.

DEBT-TO-INCOME RATIOS: front-end ratios are what the borrower pays towards a mortgage payment, back-end ratios are the total monthly debt commitments.

DEPRECIATION: also known as cost recovery. This is an IRS deduction to reduce tax bill. Depreciation period for residential real estate is 27.5 years.

DEPRECIATION RECAPTURE: the amount of tax benefit that has accumulated over the years of property ownership that is taxed at a rate of 25% upon sale of the property.


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DISPARATE IMPACT: when policies, practices, rules, or other systems that appear to be neutral result in a disproportionate impact on a protected group.

DISPARATE TREATMENT: intentional discrimination, such as refusing to rent to someone based on their gender or sexual orientation.

EFFECTIVE INTEREST RATES: calculated by adding prepaid interest and/or penalties to the total interest.

FATCA: Foreign Account Tax Compliance Act

FIRPTA: Foreign Investment in Real Property Tax Act

GENERAL PARTNERSHIP: similar to sole proprietorship, each individual owner is liable for income taxes on his or her share of the business income.

GROSS RENT MULTIPLIER: quick method to determine value of an investment property compared to others on the market.

GROSS POTENTIAL INCOME: the maximum market rent that can be derived from 100% occupancy and collection of rents over the course of a financial period, normally one year.

HIGHEST AND BEST USE: the reasonable and probable use of a property that will support the highest present value of the land.

INVESTMENT VALUE: a subjective valuation of a property based on the investor’s criteria, such as rate of return, cash flow, or tax considerations.

JOBS ACT: Jumpstart Our Business Startups

LIABILITY INSURANCE: protects against claims that a property owner’s negligence or inappropriate action resulted in bodily injury or property damage.

LIMITED PARTNERSHIP: structured around a general partner who has management control and is responsible for all business actions and debts and limited partners who contribute capital and have little involvement in day-to-day operations.

LIMITED LIABILITY COMPANY (LLC): can have multiple owners (called members) which can be individuals, partnerships, trusts, foreign investors, or corporations, each owning a different percentage. Helps owners avoid paying both corporate and personal taxes.

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LOAN-TO-VALUE RATIOS: express the relationship between the loan and the appraised value. Calculated by dividing the loan amount by the property value.

LOAN CONSTANT: the percentage of the loan amount that is required annually to make the annual principal and interest payments on the loan.

MARKET VALUE: the price the property would command in the open, competitive market.

MATERIAL PARTICIPATION: involvement in the operations of an activity throughout the year on a regular, continuous, and substantial basis.

MULTIFAMILY HOUSING: properties having four or fewer units.

NEGATIVE LEVERAGE: when the cost of a debt on a property is higher than the rate of return the property can produce free and clear of debt.

NEUTRAL LEVERAGE: when the free-and-clear rate of return equals the loan constant.

PASSIVE INCOME: earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved.

POSITIVE LEVERAGE: when the cost of debt on a property is lower than the rate of return the property can produce free and clear of debt.

PROPERTY (HAZARD) INSURANCE: coverage for direct physical loss to the property from any event that is not specifically excluded or limited.

REAL ESTATE INVESTMENT TRUSTS (REIT): corporations that own and may operate income-producing real estate. Two types: equity and hybrid.

REALTORS PROPERTY RESOURCE: an exclusive website for realtors created by NAR, includes the Realtor Valuation Model (RVM).

REPLACEMENT VALUE: reflects the cost at current prices to replace or restore a property to its pre-existing condition and appearance.

RETURN ON INVESTMENT: basic calculation is the net gain (gain less expenses) divided by the cost of the investment.

S-CORPORATION: owners pay personal income tax on corporate profits; corporation reports those taxes under its own corporate tax returns. Requires scheduled director and shareholder meetings, stock transfers, records maintenance. Excess profits can be distributed as dividends.


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SOLE PROPRIETORSHIP: business owned and run by an individual or spouses.

UMBRELLA INSURANCE: overarching liability coverage that protects other assets, covers liability claims from all policies underneath it.

1031 EXCHANGE: complex transactions that defer taxes on capital gains.

Documents

Student Manual REAL ESTATE · 2021. 2. 26. · TEST YOUR INVESTMENT REAL ESTATE IQ Test your knowledge of investment real estate. Mark the best answer. 1. The depreciation period