ARE YOU A CASH FLOW OR EQUITY INVESTOR?
There are three types of real estate investors. One is the cash flow investor. Another is the appreciation/equity investor. Then there is one considered a combination of both. The cash flow investor usually selects to purchase an investment of average condition that is not in the best area. But they decide to buy the asset to hold because the pre-tax cash flow (NOI minus Debt Service) is within the parameters of their investment goals. The appreciation/equity investor purchases an ‘A’ quality building usually in a fantastic location (near the beach or suburbs). Their goal usually is to see a specific return on equity percentage which is a primary justification for retaining the asset over a certain period of time.
A cash flow investor needs the income to supplement their retirement or other sources of income for various reasons such as saving for child or grandchild’s education or to off-set a spouse’s medical expenses. They use tactics like forced appreciation as part of their strategy to augment their bottom line by raising rents and/or lowering expenses. There are some cash flow investors who purchase a property all cash so there is no debt service, which will be reflected in a higher annual cash flow.
An example would be a property purchased for $1,000,000.00 all cash bringing in $100,000.00 in SGI with a 3% vacancy factor and a 35% expense factor. The NOI and Cashflow would be exactly $63,050.00. One would think the return would be higher than if the property were leveraged. Think again. Due to the fact that the purchase price and initial equity (all cash) is the same, the return on your investment will only be 4.21%. But the goal for this investor is increased cash flow not the return on investment. After-tax cash flow will include some other factors that include tax bracket percentage and depreciation deductions.
Cash flow percentages are calculated by first obtaining the GRM (sales price divided by SGI – followed by dividing the sales price by the GRM to obtain a percentage of value based on the gross revenue. So let’s say that property purchased for $1,000,000.00 had an increase in SGI to $125,000 after seven years. With a GRM of 8, the percentage of value would be 12.5%. Using expense/vacancy factors equating to 38%, the cash flow percentage would be 7.75% (38% from 100%=62% divided by the value percentage 12.5).
Using leverage when purchasing the same property will bring about less cash flow but an increased return on investment. This is the reason many investors choose to leverage by using the bank’s money along with their own to increase their return as a percentage of the sales price. If this investor put 50% down and had a first trust deed of $500,000, their initial or first year cash flow would be lower at $39,815.60; however, their return on equity would almost double at 7.96%
There does tend to be bump in the road for these types of investors especially in states like California where there is high value appreciation. Their goal is to avoid a diminishing return on equity. In the scenario above, the return on equity was 7.96%. But say for instance the $1,000,000.00 property is now worth $1,200,000.00 with a cash flow of $55,578.00 The return on equity diminishes by 3/10th of a percent to 7.63% even with the reduced LTV (39.33 %).
Some investors do not like to see their return diminish or continue to do as would probably be the case in this example if the cash and appreciation continue to increase. Since the LTV is less than 50% the investor can sell the property for $1,200,000 and exchange into property valued at $2,400.000 with $175,000 SGI and with $600,000 down the return on equity would increase by over 2.5% to 10.5%. Another advantage to selling would be a reset of the depreciation schedule where the tax benefits also diminish at about the 7-9 year mark. Be mindful that the tax changes proposed by President Biden could drastically change things after this year in terms of capital gains, exchanges, and depreciation bonuses.
Our disclaimer as always is that investors should seek the advice of a tax professional or CPA for any tax-related questions or counsel. If you would like to have a free annual return on investment assessment performed for your property or are looking to place your property market or looking to pick up another investment, feel free to contact our office.
M. A. Williams, Broker/Owner