A subscriber asks: Real estate investing in an uncertain world

Chris:

What would you recommend about rental real estate in Minneapolis (or any similar city) at this time? I have a cousin there who just retired. Pointed him to your podcasts and we both listen then discuss your advice by email.

He wants me to go in on 2 or 3 rental houses in Minneapolis area. He used to own a barbershop and the small building it was in. In recent years the neighborhood got [worse]. Barbershops are one of the few businesses that do well in “diversity” neighborhoods, so he was offered a decent price to sell 18 months ago. He got enough for substantial downs on 2 or 3 modest rentals, but needs more for working capital.

Wants me to invest 50-50 with him. (I’d be totally passive investor with separate LLC on each house.)

He says house prices in Minneapolis suburbs are dropping fast — due to recent “events” there. Is now a good time to buy? Or wait? If wait, then wait until what? What will be the signal to buy in cities like that? After the election, maybe?

Thank you.

P

It’s all about the numbers

Our purchase/sale decisions regarding rental real estate should be very straightforward. Essentially, if the numbers make sense then we can tune out all the other distractions via friends and family, politics, and the media. By focusing on the numbers, our investment decisions become much easier and less stressful to make. By using the numbers, you won’t have to do a whole lot of guessing when trying to spot opportunities.

So, which numbers matter? Although residential housing differs from all other forms of real estate, because of the emotional factor, we can still use basic commercial real estate math to determine whether or not a prospective purchase makes sense.

Here are two formulas I use all the time. They are easy to calculate, since their spreadsheets are freely available on the internet:

Capitalization Rate:
The capitalization rate, also just called the cap rate, is used by many investors to quickly determine what a property is worth, or to measure the performance of a property they already own. The advantage of the cap rate is that it takes into account vacancy, credit losses, other income, and operating expenses. It also doesn’t require a multi-period projection of cash flows like the internal rate of return (IRR). The disadvantages of the cap rate are that 1) It only looks at the first year of operating data, 2) It doesn’t take into account debt financing.

Example: We can determine the cap rate of a house

Purchase price and upfront costs to get rented: $250,000
Gross annual rent (going market rate): $1,650 x 12 = $19,800
Vacancy rate: 5%
Effective gross rent = $18,810
Annual taxes and insurance = $3,800
Annual operating expenses = $1,000
Annual net rental (operating)  income = $14,010
Cap rate = 5.6%

If the historic cap rate for this property and surrounding neighborhood is consistent with what you would derive at the current purchase price then I would say the investment makes sense. On the other hand, if the historic cap rates were say, 7.5%, then I would perhaps try to get a better price or look elsewhere.

Personally, I look for the best neighborhood in which I can achieve a cap rate of 7.5% on my prospective purchases, including up front costs for any rehab work. Any rehab work on your end has the potential to save a lot of money, and since you will be buying to hold, you will be able to “season” your title to get the best returns, as opposed to flipping. In this mature market it is incumbent to find the best value and cheapest financing. Though the cap rate does not take financing into account, the next formula (IRR) does as it only includes the up front money you spend, including down-payment.

Internal Rate of Return (IRR):
The internal rate of return is the discount rate that is used in project analysis, capital budgeting, or real estate investing over a defined period that makes the net present value (NPV) of future cash flows exactly zero. In the IRR calculation, we set the net present value equal to zero then we solve for the discount rate. Remember that the discount rate is the rate of return we could expect from alternative projects; therefore, when comparing similar projects, it is generally more desirable to undertake the project with the higher IRR given other common parameters. Thus, the higher a rental property’s IRR, the more attractive it will be as an investment, all other things being equal.

We can also think of the IRR as the expected compound rate of return of a project. While the cash flows may vary, you only have one IRR per property, because here we are calculating a discount rate that is the same for each year.

  • IRR is the annual rate of growth an investment is expected to generate over the period in question.
  • IRR is calculated using the same concept as NPV, except it sets the NPV equal to zero.
  • IRR is ideal for analyzing a rough annual growth rate from any income-generating asset or project, and a rental property fits here.

Here is a link to an IRR calculator using a five-year time horizon (the industry standard)

Internal Rate of Return (IRR) Calculator

Keep in mind that the “year 5” cash flow includes your net proceeds from the theoretical sale. The IRR takes your financing into account, because the investor will calculate the return based on the out-of-pocket cash as his initial investment. The disposition proceeds are net of any loan payoff. The higher your loan-to-value, or the less cash up front as your initial investment, the higher your IRR, as long as prices and rents remain stable or move higher over time.

Example 1: A rental purchase for $250k with a sale at the end of year-5 for $300k. (Assume all cash and no loan)

Purchase Price: $250,000
Annual net rental income cash flows:
Year 1: $15,000,
Year 2: $16,000,
Year 3: $17,000,
Year 4: $18,000,
Year 5: $19,000+$300,000 (disposition)
IRR: 10.0%

Example 2: (This time we assume a 20% down-payment for the $250,000 house)
Initial investment: $50,000
Annual net rental income cash flows (while your mortgage P&I is deducted from your annual net rental income, the rent you receive that is devoted to your amortized principal pay-down is considered income for tax purposes and reduces the loan balance. Thus, it will be included in your IRR calculation at the end of year 5, when you sell. Your escrow component is for your taxes and insurance and is an expense whether you finance or not.):
Year 1: $2,000
Year 2: $3,000
Year 3: $4,000
Year 4: $5,000
Year 5: $6,000 + $120,000 proceeds*
IRR = 24.4%
* proceeds of $120,000 is derived by the sale at $300,000 less the mortgage balance of $180,000 ($200,ooo initial loan balance minus $20,000 principal paydown)

These are very reasonable scenarios for this rental property and if a purchase is handled appropriately and you can build up equity through your labors, these IRRs could be even higher.

For those with the experience to spot bargains and value in real estate, we can achieve rates of return that are superior to any other forms of investment, which is why I tend to recommend rental investing for the average person. When you throw in all the extra tax benefits of owning rentals, I think the choice is clear.

Look for IRRs that offer a compelling reason to buy. Rental investing does come with risks and opportunity costs, so make sure you pay yourself enough money to make it worth your while. Any rental investment with an all-cash IRR in the single digits, especially assuming appreciation, should be avoided. As the above example illustrates; if you can obtain superior financing, you have the potential for a rate of return or IRR that rises a lot.

Advice for those using partners in real estate

As a rule of thumb, whenever I use partners, I establish title via a multi-member LLC domiciled in the state where the properties are located. These LLCs are constructed differently than single-member LLCs (or disregarded entities) and receive their own TIN for federal and state income tax purposes. Single-member LLCs use the principal member’s SS# and all the income/losses pass through to the individual.

Since you plan on investing with your cousin, I would recommend placing all three properties into one multi-member LLC, since your percentage of ownership will be the same.  This makes even more sense if you employ leverage and have little money out of pocket up front. Generally speaking, multi-member LLCs are much more difficult to pierce from lawsuits against a partner than single member LLCs, and are thus afforded more protection. Please consult an attorney in Minnesota who is familiar with real estate when you establish your LLC. You want to make sure you set it up correctly. Once this is achieved, there is little need to use an attorney on an ongoing basis and you can directly use your title company to consummate your transactions.

If you establish an LLC for each property, you will have to file a federal and state tax return for each LLC, as well as file an annual report for each LLC with the state. Depending on your circumstances, this could cost you an additional couple thousand dollars a year. I would only establish another multi-member LLC if titling interest is different.

Here is an idea for you and your cousin to think about. Perhaps you could establish a 50%/50% interest in the LLC, but the LLC operating agreement could stipulate that the LLC pays your cousin an ongoing management fee as consideration for his hands-on management.

I hope this helps.