How to Put a Price on Income Property
QUESTION: I own a 10-unit apartment building that I want to sell because I am tired of managing tenants. However, I have no idea how much to ask for my property. What is the best way to determine a fair price?
ANSWER: Consult several local real estate agents who specialize in selling apartment buildings in your area. Ask them to evaluate your building and to give you an estimate of its fair market value.
They should use the income capitalization method of valuation. That means the net operating income is capitalized. The local “cap rate” is determined from recent sales prices of similar nearby income properties.
Make certain each agent carefully documents how the market value was arrived at. Disregard any agent who uses the “gross multiplier” method. This technique multiplies the building’s gross income by a multiplier, such as seven or eight, to arrive at its valuation. The pitfall of using this method is it does not consider the property’s operating expenses.
A gross multiplier should only be used to determine if a building might be a good buy. For example, I once bought a building with a low gross multiplier of four. Although it was a run-down property I knew with such a low gross multiplier it was hard to go wrong.
Recreational Property Not for Investment
Q: I am considering buying property at a year-round resort area where there is winter skiing and summer boating and fishing. This is a new project offering single, double and triple homes. As I will only use the place a few weeks in the summer and winter, I plan to have the developer manage it for rental to tenants when I am not there. Which type of home would be the best investment?
A: Never, never, never buy recreational property as an investment. Consider it to be only vacation property. Please don’t invest money you can’t afford to lose.
That is what often happens in resort areas where the market for second homes is frequently very distressed. If you are counting on the rental income to pay the second home’s expenses, you may be in for a surprise. As for the most desirable property, single-family houses are usually the best.
What Investments Best for Potential Profits?
Q: In your opinion, what type of real estate offers the best real estate profit opportunities? Do you think rural land has the best potential? What about city houses? Or are apartments better?
A: Although it is possible to earn large real estate profits with virtually any type of property, in my opinion, run-down, fixer-upper single-family houses offer the best opportunities.
To be profitable, such properties must be purchased substantially below the market value of comparable houses in good condition.
They must only need cosmetic work, such as painting, cleaning, landscaping and minor renovation. Avoid houses that need major rehabilitation, such as foundation repairs and costly structural reconstruction.
By upgrading a property with profitable renovation, you will be forcing its market value up if you make the right improvements. For example, if you spend $5,000 adding a second bathroom to a one-bathroom house, don’t be surprised if you increase its market value by at least $10,000.
However, spending $20,000 for a new swimming pool will rarely add even half its cost to the home’s market value. I use these examples to show the importance of making the most profitable improvements to upgrade fix-up houses.
What Is Depreciation on Income Property?
Q: You often mention depreciation as an advantage of owning income property. Please clarify exactly what is depreciation and how does it benefit property investors?
A: Depreciation is a non-cash estimated income tax deduction for wear, tear and obsolescence of depreciable property such as apartments, offices, rental houses and warehouses. But land value and personal residences are not depreciable.
To illustrate, suppose you buy a $150,000 rental house to which you allocate $100,000 for the value of the depreciable structure. Using the current 27.5-year straight-line residential rental depreciation useful life, you can deduct $3,680 annually for the next 27.5 years. Commercial buildings are depreciated over 31.5 years. The net result is each year you would shelter $3,680 of otherwise taxable income, such as rent earned by the property, from taxation.
No Special Tax Benefits in Owning Vacant Land
Q: I am considering buying vacant land as an investment. What income tax advantages will I receive?
A: Sorry, there are no special tax benefits for the purchase of vacant land. If the property produces income, such as pasture rental, the income as well as mortgage interest, property taxes and other operating expenses are reportable on Schedule E of your income tax return.
Some Rules of Thumb on Income Property
Q: Are there any rules of thumb as to what maximum percentage of the income from apartment or commercial property should go to pay the operating expenses and mortgage payments? Also, what is a good vacancy allowance to use?
A: The general rule is that mortgage payments, including principal and interest, should not exceed 50% of gross income. The operating expenses should not exceed 40% to 45% of gross rental income. That leaves a 5% to 10% vacancy and credit loss allowance. But in towns with high vacancy rates, such an allowance may not be high enough.
Depreciation Can Be Taken on Vacant Rental
Q: I own a rental house which I have had trouble renting because the rental market is very soft in my area. It was vacant four months in 1989. Will I still be able to depreciate it on my tax returns?
A: Yes. In fact, Uncle Sam requires you to depreciate real estate held for investment or use in a trade or business.
A rental house qualifies. Of course, the land value is not depreciable, but the building must be depreciated.
Single Use Investment Property Can Be Risky
Q: I have a considerable amount of money to invest in real estate. A realty broker showed me a listing on a big building which is leased to what I consider a second-rate discount store chain with a poor financial statement. But the property is a steal with a 12% return on my cash investment, net, net, net. What do you think of this deal?
A: Be very careful. It sounds like you have encountered a single-use investment property. What would happen if the discount store chain goes bankrupt? Can you find another tenant easily or will the store be vacant for a long term?
That 12% return on your investment is rather high. Perhaps the seller knows something you don’t know. Another factor to consider is the property’s potential for future increases in market value. Considering the high risk, if the property doesn’t have much prospect for increased value, perhaps you should keep looking for a better investment.
Tax Deduction Worth More Now Than Later
Q: My husband and I sold an apartment building in 1989 on which we have about $65,000 net profit. We carried back the mortgage for the buyers.
Our tax man says we can either report our sale profit in future years as we receive payments from the buyer or we can “unelect” the installment sale benefit and report all our profit on our 1989 tax returns. He advises doing so since we have substantial offsetting losses from our other investment properties. What do you advise?
A: I agree with your tax adviser to use your tax losses now to offset your $65,000 profit. Then you will only have to pay tax on the interest, not the principal payments you receive in future tax years.
A few years ago, I would not have given the same advice. But Congress has become so irrational by changing the tax laws every year that it is impossible to guarantee that you can use installment sale benefits in future tax years. In the 1986 Tax Reform Act, real estate investors were so badly treated they can no longer count on future income tax breaks. For this reason, a tax deduction today is worth more than one in the future.
