Investing In Rental Real Estate
Basic Terms with Rentals
GROSS INCOME - This is the total rent collected before expenses are deducted. Gross Income is also known as Annual Income, Gross Rent, and Income for accounting purposes.
NET INCOME - This is the total rent collected with ALL expenses subtracted from Gross Income. It is also known as Taxable Income. It is also known as Profit.
The mathematics associated with investing into rental real estate involves several different mathematical equations. Luckily, the simple use of basic math is all that is required. The hard part is figuring out which equation is to figure out first.
The main aspect to remember is that we have to calculate the true net income provided by the subject property. Obviously, there will be a preponderance of subtraction calculations in the beginning.
Appraisal of Rental and Commercial Property
The purpose of purchasing rental property is to provide NET income to the owner. The Appraisal Method that utilizes Net Income in determining value is called the Income Approach.
The Income Approach emphasizes value based on the NET income the rental or business will produce. The Income Approach is also known as CAPITALIZATION.
Income Approach - This appraisal method is utilized in determining the income producing ability of the subject property. The Income (Capitalization) Approach is used with commercial property and rentals.
Method - This appraisal method considers the future benefits from the income producing power of the property or business. It bases the future income power on the present NET income and gives an estimate of the amount of RETURN ON INVESTMENT based on percentage desired by the buyer. This is known as the capitalization rate.
Value - The value of the property is equal to its capitalization rate. The capitalization or Cap Rate is a percentage chosen by the appraiser or buyer in determining the overall value of the rental or business.
Capitalization Rate Formula: PROPERTY VALUE = NET INCOME divided by the CAPITALIZATION RATE.
Capitalization (CAP) Rate
This is an determination of the quality and the quantity of the net income expressed as a net interest rate of return. The buyer would choose a capitalization (interest) rate that they desire to earn on their invested money. The capitalization rate is the quality and the quantity of the net income from the investment property. This will be a number that shows how long and how good the income will be.
Quality of the Income - When we say the quality of the income, we are really talking about interest or return on the investment. In other words how much net income can be expected to be received by the buyer/investor? The appraiser would separate the income into two different categories called the safe rate and the risk rate.
Safe Rate + Risk Rate - This is considering the use of the buyer's own money in the bank or the amount that would be invested in real estate.
Safe Rate - The safe rate is the return that the investor can safely earn on their money at a bank. The account is insured and earning a rate of interest without any risk.
Additional Benefits - The "Quality of Income" does not take into consideration appreciation in value of the property. It does not take into consideration the tax deductions the buyer will be able to take each year.
This takes into consideration how long the income stream will last. We have to think in terms of how long the income will be received AND that the investor (buyer) will get all their money back. If the investor invests $150,000 into an investment, the investor wants the income and the $150,000 back at some point in time.
Recapture Rate - This is the amount of interest you want to earn on your money plus you want to receive all your money back. The investor must determine how long the income will last and how long it will take to recapture their investment by the time the income producing power is over.
Recapture Investment - This is the same theory as depreciation; the expected economic life of the investment property. We first have to determine the length of time the economic life is. Then we place 1 over that figure and we have the economic life fraction per year (1/E.L.).
Note - The "quality and quantity of income" does NOT take into consideration appreciation in value of the property. It does not take into consideration the tax deductions the buyer will be able to take each year.
A man is interested in buying an apartment building. It has 9 four bedroom units which rent for $425 a month, 16 three bedroom units which rent for $400 per month, and 18 two bedroom units which rent of $375 a month. Assuming that there is no vacancy factor, what is the annual gross income of the property?
The analysis of alternative conclusions to arrive at a final value estimate is referred to as:
A) an addenda
B) an analysis of date
D) the market approach
Using the income approach to valuation, which of the following is not a proper deduction from effective gross income to determine net income?
A) reserve for replacement
B) maintenance expense
C) interest payments on loans
D) management costs
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