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Use a Cost Segregation Study to Improve Your Bottom Line

The IRS gives a tax break called depreciation to commercial property owners. According to the rules, an apartment building will be worthless after 27.5 years of ownership. That means a building depreciates about 1/27, or 3.64% per year. Therefore, each year the owner is allowed to deduct 3.64% of the building’s value from the property’s income before computing the tax liability.

Non-residential commercial property is depreciated over 39 years, so each year 2.56% of its value can be deducted as an expense.

It must be noted that land does not depreciate, at least according to the IRS. Many property owners use an 80/20 rule to value the building versus the land. In the case of an $800,000 purchase, the building(s) would be valued at 80% of that or $640,000. The land would therefore be worth $160,000. Starting at this point, an apartment owner could deduct $640,000 x 3.64%, or $23,296 each year. For an owner in the 28% tax bracket, that’s a real savings of $6,522.88 a year.

However, through a formal procedure known as a Cost Segregation Study (CSS), much greater savings can be realized. The IRS allows you to speed up depreciation on certain elements that make up the property. For instance, many land improvements such as parking lots, fences, sidewalks, sewer lines, etc. can be written off over a 15-year period. Items classified as personal property can be depreciated over a 5- or 7-year period. Examples include carpets, appliances, window coverings, countertops, cabinets and more.

From the perspective of saving on taxes, the savvy commercial property owner will label as much property in the 5-year category as possible. If $100,000 of personal property was so designated, for each of 5 years the owner could take $20,000 as depreciation expense, lowering his taxable income. If that much property had not been segregated out, it would have depreciated over 27.5 years, resulting in only $3,636 saved per year. Over the 5 year period, just this one category would save over $81,000 in taxable income.

Let me give you a real life example. We recently purchased an 18-unit apartment property for $800,000. As noted above, if we just took 80% of this as value of the buildings and depreciated it over 27.5 years, we could expense just over $23,000 a year.

Now let’s see what happens when we do a Cost Segregation Study. To be in compliance, you need to have a third party perform the CSS. We picked a local engineering firm that specializes in this process.

They went into one unit of each type: studio, one bedroom and two bedroom. They measured the carpet, the countertop space, the cabinets, floor molding, window covers, electrical outlet covers, lights, interior doors and shelves, etc. Outside they inventoried the exterior lights, parking lot, fencing, retaining walls, planters, handrails, sidewalks and more. They ended up with almost 100 items put into the 5-, 7- or 15-year categories.

Here are the totals in each category:

5-Year: $86,775

7-Year: $66,543

15-year: $66,369

27.5-year: $511,916

Taking the first number, you can take 1/5 of the $86,775 or $17,355 as an expense every year for the first 5 years you own the building. Similarly, you can take 1/7 of the $66,543 or $9,506 each year for 7 years and 1/15 of the $66,369 or $4,425 per year for 15 years. And you also get 1/27 of $522,916 or $18,615 per year for 27.5 years.

So in each of the first 5 years you can deduct $49,901 from the property’s income before figuring your taxes. If you have a loan and are deducting the interest payments, that’s also deductible, along with your usual operating expenses. Thanks to the great power of the CSS, it’s actually possible to have a property throw off great cash flow and still show a loss on your investors’ K-1s. So they can have an income stream as well as a deduction on their personal taxes.

When you sell the property, the total amount you claimed as depreciation will be taxed (currently) at 25%. Still, you’ve saved way more than that upfront, so it’s still a great thing to do. And if you take advantage of a 1031 exchange when you sell, you can push that tax even further into the future.

Be sure to have a good conversation with your accountant before you get into this. It can really save you a lot of money over the long haul, but it’s best to leave the details to the experts.

DFW vs. Las Vegas for Apartment Investors

In response to an inquiry regarding the prospects of these two markets, I put together the following short clip. In it I pulled data from the Bureau of Labor Statistics as well as subscription services comparing DFW and Las Vegas for job growth over the past decade, and projections of population growth through 2015.

 

Buying an Austin Apartment at 8 Cap vs. 9 Cap

I’ve been studying a property in Austin, Texas lately. It’s an 84-unit apartment that was rehabbed “down to the studs” in 2005. The owner recently installed artificial bermuda grass to reduce maintenance and improve appearances. There is also an outside video surveillance system that is accessible via a password-protected web page.

The asking price is $3.7 million, which given the NOI (see Jargon Explained page) of $295,000 results in a cap rate of 8%. This means that if you had no debt on the property, you would produce an 8% annual return. With a 25% down payment and $185,000 in acquisition and closing costs, the cash-on-cash return would be 10.2%. Giving the investors 75% of the cash flow, they would expect to receive about 7.65% return on their investment. Not bad, but I’m looking to get them at least an 8% return before their 75% share of the back end profits. 

Yesterday I had a long talk with John Dennis, a property manager with over 30 years experience in the Austin market (http://www.jldpropertiesinc.com/). One of his services is every six months taking the NOI of the property and combining it with the current Austin cap rate to give a current value. I asked him what he was quoting as the current cap rate in Austin and he said it was 9%. 

So, if we use that figure to calculate the value, we lower it to $3,275,000. At that price, we could put down 30% and still raise the cash-on-cash return to 12.1%, giving the investors a return of better than 9%. This, combined with a current vacancy of only one unit, and the fact that Austin ranks number 1 in job growth among large cities for last year, makes this a very attractive investment. We’ll have to see if the current owners are interested in selling at this price.

How to Pool Investor Funds Without Running Afoul of the SEC

Since commercial real estate often requires a larger down payment than most individuals can come up with, investors usually pool their funds in order to raise sufficient cash to cover the down payment and other acquisition costs. Doing this incorrectly can lead to huge fines from the SEC, not to mention potential liability from lawsuits.

Anytime money is pooled with the expectation of making a profit, a security is created. After the Great Depression, the Securities Acts of 1933 and 1934 were enacted to protect the public against fraudulent securities. It was at this time that the Securities and Exchange Commission (SEC) was created to oversee the implementation of these laws.

The person who pools investor funds creates a syndication and is known as a syndicator or a promoter. This person must be very careful to follow all the SEC regulations because the fines for violations are very stiff. The laws are not difficult to understand and follow, but claiming a lack of knowledge about them will not be a suitable defense.

The syndicator must ensure that all the potential investors are given enough financial and other important information regarding the security being offered for sale so that they can make an informed decision about the suitability of this particular deal.

In 1946 the Supreme Court heard a case called SEC v WJ Howey. The Howey Company sold land in citrus groves in Florida and also offered to plant, harvest and sell the fruit for the new landowners, who were mostly out of state people looking for a passive investment. When things went bad, it ended up going through the courts, and resulted in what became known as the Howey Test. This test determines what qualifies as a security and has four main points, all of which must be true.
1. There must be an investment of money, and
2. There must be a common enterprise, and
3. There must be the expectation of profit, and
4. This will be managed soley through the efforts of the promoter.

If all four of these are true, a security has been created which falls under the SEC guidelines. The most critical part of the law for our purposes is called Regulation D, usually just called Reg D. Reg D describes a private offering made only to accredited or sophisticated investors. When this is done correctly, it allows full exemption from registering the security with the federal SEC. Since registration can cost upwards of $250,000, avoiding it is a worthy goal for most of us.
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Buy Apartments Now Says Marcus & Millichap Expert

Hessam Nadji, managing director of research at real estate brokerage Marcus & Millichap, believes that now is a great time to invest in apartments, especially older ones. According to Nadji, during a recession people often choose older units with fewer amenities.

The echo boomer generation is just beginning to move out on their own, and they often start out renting in this type of apartment. Even though their unemployment rate is currently high, they should be the first ones hired when the economy starts to recover, says Reis Research Director Victor Calanog.

Nadji urges investors to buy while prices and interest rates are low. “There is a good chance that if an investor waits for a recovery to materialize, they’ll see prices go up again,” Nadji says.

To learn more, see the article at Realtor Interactive Magazine.